Is Germany resisting the "Race to the Bottom" in Europe?

Germany, and Angela Merkel the German Chancellor, clearly lost the battle over the bailout package and the European Central Bank’s move to buy bonds. (See “Where’s the Leadership in Europe, http://seekingalpha.com/article/204702-where-s-the-leadership-in-europe.)


Is Germany and Merkel now trying to stage a “comeback”?

There are certainly signs that Berlin is attempting to re-asset itself in the moves it made on short selling and other complex bond transactions. Furthermore, Merkel is asserting herself into the financial reform debate. At a meeting of the G-20 Thursday: “German Chancellor Angela Merkel said Thursday she will push her Group of 20 counterparts to accelerate steps to tighten political control over financial markets and add new taxes on banks. Ms. Merkel also said she will push G20 leaders to coordinate their strategies as they look to withdraw stimulus measures enacted during the financial crisis.“ (http://online.wsj.com/article/SB10001424052748703559004575256051573932296.html?mod=WSJ_hps_MIDDLEThirdNews.)

Politically, in the German state itself, Merkel needs to exert herself to defend Germany and Germany’s support of a sound fiscal and monetary stance within the European Union. The political feedback to the Chancellor’s position on the bailout was immediate and dramatic. She and her party lost seats. To maintain her coalition, it seems as if she must place herself in a stronger position.

Within the broader picture, however, someone needs to step up in Europe and show some real courage, something that will not be easy. That leadership has been sorely missing and the decline in the Euro to a four-year low just underscores how the market is ‘grading’ the response of the European Union to their current financial crisis. The immediate reaction to the German actions was disappointment in the response of the rest of the Union. There obviously is no unity within the European community.

Yet, the German movement is not without reason.

Someone has to step up to the plate.

Unfortunately, the European Union has tolerated the lack of discipline and incompetence in its member nations for years. As a consequence, there has been a “race to the bottom”; a movement to the lowest common denominator and the recent financial crisis is the result. And, now all members of the European Union are suffering.

Nature does not allow a vacuum to exist for very long in any human association. If the association allows the undisciplined or incapable to dominate, then the performance of the association comes to reflect this bias. Need I present a sports analogy?

The other alternative is for the members of the association to have standards set by the disciplined and capable where a situation can be achieved in which the rising performance of the community is shared by all.

A successful union has enough benefits for all to share. In an unsuccessful union no one is really happy!

In the European Union it seems as if there is no one else to turn to but the Germans for this leadership. It is certainly not going to come from France. France is the epitome of the acceptance of the mediocre. France’s leadership has guided the European Union into the state it is now in. It is not the future.

Will other nations listen to Germany? Will new leadership be established in the European Union?

I’m not sure that the rest of Europe is ready to get ‘disciplined’. There is a lot of ‘mouthing’ of the need for discipline, but are the nations doing this talking ready to change things for the longer term or will they revert to old habits once the immediate crisis is over? Can governments that really ‘tighten up’ be able to be re-elected in Greece, and Spain, and Portugal, and other places? Will other nations in the European Union really stand for German discipline and leadership?

Watch the hips, not the lips!!!

If the nations in the European Union other than Germany fail to get their acts together, will Germany and the German people be able to drop their standards of performance to the level of the ‘bottom’?

My guess is that the Germans do not want to be mediocre.

Therefore, disunity and disgruntlement will continue to rule in Europe. And, this will not be good for the Euro.

What might change attitudes in Europe?

The answer might be years of falling further behind the United States, China, India, Brazil, Russia, and other emerging nations. The European model, as it now stands, cannot compete in this world of the future. Competition is going to be fierce and nations that thrive on low performance and undisciplined behavior will fall further and further behind. But, this is a message to all nations, including some that are in the list just presented.

Unfortunately, Europe stands in a position to cause a lot of disruption to others. It is still important enough to let its failures cause dislocations in the world economy.

The United States should applaud the behavior of the Europeans. The behavior of the Europeans and the decline in the value of the Euro takes a lot of attention off of the value of the United States dollar and the weakness it has experienced due to the undisciplined behavior of the United States government with respect to its fiscal and monetary policies.

Still, I would like to see Germany and Angela Merkel succeed. I would like to see a strong Europe and a strong Euro. But, maybe I am just being sentimental.

The Euro and the European Union

When have you last heard that the dollar might drop into the $1.05 to $1.15 range? This morning we are trading at about $1.34.

The lower number is projected if some country leaves the European Union or if there is a national default in the euro area.

The cost of protecting debt from default over the past six-months has risen dramatically in several of the major European countries: Greece leads the world in this category. But, Portugal is right behind as credit-default swap data, compiled by Bloomberg, indicate an increase of about 150% in the last six months. (Remember the debt rating of Portugal was just reduced by Fitch last week.)

Major increases in the cost of protecting debt from default have also been registered against the debt of Spain, Italy, Belgium, England, and France.

The bottom line: governments cannot just spend and spend and spend expecting either the bond markets or the central bank to bail them out. Social programs or not, a democracy has to balance the competing ends within a country and if the social programs cannot be financed through sound finance then they will just have to wait. The lesson is very clear.

Historically, it is government spending that drives the finances of a country and not the central bank. Remember the European Central Bank and the Bank of England have been much more conscious “inflation targeters” than was the United States. Also, governments, historically, were always the leaders in financial innovation and not the private sector. The late 20th century is no exception to this rule. (See Niall Ferguson’s “The Ascent of Money” and also http://seekingalpha.com/article/120595-a-financial-history-of-the-world.)

In the past, if a country over-extended its finances then they would generally have to devalue their currency and then proceed into the future. With a common currency, the euro, a country loses the choice about devaluation because that country is now one among many and so must accept its position in the community. The poor country that has over-extended itself must bring its budget back into line, a very painful process as Greece is now experiencing. This is tough medicine to take.

What about the countries that were prudent and disciplined? Their emphasis on sound finance is now being called a vice by some because they do not want to be overly generous to those countries that were not prudent and disciplined. (One prominent critic has been Martin Wolf of the Financial Times: http://www.ft.com/cms/s/0/924b4cc0-36b7-11df-b810-00144feabdc0.html.)

And, the current crisis is bringing out those that are or have been opposed to the European Union as it is now constructed. For example, an op-ed piece in the New York Times “Euro Trashed” by a German professor, captures some of the tone of this side of the argument: http://www.nytimes.com/2010/03/29/opinion/29Starbatty.html?ref=opinion. A suggestion is made that the “strong” governments could pull out of the current arrangement and form a bloc that would “fulfill the euro’s original purpose” and would not have to worry about “laggard” high-debt states.

The betting is against the euro right now. John Taylor, the chairman of the currency hedge fund, FX Concepts Inc., argues that “Those people who are calling for the euro to go up are thinking the stock market is going to continue higher and that the euro zone problem is not going to spin out of control. I disagree with both of these things.” So, of the three areas that have experienced, in the recent past, the most negative vibes concerning the value of their currencies, the United States, Japan, and the euro zone, the pointer has rotated to the euro zone, taking the pressure off the other currencies, at least for the short run.

This could change. The reason for the current focus is that the euro zone faces the most current difficulties that have to be dealt with. But, this focus could be altered overnight because of the things happening in United States financial markets. The first has to do with the Federal Reserve signaling that it will honor its statement that its purchases of mortgage backed securities will end as March 2010 ends. The 10-year U. S. Treasury issue has bounded up to a 3.85% yield again, a level it was at in June 2009, August 2009, and January 2010. The concern by some is that yield could accelerate through 4.00% in the near term.

Why is this of concern? Well for one reason, upon the reaction in the bond markets, mortgage rates have moved above 5.00% with the expectation that they could go higher as the liquidity in the mortgage area of the capital markets declines. Banks and mortgage banks have already put a hold on committing to mortgage rates in the near term because of the uncertainty connected with the future level of mortgage interest rates. This, of course, is problematic because of all the variable rate mortgages or teaser mortgages that must re-price over the next 12 months.

There is also the concern about how easy it will be to place the upcoming quantity of the federal debt coming to the market over the next six to nine months. How much added pressure these new amounts of debt will have on interest rates is highly uncertain at the present time.

And, then what about the Fed’s exit strategy, the Great Undoing? How is the Fed going to act or react to all these market pressures? The exit strategy is planned to take place in an orderly financial market. What if the financial markets don’t cooperate and become dis-orderly over the next year due to everything else going on in the world? Just how is the Fed going to accomplish its Great Undoing in such an environment?

So, the emphasis is all on the euro right now and the political problems being dealt with by the nations of the European Union. Except for Germany’s Chancellor Merkel, the current batch of European leaders seem extremely weak at the present time. The weakness claim extends to the Prime Minister of England as well. What comes out of this mess is anybody’s guess right now, but it would seem that a country, like Germany, who is in relatively good fiscal shape and with a leader that can command some significant backing from her people, can be pretty adamant about what they want. The other countries in the EU may not like what Merkel is advocating, but they are not in the strongest position to suggest alternatives.

If this is the case, then it would seem as if the European Union will continue to battle on, but the debt-heavy countries that are now experiencing significant difficulties obtaining funding will have to get their houses in order for the Union to continue to function. Otherwise, as suggested in the New York Times this morning, we might see a move to one bloc of countries with a single currency who are relatively sound, financially, and all of the others who will re-establish their own currencies once again.

Politicians in the United States should pay attention to what is going on in Europe and take some lessons about their own fiscal responsibilities.

"Europe's Plot to take over the World"

There is an interesting article in this morning’s Financial Times (10/6): “Europe’s plot to take over the world” (see http://www.ft.com/cms/s/0/a47079b2-b1e6-11de-a271-00144feab49a.html.) It was interesting to me because it has always seemed to me that the one who controls the writing of the agenda for a meeting is the one that most often ends up controlling the results that come out of the meeting.

And, according to my reading of Gideon Rachman’s comments, this is exactly what Europe is trying to do.

The thrust of Rachman’s argument ties in with my post of October 5 (see “What’s the dollar’s place in the new financial order”: http://seekingalpha.com/article/164848-what-s-the-dollar-s-place-in-the-new-financial-order.) where I discussed the changing nature of the world’s economic and financial relationships as observed in the changes occurring within the G-20 (and the lessening of importance of the G-7) and the jockeying of nations for position within the World Bank and the International Monetary Fund.

Whereas so much attention has been given to the rising strength of the BRIC countries of Brazil, Russia, India, and China, Rachman focuses on the bureaucratic reality of the evolving organizational structure of the G-20 itself. There are three points the author makes that I think are worthy of consideration.

First, Europe dominates the leadership of the G-20. Whereas Brazil, China, India, and the United States are represented by one leader each, the Europeans had eight positions at the conference table: Britain, France, Germany, Italy, Spain, the Netherlands, the president of the European Commission and the president of the European Council. Furthermore, the primary international civil servants at the meeting were Dominique Strass-Kahn, the head of the IMF, Pascal Lamy, the head of the World Trade Organization, and Mario Draghi, the head of the Financial Stability Board and these are all Europeans. The only other civil servant of similar weight was Robert Zoellick, the President of the World Bank, and an American.

Second, the Europeans seem to have a grasp of what is going on in the world than do the other participants at the G-20 conference. Rachman ties this back to the experience of the Europeans at European Union summits. The Europeans seem to be well advanced in the techniques of “bureaucratic paper-shuffling”, a process of introducing issues that they never let go of and which have important political implications in the upcoming years. Rachman argues that the European Union “advanced” from the very start “through small, apparently technical, steps focusing on economic issues.” The method used was to build the union through “the common management of common problems.”

Third, Rachman states that “the kernel of something new has been created. To understand its potential, it is worth going back to the Schuman Declaration of 1950, which started the process of European integration. ‘Europe,’ it said, ‘will not be made all at once, or according to a single plan. It will be built through concrete achievements, which first create a de facto solidarity.’”

The agenda is bigger than forming a G-3, a group of the United States, China and Europe. The world of the future cannot be organized by just these three territorial giants. The world of the future is either going to be integrated in a way that many might conceive of as inconceivable, or, the world is going to collapse into separate blocks with limited international trade and cooperation.

The model for this last scenario is the world at the start of the 20th century. World integration was discussed then for the world was open in the early 1900s in a way that has not been equaled since. Yet, the world conflict taking place in the 1910s split the nations apart leading up to conflicts of the 1920s and 1930s and the second world war that followed.

For the G-20 to help the evolution of the world into something approaching the first scenario the United States is going to have to adjust its attitude. Yes, the United States is still going to be the most powerful nation in the world, both economically and militarily, but it is going to have to change its belief that it can act, either economically or militarily, independently of the rest of the world.

If Rachman is even close to being correct on his view of how the G-20 might evolve, the United States is not going to be able to get away with continually allowing the value of the dollar to decline. The United States cannot have it all! Other countries must adjust their behavior as well (for example, the savings rate in China must fall), but the day is coming when the United States is going to have to accept the consequences of the irresponsible fiscal and monetary policy of the last eight years. And, the current administration cannot continue to add to these policy blunders going forward as they now seem to be doing.

Something new is happening. And, Nicolas Sarkozy and Angela Merkel, and other leaders in Europe are not going to let this opportunity pass them by. They will talk about cooperation with the United States, internationally, but they want the United States to get its shop in order. France, and Germany, and Britain, all went through the economic wringer in the last half of the 20th century as international financial markets took their governments to task for irresponsible fiscal policy and extremely loose monetary policy. They certainly are going to ask for the American government to exhibit a little more discipline going forward.

For people interested in the value of the United States dollar, my view is that the value of the dollar will continue to decline until the United States government stops talking about achieving a strong dollar while running up trillions and trillions of dollars in deficits and actually begins to act to achieve a strong dollar. How long this will take depends upon how much pressure is exerted in organizations like the G-20, the World Bank, the IMF, and elsewhere. This pressure will only continue to grow as the G-20 achieves more influence and these other international organizations are given more and more responsibility to oversee international financial markets. This is not going to happen, however, overnight.