Europe redux (again)

The EU governments continue to walk a tightrope with respect to the fiscal crisis that they are facing. Ch Merkel said yesterday that Greece will NOT default but that there will be no “big bang” solution to end the debt crisis. 

She correctly, in my opinion, said that a Greek default would have unpredictable consequences, and could lead to speculative attacks on other vulnerable countries.  This would in turn risk a negative impact on the German economy. (source: Bloomberg).  But Merkel admitted that her “entire council” of economic advisers said that Greek debt should be restructured—advice that she is not prepared to accept for political reasons.  She questioned that if a “haircut” were to be imposed on Greek debt, where would it end?  Would there be a line of countries asking for similar relief.  This would of course disadvantage German taxpayers who had lived in a more prudent fashion.

She concluded that the only way forward was collectively; that there was no prospect of Germany going it alone—like Switzerland.  Earlier today, Ms. Merkel said she would support bank recapitalization if there was a "joint assessment" that it was needed and the rules were "uniform".

While this is a dynamic situation that is shifting rapidly, Ch Merkel’s remarks lead to a conclusion that the Euro leaders are likely to continue on the current course:  put pressure on the heavily indebted countries to heal themselves while providing a modicum of expensive Euro level financial aid to assist in the task.  This would create a continuing period of uncertainty, and a restraint on global growth as the major European countries adopt austerity measures from a budget standpoint. 

Many have predicted the death of the Euro (e.g., Pimco), but the reality may be worse—it will survive but go through a very long slow rough patch.  Ms. Merkel has clearly tied the existence of the Euro, and the EU, to German foreign policy (sic) noting that this is one of the fundamental pillars of peace in Europe. 

I would still advocate a TARP-like recapitalization of the major European banks, with a further facility available for additional problems.  This could be financed on a state-by-state basis.  Of course, this only increases the pressure on sovereign debt (see Ireland), but it creates a firewall against contagion.  Hopefully, the affected banks can find private capital in due course, but the sovereigns would be the investors of last resort.  Politically, this is not going to be too popular; but it is simply a reality that no European government (aside from Greece) is going to allow their banks to go bankrupt.  

The US equity markets seem poised to move higher today bolstered by a potential rate cut in Europe on the retirement of Trichet, the Euro bank recap plan, and slightly positive US employment data.  Of course at this point, the life of a rally is measured in days or less.