The European Crisis Continues

The European Crisis Continues

American Equity markets are anxious for a definitive resolution to the European Debt/Fiscal crisis.  Despite the rhetoric surrounding the latest “solution”, they will be disappointed. 

First, lets cover some basics.

1.     The EU is not going to break up because it is in the individual interests of the all of the main players for it to continue.  It IS a political union (or Confederation) and for all of its shortcomings it has created the foundation for over a half-century of peace. 

2.     The Eurozone will survive in its present form.  I wouldn’t say it is impossible for Greece to leave but highly unlikely.  I am also NOT saying that there won't be a default.

3.     The European leaders will not accept a “real” solution, but will resort to smoke and mirrors accompanied by high-minded rhetoric.  The pseudo-solution will not solve anything but WILL kick the can down the road.  Eventually, over the next decade, higher economic growth will solve the current problem. 

It is commonly understood how to definitively solve the current fiscal crisis.  As Secretary Geithner points out repeatedly the EU must create a “shock and awe” wall of money that will assuage the worries of the global credit markets.  The problem is that this will require at least €2 Trillion, and the principal funding source, Germany, is simply politically unable to make the required commitment.  The latest “solution” suffers from the same problems as the previous attempts.  It is simply too little and too undefined.  

The Structural Agreements

The European Summit agreed on basic budgetary principles that would limit “structural deficits” to 0.5% of GDP with “automatic correction measures” when national deficits violate the target..   This is in addition to a tightening of the disciplinary procedures for countries that violate the limit of deficits over 3% of GDP.  These principles would apply to the 17 Eurozone countries. On its face, this solution is implausible and unworkable. 

This first prong of the framework is a Treaty amendment to attempt to establish greater fiscal discipline.  The new plank is a requirement for the member states to adopt a sort of balanced budget amendment that will be deemed satisfied if “structural deficits” are limited to 0.5% of GDP.  Each nation is expected to adopt constitutional “automatic correction mechanisms” pursuant to principles to be established by the European Commission.  In addition, the existing limit on deficits to 3% of GDP will be strengthened by additional (undefined) “automatic consequences” for failure to adhere to this limit.  Why the reference to structural deficits?  This relieves countries that might suffer temporary deficits due to recessions—such as occurred in France and Germany (!!!) in 2008-09, and continues in France today.  The “automatic corrections” or the increased “disciplinary” actions have yet to be defined or implemented.  Even if they were legitimate, they would be highly contractionary. 

Little of this debate is new. 

The issue of acceptable budget deficits was anticipated and debated in the early 1990s in connection with the adoption of the convergence standards in the Maastricht Treaty in 1992.  The German position has not changed.  Germany worried about the profligate Italians at that time and they accepted two “solutions”.  One was an independent central bank, the ECB, that would adopt the strong German-oriented anti-inflationary fiscal policy.  The powers of the ECB were carefully negotiated.  The powers reflect a compromise of the divergent views of monetary policy within the EU and are unlikely to be radically changed. 

In addition, fiscal deficits of the participants in the Eurozone were restricted to 3% of prior year GDP, except for temporary exigencies, in the Maastricht Treaty in 1992. The problem is that ALL of the Eurozone countries, including Germany, violated the limit during 2008-10.  France is still in violation of the limit and is hoping to get back to it in 2012.  (However, the question is whether the French public will support the changes necessary to bring expenses back into line. )

During the last decade the European Commission abandoned its cherished dream of fiscal harmonization, which is a necessary predicate to fiscal or political union, due to an inability to harmonize the BIG issues.  This is nearly a decade-old process and it is not going to be reversed.  The BIG issues are the places in which there is BIG money: pensions, medical care, labor regulation, and other social benefits.  Americans see all of continental Europe as a bunch of aging socialist countries.  There is a large dose of truth in this, but it masks very significant differences, both in terms of social benefit structure, savings rate and demographic makeup.  Harmonization, and, therefore fiscal union, has not occurred because it is simply intractable. 

American investors find Chancellor Merkel to be a difficult myopic personality. Actually, she merely reflects German culture and her life experience.  There is no “equity market” culture in Germany. Investment in publicly traded equities is confined to a tiny portion of the populace.  Ms. Merkel grew up in East Germany, and is educated as a physicist.  She has no intuitive feel for the relevance of the capital markets.  In Germany, capital is the responsibility of banks, supplemented by a small coterie of wealthy private family businesses.  Germany is simply not a dynamic market based economy, and frankly, rejects every suggestion that it become one.  American hand wringing about dithering misses the point. Providing certainty to the equity markets to encourage investment and innovation is simply not a goal of policy makers because their equity markets don’t provide that function in their societies.  There is greater concern for the Bond market, but primarily insofar as it relates to local Banks. 

The German goal is for each nation in the Eurozone to fix its own problems with only limited support from the other member states, i.e., the Italians must fix Italian problems.  The Germans really don’t care how they do it: higher taxes, higher poverty etc.  They are willing to provide a limited amount of backstop support but as little as possible.  In this regard, Ms. Merkel is reflecting German public sentiment.  Frankly we are watching a multi-dimensional game of “chicken”.  Ms. Merkel wants to provide the smallest commitment possible that will achieve economic stability (Germans love stability).  This is a TRIAL AND ERROR process.  It will continue inching along until they find equilibrium.  No German leader is going to be hurried. 

There is one certainty.  The solution will not be “real”.  It will not really address the fundamental drivers of government spending: the large welfare state that is financed by a decreasing number of workers.  Sarkozy is proposing to extend the retirement age for some workers, but this is still tinkering around the edges.  And he is encountering fierce resistance.  But over the next 30 years, as the baby boom ages, the problem will simply fester for another generation of leaders to deal with.  Second, the solution will be highly contractionary.  Europe is headed for a recession in 2012 in any event and the actions taken will exacerbate.

The Money game

While much attention has been focused on the purported benefits of the greater coordination of fiscal discipline, this will not solve the current short term funding issues in Europe.

The Summit took two actions, but the math is fuzzy.  When math is fuzzy there is a reason.  First, there was agreement to make €200 Billion of additional funding available from the European central banks to the IMF with a plea for more money from non-EU nations.  Apparently, the understanding is that this would be lent back to the European nations in some form.  This commitment apparently involves “real” money. 

Secondly, the new European Stability Mechanism was accelerated by a year to mid 2012 and would operate side by side with the existing EFSF until its expiration in  mid-2013.  However, the total amount allowed to the combined EFSF/ESM was limited to €500 Billion. However, this limit would be reconsidered in March.  In this case, the actual cash contributions were limited to 15% of the Funds with the rest to be obtained through “leverage”.

It seems that in the current best case, there is €700 Billion possibly available to solve short term funding issues in Europe. Apparently, the IMF is being used to avoid some of the constitutional restrictions on actions of the ECB.

Nevertheless, €700 Billion is not close to adequate to refinance the sovereign debt due in 2012 which Bloomberg estimates to be over €1 Trillion with an additional €500 Billion of European bank debt also needing to be refinanced and at least €100 Billion of bank capital to be raised in the first half of 2012.  In effect, the EU is leaving Italy, Spain, and the other heavily indebted countries to live with the market reality of their position.  The onus is on them, as the Germans desire, to create budgets that restore the confidence of the bond markets and reduce borrowing rates to a sustainable level.  The ESM/EFSF and IMF will stand as a kind of last resort to plug any small gaps but will not to be the supra-financing vehicle that the Fed Reserve is in the US.  The simple fact is that Germany is not willing to increase its assistance to the other nations of the Eurozone

The summit was long on rhetoric and short on funding.  It is a continuation of the Euro leadership’s response to the crisis: an elaborate fudge.  Initially the global equity markets seem content while global bond and currency markets are more wary.  But the reality of the situation will set in during the first quarter of 2012 when European bond auctions occur. 

The net result of the latest machinations is that the “can is simply being kicked down to road” to the next summit in March 2012.