The European Crisis is proving to be more of an unraveling than a contagion.
I have long written that the European Monetary Union (EMU) constitution and euro currency should be viewed in the context of a risky bet versus a sound regional monetary strategy. The odds of the EMU’s survival are presently reflected in a plunging euro, despite a historic and unprecedented intervention. This indicates that the EMU’s existence in its current form is now a bad bet.
The good news is that this is becoming obvious and it suggests that the serious governance flaws of the 17 year "euro experiment" may finally be addressed. It took a crisis to see its first test, which has been the generally accepted view of when the "euro experiment" would prove its viability.
The established momentum of the EU since its inception and its broad acceptance prove that its survival is presently a matter of European preference with most eurozone members feeling it an absolute necessity. We’d therefore expect to see the EU constitution reformed.
What should concern investors the most however is how the mechanics of what will be a ‘forced reform’ will unfold. The highly visible process will have profound implications to the stability of global financial markets and to a very tenuous global economic recovery.
I see the long standing philosophical difference between Germany and France to be at the core of this potentially very public resolution. During the recent behind closed door emergency bailout negotiations, these differences are reported to have come to the fore. Additionally, Frau Merkel and Monsieur Sarkozy are very different personalities. Will Frau Merkel show German Steel or as the German tabloid Bild proclaimed on news of the euro bailout, become ‘schmucks’? Will Sarkozy the ever populist media hound prove to be a true diplomat or display what Germans perceive as insulting French arrogance? Unfortunately, the world must wait and watch while financial markets will no doubt fluctuate wildly on the uncertainty of the outcome.
What financial markets are oblivious to is just how crafty these two politicians are. There is more going on regarding a European strategy than the media once again fails to recognize.
WHY THE EURO EXPERIMENT IS FLAWED
The core issues with the "euro experiment" which need to be resolved are about a workable governance structure. They can be summarized as follows:
- There is no effective policing of sovereign fiscal authority.
- There are no sovereign penalties for failing to adhere to the “Eurozone Stability and Growth Pact“
- A single currency does not allow a standard depreciating currency option with which to resolve a sovereign growth or productivity failure without forcing a devastating sovereign economic austerity shock.
- There is no ability to effectively coordinate Monetary and Fiscal Policy initiatives during a financial crisis.
- The ECB is not empowered to monetize national sovereign debt. It is specifically constitutionally banned from doing so.
In other words there is no single government, no single treasury, no effective fiscal coordination and no mechanism for crisis management.
Let’s briefly consider the leadership responses to recent issues through the lens of the first three political altercations or ‘political dances’, to see if we can get a clearer view of how this ‘forced reform’ I mentioned above will unfold.
SCORING THE FIRST 3 DANCES:
1- THE GREEK BAILOUT
Germany: Takes the position this is a Greek problem and a matter for Greece to solve without EU involvement as per the EU charter.
France: Takes the position that EU aid should be given but with a plan on how austerity plans will be implemented.
SCORING: Greece has received $145B in financial support
2- THE EU SHOCK & AWE “TARP”
Germany: Once again takes the position members need to solve their own problems but reluctantly is willing to support a marginal scope of effort towards a bailout.
France: Wants and demands a massive coordinated ‘shock and awe’ response to stabilize the euro and brutally punish speculators.
SCORING: A historic $1T bailout intervention undertaken with unprecedented changes to the operation of the ECB
3- GERMAN UNILATERAL NAKED SHORT BAN
Germany: Unilaterally implements a ban on naked short sales and on the shorting of specific financial institutions.
France: Completely rejects Germany’s position which makes German efforts meaningless and only further
weakens the euro.
SCORING: Euro collapses further and global markets sell-off. Libor increases as does the Libor-OIS spread.
- Chancellor Merkel is in a tenuous political position. Ruling with a coalition, she lost a critical election in North Rhine-Westphalia on May 8th, which was the weekend of the summit negotiations. She is acutely aware that the German people are decidedly against German financial support of spendthrift countries, especially after German experiences with East German unifications and the last 10 years of ‘belt tightening’ to make Germany globally competitive. Frau Merkel is caught in what appears to be a nearly impossible political position. She is politically exposed.
- German banks are extremely vulnerable to defaults or possible work out plans with troubled PIIGS.
- The German economy has slowed dramatically and though not in a recession, further weakness in the euro zone will have immediate impact on the German economy.
LIKELY APPROACH TO ‘FORCED REFORM’
Germany talks of ‘economic governance’ while France talks of ‘economic government’. When you explore them you find there is a significant cultural difference. To Germany the word government implies that an outside body would control economic policy as opposed to governance that would convey the idea of structure, framework and sanctions.
Germany now senses the opportunity to reform the euro zone so that similar crises do not happen again. For starters, this will likely mean entrenching the European Central Bank's ability to intervene in government debt as a long-term solution to Europe's mounting fiscal problems. It will also mean establishing German-designed European institutions capable of monitoring national budgets and punishing profligate spenders in the future. Whether these institutions will work in the long term - or fail as attempts to enforce Europe's rules on deficit levels and government debt have in the past - remains to be seen. But from Germany's perspective, they must.
- As French President he does not face election until 2012. He is politically safe.
- French banks are also heavily invested in PIIGS
- France’s deficits have ballooned and austerity plans even remotely resembling those in Greece would bring violent protests from notorious militant French unions and workers.
LIKELY APPROACH TO ‘FORCED REFORM’
It is in Monsieur Sarkozy’s interest to fight for a US like Keynesian solution with excess money printing. This would ‘kick the can down the road’ and avoid an impossible ‘austerity cuts’ war with French unions and workers. He sees what is happening in Greece as something he is likely to face in 8-12 months. The current increasing Credit Default Swap (CDS) rates for France also reflect this concern by investors.
Ulrike Guerot, senior research fellow at the European Council on Foreign Relations (ECFR) suggests that Monsieur Sarkozy would respond: 'what is so wrong with inflation of four percent? It will be competitive inflation. But for the Germans, inflation at four percent is evil".
Alexander Law, chief economist at the Xerfi consultancy in Paris believes “France and Germany will have to start speaking the same language or else the euro will disintegrate. I think that France will end up agreeing with everything Germany says, because they have to, but then they will simply continue to flout the rules as they have done in the past".
THE FORM THE CHANGES WILL TAKE
Having played the schmuck, Germany is likely to win the dance finale. With the euro approaching its original 117 value or very near parity to secure German support (who are going to be the big taxpayers behind successful ongoing bailouts), Germany must feel ‘German Steel’ has been brought to bear in resolving the EU crisis. Even a smart Sarkozy will know when it is time to lose a hand to keep his winnings.
CRAFTY POLITICIANS & SLY CENTRAL BANKERS
Now the shocking truth – ALL THE HARD WORK HAS BEEN DONE!
Politicians and strategists always wait to employ a crisis event to enact politically difficult solutions. Whether “False Flag’ operations or just opportune timing, history is replete with them. Experienced politicians wait for the public to demand action during a crisis, and then make their move just when the public is willing to accept any action rather than no action.
A shrewdly crafted political strategy or a well coordinated plan of the central bankers or circumstances; I will let you be the judge.
The two major issues facing Europe have actually subtly been addressed and all that is now left to do is to go through the public dance of appearing to take actions to resolve the crisis. The two critical achievements that were central to an EU survival solution were:
1- A massive devaluation of the euro - DONE
a. To allow the EU to be competitive globally
b. To allow the southern euro countries to regain some of their especially hurt productivity due to a strong euro
2- A reconstitution of the EMU and specifically the role of the ECB regarding assumption of sovereign debt – DONE (with the euro bailout)
a. The European banks still maintain leverage ratios over 50:1 and have not addressed toxic assets like the US
b. Europe needed an immediate TARP-like solution to address a pending European banking crisis that would never have been approved across the broad EU membership without the cover of a crisis.
With both of these key goals now secured, (which would have never been achieved in public debate) the public discussion over the wording of the reform can take place. As mentioned earlier, the ongoing volatility of the financial markets will give the politicians the cover to force these changes through their respective sovereign political apparatus.
We should likely expect the 27 member European Union to soon become more vocal since any and all decisions will have a profound impact on their economies. We’ll likely see the emergence of a couple of leaders to counterbalance German and French parochial views and lead to a more collective, cohesive EU view of itself as a political entity versus a bundle of disparate views.
What this means is we may see the final emergence of a United Sovereign States of Europe (USSE). This would be a blended version of US capitalism and Eastern European socialism. You can likely expect Merkel and Sarkozy to be strategizing to be its first President.
For the unabridged version of this research paper and accompanying slide presentation see: Tipping Points - Commentary
Disclosure: No positions