Behind the scenes there is a regulatory power play developing that could solve the European debt crisis once and for all. The mainstream media has done a terrible job of detailing the fundamentals of this probable solution. Prevailing sentiment suggests that any kind of Greek default is bad news for the global financial system because of the stress it will cause to banks who hold Greek, Portuguese, Spanish, Irish or Italian (mostly Italian banks') debt. However, Germany also knows that the current debt landscape will require bailout after bailout and German citizens will eventually revolt against such lunacy. A new plan is needed. Any long term solution to the European debt crisis must provide solutions for the following three economic elements:
1. Bank capitalization. If the German plan of restructuring (default) wins out, a simultaneous change in accounting standards must accompany the plan. If not, we will see a crisis on par with the financial crisis of 2008-09. Banks must be permitted to remain solvent in the short run even if they have high exposure to troubled European sovereign debt.
The biggest barrier of the 2008-09 crisis was mark to market accounting; CDOs were marked to market and the banks were forced to raise capital every time the value of those holdings dropped, which caused bear raids on those banks that could not raise adequate capital quickly enough. It wasn’t until mark to market regulatory requirements were relaxed in April 2009 that the banks finally stabilized and an economic recovery began.
Regulatory accounting requirements do not get enough credit from the media. Most analysts don’t understand them and most investors are ignorant of the impact. Mark to market was the primary cause of the Great Depression in the 1930s. It wasn’t until FDR relaxed the short term liquidity requirements on banks that the U.S. was able to recover. Europe’s problems are long term in nature and the struggling countries in the euro zone must be given ample time to recover from those problems. The restructuring of debt combined with relaxed accounting regulations for the banks will put Europe on the road to recovery.
Behind the scenes, these regulatory changes are already occurring. In an article posted on July 5 by Reuters, we discovered that the International Accounting Standards Board (IASB) brought in a new chairman two weeks ago, Hans Hoogervost, who is anti-mark to market and has already proposed a solution to the European debt crisis known as IFRS 9. If Greek and other troubled European bonds can be marked at cost -- as IFRS 9 allows -- rather than marked to market, then those banks holding the bonds would not be required to raise capital to meet regulatory requirements. “There are many people in the Commission who think we should adopt it quickly because it gives us a little more leeway in terms of Greek government bonds,” Hoogervost said.
This new IASB chairman is all of a sudden the most important man in the world. If he can get this new accounting regulation passed, it will signal an end, once and for all, to the European debt crisis that we have had to deal with on and off for the last 12 months.
2. Austerity. 50% of the root cause of European economic weakness is traced to its socialist system that provides jobs to unproductive labor. For Europe to succeed, it needs to reform the excess out of its economic system. This process is happening.
3. A higher dollar. The other 50% of Europe’s economic weakness can be traced to the low dollar. Because the United States is suffering from a prolonged housing crisis and 25% of U.S. jobs are in limbo because of it, the Fed/Treasury has had to manipulate a low dollar in order to boost exports and make up the macroeconomic difference.
The United States will always be the most important country in the economic pecking order, and if America needs a low currency, it will get one -- while Europe is left to suffer the consequences. Over time, the dollar will rise and Europe will once again thrive as the euro weakens. But this will take time. In the meantime, Europe needs to pass austerity measures and restructure debt without causing bear raids on the banks. If it can do those two things, we will avert a disaster.
All eyes should be on the IASB and the passage of the new accounting regulation, IFRS 9. Once that is passed, we can all move on from the threat of a Europe recession trigger. Until it is passed, we will continue to deal with intermittent market disruptions caused by contagion fears.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.