Euro Area: A Deceptive Calm

Includes: FXE
by: Acting Man

Over the past week or so, an uneasy quietude has descended over Europe. Ever since the ECB began its interventions in the government bond markets of Italy and Spain, the sense of immediate crisis has diminished somewhat, as euro area bond yields and CDS spreads have declined in its wake.

And yet, everybody knows that the basic fundamental problems haven't gone away – in fact, they have worsened, as lately even Germany – hitherto regarded as the growth engine of the euro area – has seen its economy beginning to sputter.

As Reuters reports:

German gross domestic product growth slowed more than expected in the second quarter, dropping to 0.1 percent in seasonally adjusted terms from a revised 1.3 percent in the first three months of the year, data showed.

The unadjusted preliminary data from the Federal Statistics Office released on Tuesday also showed that growth eased to 2.8 percent compared to the same quarter a year earlier, after 5.0 percent in the first three months of the year.

The figures compared to Reuters consensus forecasts for a 0.5 percent expansion in quarterly terms and a 3.2 percent rise year-on-year. Quarterly growth was at its lowest since it posted a negative reading in the first quarter 2009.

In the meantime, the news backdrop is oscillating between irrelevance, disappointment and absurdity. (Among one of the more absurd events Finland has received a 'loan guarantee' from Greece in the form of an undisclosed cash amount for Finland's portion of the Greek bailout. Does this make any sense whatsoever?)

The well-known globalist oligarch, hedge fund manager George Soros – a man who for some reason, in spite of having fled from the communists and having made his money in the markets, usually displays an astonishing degree of hostility toward free markets and calls for interventionism by the State at every opportunity – garnered some attention when he penned an editorial in the Financial Times calling for the 'introduction of eurobonds' (see also this interview he gave to the German magazine Der Spiegel). This has possibly raised hopes among supporters of the idea that it may finally be implemented, but these hopes were quickly dashed again.

These bonds would be government debt securities issued by the euro area as a whole, an idea that is understandably resisted by the countries with the highest credit ratings – as it would pull their credit ratings down and represent the final step toward a transfer union. From the point of view of Germany, this would not only likely be unconstitutional, but also amount to political suicide for the political leaders agreeing to it. Note here that the latter concern is a far more important obstacle than the former. The entire gamut of 'euro rescue' efforts and bailouts after all rests on the flimsiest legal foundations imaginable. The political and bureaucratic classes of Europe don't care one whit whether what they do is legal or not. Just about anything can be justified by an 'emergency' after all. It is important to realize that this is simply how the State operates – always and everywhere. 'Democracy' and 'constitutions' are by no means effective shields that protect citizens and tax payers from the State's predations– all that is required is a sufficiently scary 'emergency' and immediately the law goes out the window. As we noted before – quod licet Iovis, non licet bovis.

It is different with the danger posed by the prospect of losing an election. Government power will always fall to political organizations that represent the establishment status quo, which is to say, nothing at all in effect changes for the citizenry should it decide to vote for a different party. Alas, for the parties themselves it is obviously important who will end up sitting the closest to the trough. So it does make a difference for the ruling classes and hence there is little inclination to opt for political suicide, regardless of personal convictions or overarching agendas.

As it is, no decisions of importance will be made in the euro area without Germany's assent. So far the Germans have been reluctantly dragged into agreeing to ever more interventions, but political resistance to a transfer union remains quite high. For instance, Mrs. Merkel's coalition partners, the FPD ('Freiheitliche Partei Deutschland's) and the CSU ('Christlich-Soziale Union'), the former a basically conservative outfit with very slight classical liberal leanings and the latter a deeply conservative party based in Bavaria, remain dead set against the euro-bond idea.

As Ambrose Evans-Pritchard wrote on this ahead of the much-heralded Merkel-Sarkozy meeting:

The simmering revolt in the Bundestag makes it almost impossible for Mrs Merkel to offer real concessions at Tuesday's emergency summit with French president Nicolas Sarkozy.

"We are categorical that the FDP-group will not vote for eurobonds. Everybody must understand that there is no working majority for this," said Frank Schäffler, the finance spokesman for the Free Democrats (NYSE:FDP).

Oliver Luksic, the FDP's Saarland chief, told Bild Zeitung the survival of Germany's coalition was now rests on the handling of this issue. "Eurobonds are a sweet poison that leads to more debt, rather than less. Should the government endorse a common European bond and with it take the final step towards a long-term debt union, the FDP should seriously ask whether the coalition has any future." Alexander Dobrindt, general-secretary of Bavaria's Social Christians (NYSE:CSU) and a key Merkel ally, said his party has issued a "crystal clear 'No' to eurobonds".

And so it came as no big surprise that nothing of substance emerged from the Merkel-Sarkozy meeting, luckily in the case of euro-bonds, which would institute what we would term 'euro-bondage' for the much plagued tax payers of the euro area 'core' nations. Naturally a globalist and instinctive centralizer and interventionist like George Soros loves the idea, but not a single tax paying citizen in Germany is likely to agree. As we noted before, every step that brings the EU closer to the socialist super-state once imagined by the likes of Delors and Mitterand is a step in the wrong direction. Soros later also urged Portugal and Greece to 'quit the euro in order to help save the common currency'.

In any case, the Merkel – Sarkozy meeting once again showed that the EU's foremost political leaders are mostly united by an abiding hatred for the financial markets. They rejected the ideas that would simply not fly with their voters – such as euro-bonds and a further expansion of the EFSF – but in order to be seen to 'do something' fell back on that old stalwart of proposing fresh taxes and regulations that will without a doubt hasten the economic decline of Europe. Not surprisingly, stock markets across Europe suffered yet another wave of selling in the wake of their post meeting communique.

As Bloomberg reports:

European stocks fell as German Chancellor Angela Merkel and French President Nicolas Sarkozy rejected an expansion of the region’s rescue fund and rebuffed calls for joint euro borrowing. Asian shares rose and U.S. index futures were unchanged.

Carlsberg A/S, the Nordic region’s largest brewer, plunged 18 percent after reducing its full-year outlook. Deutsche Boerse AG (DB1) and London Stock Exchange Group Plc (NYSE:LSE) lost more than 4 percent amid plans for a financial-transaction tax. Technology stocks posted the worst performance among 19 industry groups in the benchmark Stoxx Europe 600 Index as Dell Inc. missed analysts’ sales estimates and cut its revenue forecast. The Stoxx 600 declined 0.7 percent to 235.93 at 11:32 a.m. in London. The MSCI Asia Pacific Index gained 0.2 percent and Standard & Poor’s 500 Index futures were unchanged.

“The Sarkozy-Merkel meeting was the major event yesterday and anyone expecting a rabbit to be magically pulled from one of their hats would have been disappointed,” Jim Reid, a global strategist at Deutsche Bank AG in London, wrote in a report today. “Whilst markets will ponder the potential effects on market liquidity and the broader economy arising from the financial-transaction tax, it was the broader tax agreement that was unexpected.”


Merkel and Sarkozy agreed to press for closer euro-area cooperation, tougher deficit rules and a harmonization of their corporate tax rates.

(emphasis added)

The only effect of the financial transactions tax will be that liquidity in European markets will dry up, price discovery will be hampered and a lot of business will simply go elsewhere. It will also pressure stock prices and ensure lower multiples/higher risk premia in the long term. Investors will likely flee from European markets as fast as they can in the wake of this announcement.

Even worse though was the step toward 'greater tax harmonization'. As we have noted on several previous occasions, the most vocal 'harmonizers' are typically the countries that sport the highest tax rates. They want to keep producers of wealth from being able to vote with their feet by stifling tax and regulatory competition across the EU. The crisis is seen as an opportunity to finally force others to comply with these plans. This should also hasten the economic decline of Europe considerably. The currently still rich welfare states are on their way to the poorhouse if they continue to implement such policies. Investors should take heed and act accordingly.

The fact that the size of the EFSF is not going to be expanded means the ECB is facing a few tough decisions now. Should it keep buying Italian and Spanish bonds? The ECB wanted the EFSF to take over these market manipulation duties in due time. However, it should be obvious that the bailout fund simply does not have enough money. If it were indeed enlarged it wouldn't really help the situation either – on the contrary, the crisis would eat its way through to the 'core' nations even faster, as they would have to stump up the money for the enlargement.

We would note that both France and Germany are home to extremely leveraged banks that are potentially prone to suffering a banking crisis that will make the Lehman bankruptcy look like a walk in the park. In our opinion the political leaders of the EU are for the most part economically and financially illiterate and have not the foggiest idea on what a powder-keg the euro area is sitting. How else can one explain the outcome of the Merkel-Sarkozy meeting? What came out of it was mostly the promise of more and higher taxes and 'more meetings'. They could not possibly have come up with a worse resolution.

Of course Sarkozy is well known for having absolutely no idea of how markets work (see his frequent exhortations to institute price controls in commodity markets) and very much personifies the anti-capitalistic mentality so popular in France. Why he is heading a 'conservative' party we will never know. We shudder to think what a French socialist might look like. Mrs. Merkel's grasp of economic issues meanwhile appears rather provincial, although this may actually spare the German tax payers some of the depredations they might suffer under a more 'cosmopolitan' leadership. Unfortunately for the Germans, it will hardly help them if they vote the authoritarian left consisting of the Greens, the Social Democrats and the SED rump 'Die Linke' into power. On the contrary, if such a political constellation were to come to power, it would probably ensure that Germany would give the eurocrats anything they want.

As reported elsewhere, Merkel and Sarkozy also announced that 'closer fiscal and economic integration of the euro-area' is on their agenda. They also made their standard call on Ireland to also raise its corporate tax rate, something the Irish have luckily resisted thus far. They also proposed that euro area members should introduce constitutional amendments that prescribe public debt ceilings. Why anyone would think that those would work better than the existing Maastricht treaty debt ceilings must remain a mystery for now. The closer fiscal and economic cooperation is to be achieved by half-yearly meetings chaired by the eurocrat everybody loves to hate, European Council president Herman van Rompuy. We're not sure how holding even more meetings will help to remove the basic flaws in the euro's design and apparently the markets don't care much for the idea either.

The two leaders, who held an emergency meeting in Paris on Tuesday on the debt crisis — which is threatening to spread to Italy and Spain — also called for enforcing strict budgetary discipline by incorporating a "debt brake" in member nations' Constitutions by the middle of next year.

In addition, they suggested imposing a financial transaction tax to curb speculative trade, which could endanger the stability of debt-laden member nations.

The meeting was hurriedly convened in the wake of severe turbulence in financial markets last week and speculation that France may be downgraded from its top-level AAA credit rating by ratings agencies.

Merkel and Sarkozy said the proposed joint economic governance is intended to closely coordinate the financial and economic policies of the 17 nations under the leadership of their heads of state and government, who will meet every six months.

European Council President Herman van Rompuy will chair those meetings.

(emphasis added)

Naturally, a new tax on financial transactions will do absolutely nothing to 'curb speculative trades' , which the politicians wrongly presume to be the source of the euro area's troubles. Investors are merely taking action to preserve their capital. Why would anyone want to invest in the debt securities of bankrupt governments? Just to please Mr. Sarkozy? And why would Sarkozy and Merkel expect that the incentive to invest into the bonds of bankrupt governments can be increased by taxing financial transactions? Logic doesn't seem to be their strongest suit.

Lastly, the idea that closer economic and fiscal cooperation between the euro area governments will solve the problem is mistaken. The basic problem is that there is an under-capitalized, fractionally reserved banking system that is deeply intertwined with the increasingly insolvent government debtors due to holding the bulk of their bonds. There is practically no brake on the creation of fiduciary media, i.e., money from thin air by the banking system. Governments have profited greatly from this system, which they have misused to impose an enormous inflation tax on citizens (euro area true money supply [TMS] has expanded by about 145% in the past decade) and by financing debts that could not possibly be financed absent such unbridled credit expansion.

As Philipp Bagus has pointed out, the situation is akin to the 'tragedy of the commons' – the profligate member nations thought they had nothing to lose by being profligate. In addition, a currency union works a bit like a peg or a currency board – when economically disparate nations are bound together by such a peg, it seduces investors hunting for yield to invest as much money as possible in the securities that offer a slight yield premium – after all, there is seemingly no currency devaluation risk. At the same time, the credit expansion of the fractionally reserved banking system undermines the pool of real savings and helps with piling up ever more unproductive debt, both in the public and private sectors.

It should be obvious that if the banking system were 100% reserved that there would not be a crisis now. And yet, this subject is completely taboo. We frankly doubt the politicians even understand how the system works, but we are fairly certain that they will eventually badger the ECB into printing money 'Fed style', via unsterilized quantitative easing. This will probably prove to be the 'solution' that is the politically most palatable, as most citizens will be unaware of the horrendous cost until it is way too late.

Merkel and Sarkozy – they're sitting on a powder keg, but still seem to be blissfully unaware of it.