Aristotle described tragedy as a story in which a protagonist with sympathetic traits, in the course of an earnest pursuit, proceeds inevitably towards a horrible fate. Typically, the protagonist possesses an innate flaw that he cannot escape. According to Aristotle, it is not the horrible end of the story itself, but the inevitability of the protagonist’s awful conclusion that bestows tragedy with its dramatic quality and endows it with its most intellectually and emotionally distinct feature as an art form.
In my estimation, Europe is pure tragedy, in this Aristotelian sense. European integration is a noble cause earnestly pursued by well-intentioned people all over the continent. The problem is that the European Union (EU), and the eurozone (EZ) in particular, are beset with certain fundamental foundational flaws that essentially sealed the experiment’s tragic fate from the beginning.
Exactly how the story plays out from here is mere details. However, a sad ending seems increasingly assured.
There are five main issues – wholly derivative of the fundamental flaws of the EU and EZ – that threaten to explode this noble experiment in the medium or even the short term.
- Recession. Deepening economic slow-downs and contractions in Europe virtually guarantee that nations such as Italy and Spain will not be able to meet their fiscal targets. As a result, non-compliant nations will be forced to ask for forbearance, while the creditor nations will refuse to finance further deficits. The resulting acrimony can tear the union apart.
- Austerity Policy. The demand by creditor nations that nations such as Spain, Portugal and Italy meet their fiscal targets via an ever-deepening austerity will only result in deeper recessions and ever-greater impossibility of meeting fiscal targets. The downward spiral of austerity and recession does not only pose an economic risk, it poses grave political risks as the citizens of nations that are forced to adopt austerity measures are subjected to severe hardship, thereby breeding resentment towards their fellow EZ partners.
- Credit Crunch. It is estimated that European banks must deleverage their balance sheets to the tune of 1.5-2.5 trillion euros over the next two years in order to comply with tightened capital requirements. As a result, a general credit retrenchment is currently underway as banks withdraw credit lines from individuals and businesses. The impacts of this retrenchment on growth in the next two years will be dramatic, making it entirely impossible that PIIGS will be able to meet budgetary commitments.
- Lack of Funding. Given that PIIGS and possibly other European nations will not be able to meet budgetary commitments, even more funding will be needed than is currently contemplated under the various bailout programs. The problem is that Europe has not been able to find any way to fund deficits under old projections, much less much higher deficits under newer and more realistic projections. The EFSF (European Financial Stability Facility) is dead. And the ECB is highly unlikely to backstop sovereign bond markets to the massive extent necessary to backstop roll-overs and new financings to the tune of 2 trillion euros over the next two years.
- Sovereignty Issues. As detailed here, national sovereignty issues are at the root of many of Europe’s current problems and these very issues could potentially catalyze the final unraveling of the euro experiment. The attempt by Germany to enforce austerity on PIIGS via a “fiscal union” is fraught with dangers that could explode at any moment. It is entirely possible that European leaders will not be able to reach a compromise to achieve a fiscal union given that a true fiscal union requires an unprecedented cession of national sovereignty. Even if they do reach an agreement, any politically viable compromise is likely to weaken the proposed fiscal union beyond credulity, thereby rendering the effort futile. Finally, attempts by supranational entities to enforce more austerity on already suffering populations could provoke open revolt and acrimonious confrontations amongst nations of the EZ.
The road to the EZ and EMU was paved with good intentions by good people. Unfortunately, a single currency in the context of a fiscal confederation is a design flaw that simply cannot be reconciled. The attempt to proceed with a monetary union on this basis was destined to fail, sooner or later.
What will be witnessed this week as Merkel and Sarkozy attempt to hammer out their proposals for fiscal union, and as frenzied diplomatic activity attempts to get all seventeen EZ nations to sign off to a Franco-German pact, is no less than one of the final acts in a great tragedy played out on a massive international stage.
Our collective sense of pathos will be great as we witness an unpredictable series of events unfold to their inevitable conclusion. As occurs with all great tragedies, the audience – financial markets participants, in the present case that concerns us – will be anxiously hoping for the best until the very end. We will all be holding out some hope that somehow Europe will be able to escape its fate; that the protagonist will, like Jason, Hercules or the wily Odysseus, find a way once again turn potential tragedy into epic; or that perhaps the gods (the monetary policy ones) will have mercy upon them and relieve them of their tragic destiny. And as a result, market prices will not fully reflect the risks of a horrible end until the final gruesome scene unfolds.
In Greek literature, the gods would sometimes intervene on behalf of their favorite mortals (or heroes) when faced with grave danger and these lucky individuals would be granted a reprieve, for a time. But in the end, not even the intervention of the gods could prevent the ultimate fate of heroic protagonists (witness Jason, Hercules and Odysseus).
In the case of Europe, its monetary god (ECB) is weak and constrained, and unless those character traits suddenly change beyond recognition, any intervention by the ECB will only forestall the inevitable end for a short while.
But the fact remains that as long as the gods are on Olympus (ECB in Frankfurt), many watching the saga unfold will hope and keep the faith. Furthermore, on this basis, the opponents of the protagonists will be hesitant to attack the hero frontally and with full force since the gods that favor him could appear at any moment.
Indeed, without the hope of divine (monetary) intervention, in which money can be made to appear from nowhere, the European saga would have met its tragic end long ago.
Due to the incredibly high risks and stakes involved, it is my view that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing and/or holding equities - even those that appear attractive such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).