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“Fears that policy makers will again fail to come up with a credible solution to problems in the eurozone at an EU summit this week continue to affect market sentiment and weigh on the borrowing costs of other peripheral eurozone countries, including Italy.” - FT.com ($)

Confidence in European decision makers continues to slide in financial markets. Spain's Treasury sold €3.08bn of short-term debt on Tuesday. Interest rates were substantially higher: The Treasury auctioned three-month bills at an average rate of 2.362 per cent, compared with 0.846 per cent at the previous sale last month, and six-month bills at an average 3.237 per cent, up from 1.737 per cent.

Italy also is caught in this market concern: Italy sold on Tuesday €3.9bn of zero-coupon and inflation linked bonds near the top end of the range. It paid 4.712 per cent to sell two-year paper – the highest since December.

Confidence is nowhere is sight.

Also, in Italy, Prime Minister Mario Monte is attempting to get legislation passed that would provide some reform for Italian labor markets. Yet, even though the bill may be passed, no one seems at all happy with the contents of the reforms.

And, analysts argue that the bill falls fall short: “The labor reform is inadequate because it does not address shortcomings in the labor market that stifle the economy,” writes Roger Abravanel, a former management consultant.

Still some officials continue to talk about a eurozone finance minister and a joint banking union. Yet national interest and the desire to control a nation’s independent fiscal policy and banking system make such talk seem far from reality.

Some believe that this is evidenced by the fact that Germany and its Chancellor Angela Merkel have not fully let on what path they ultimately want to follow. Germany, the creditor nation, “is acting as creditors always do. It wants to be paid back or put debtors through default proceeding to extract maximum benefits.”

Germany, it is argued, can ultimately achieve its goals by one of three paths: deflation, inflation, and writing checks.

“Deflation in the periphery would eventually make it competitive, and is Germany’s favored option. But, as we are seeing, it naturally leads to default by weaker banks and governments.”

With inflation, Germany loses because it gets paid back in cheaper euros. By writing checks, Germany would pay off the periphery for leading an undisciplined life. Another case of moral hazard.

To others, Germany has made a decision. They have opted for the first of the three: European deflation. The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation.

But, as the quote above mentions, this would lead these nations to recognize their insolvency and the insolvency of their banking systems in their any solution they arrive at. Do you think this might win any friends for the Germans?

Still, it seems at this time that Germany holds the cards. Post-war Europe has been built on the premise that governments would always intervene in the economy to insure that workers would be employed as fully as possible and that economies would grow as fast as they could. The result of this policy approach is the situation Europe now finds itself in.

Germany may be trying to say that this post-war European model no longer works.

But, how much pain is Europe -- and Germany -- willing to go through to shift policy paradigms?

Source: No Confidence In Europe