The yield on the Spanish 10-year government bond was trading around 7.50 percent on Monday. (A rate of 7.00 percent has been declared "unsustainable.") The Italian bond was getting into the neighborhood of 6.50 percent, trading close to 540 basis points over the similar 10-year German bond, not too far from its euro-year spread high. Greek bonds were over 27.0 percent, more than 2,600 basis points over the yield on the German bond.
Investors were moving toward 10-year German bonds, with a yield of about 1.10 percent, and, U.S. Treasury bonds and UK bonds, both saw yields of around 1.40 percent. The "flight to quality" continues. Are we moving toward the "endgame"?
I don't think we can afford to be too optimistic because we have taken the path of optimism too many times in the past only to be disappointed again…and, again…and, again. But, the endgame we might be facing now is not the nice diplomatically negotiated fiscal union that has been talked about…or the banking union that has gained more and more attention in recent days. No, the endgame I am talking about here is the endgame that Germany is playing for. My June 26 post contained the following analysis:
"Some believe 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 any solution they arrive at."
The difficulty in forming a fiscal union…or in forming a banking union…is that the 17 countries must agree on the terms and conditions of the union, whichever one, and in doing so the individual countries would have to give up substantial authority which they now possess. This is a Herculean task given the 17 proud, independent countries that now make up the eurozone, 17 proud countries that have a long history of battles, conflicts and disagreements.
In this scenario, forming a fiscal union…or a banking union…is not going to happen unless things get pretty ugly. The German path…if it is the path that Germany is truly following…will be ugly. It is not a pretty thing to see sovereign nations declare themselves and many of their institutions insolvent.
Yet, as events progress, this looks to be the path that Germany has taken. And, one must be careful in assuming any victories over this German focus: "It is always dangerous to claim a victory against Angela Merkel. After the last eurozone summit, Mario Monti and Mariano Rajoy emerged triumphalist." This from Ferdinando Giugliano the Financial Times. In the longer run, both Mr. Monti of Italy and Mr. Rajoy of Spain have had to retreat. And, Ms. Merkel continues to plug along.
Germany has the chips. In my mind, Germany is not going to retreat from the path they have chosen because they perceive that this is the only way to save the euro…create a European banking union…and, at the same time, create a European fiscal union. I truly believe that the Germans want to see the euro continue.
It is risky…but, 17 proud, independent countries need to be brought together and the times are not such that the eurozone can wait for 10 or 15 years to achieve such a union. The world is moving too fast, and several of the emerging nations--China, Brazil, and India, for example--are beefing up to directly challenge the nations of the eurozone.
Of course, having the chips and taking such a strong stand can create some bad blood and resentments within other nations. So be it. Let the games continue. My bet is on the Germans, on the creation of a banking union…and a fiscal union…and on the future existence of the euro. Exactly how we get there is still a mystery.