The EU's Dilemma, And the Only Real Solution Left

Includes: EUFN, FXE, IMF
by: Cliff Wachtel

This past Thursday the EUR rally got smacked on disappointment over ECB Head Trichet’s ‘surprising’ dovishness. Inflationary pressures, continued improvement in the core economies, misinterpretations of statements from the ECB (and German officials playing to their voters) had led markets to actually believe the ECB would consider raising rates.

This past Friday an EU meeting concluded by not concluding much of anything, at least publicly.

The EU’s dilemma is as obvious as it is similar to that faced by other developed economies like the UK and US . It faces inflationary pressures that risk harming both its currency and economy. However the usual medicine, raising short term rates, could cripple the chances of economic recovery in much of the EU outside of the core economies.

The solution is equally obvious, though in the EU just because something is obvious doesn’t mean it is acknowledged, at least not until the absurdity of continuing the game becomes unbearable and someone giggles, or is otherwise forced to publicly admit the facts. Just search on line using any of the following search terms:

  • Greek Debt Crisis
  • Irish Debt Crisis
  • bailout AND
  • not needed OR
  • banks well capitalized

So for those who haven’t thought it through, here’s how it will go down: default, be it full or more likely, partial (aka restructure). Done properly, it can both heal the PIIGS and relieve inflationary pressures.

Here’s Why:

It’s Inevitable Anyway

Greece is already assumed to be beyond any realistic hope of repaying its debts in full. Both Greek and German officials have been hinting/rumored to have said this for some time now. Markets have priced it into Greek bonds. Note that it’s hard to imagine how once Greece defaults, others won’t follow as the risk premium on other PIIGS bonds will soar, forcing the others to either default or try to restructure before, while they can still get better terms as desperate creditors seek to ‘ring fence’ the problem before more nations hit the reset button.

Done Properly, It Saves The Banks, The PIIGS, And Relieves Inflationary Pressure

Let’s start with the banks, the real concern for markets.

It Removes Uncertainty, Saves The Banks, Stops Contagion From Threatening The EU & Beyond

That’s perhaps the biggest advantage. The big money center banks in the EU and elsewhere are the real concern. They hold the bonds, and any partial or total default immediately raises doubt about which banks are still solvent and which aren’t. Remember, we’re thinking about indirect as well as direct exposure, the unknown derivatives exposure, etc. As we’ve seen from 2007 to the spring of 2010, it’s the crisis in confidence that risks shutting down interbank lending and crashing economies and markets.

Partial Bank Bailouts Must Be Guaranteed-Keep Them Solvent But Cut Liquidity, AND Inflation Threat

As the US did with its banks, the EU must clearly define which banks won’t be allowed to fail, up depositor insurance etc. That’s not cheap (hey, I didn’t say this was a painless solution, none exists). However unlike state liabilities, those of the banks are easier to quantify, and probably far lower because the banks need only be kept alive not made whole.

Here comes the part that is frankly beyond my technical expertise to determine. The banks (or at least those that survive/avoid merger) get enough cash so that all know they are solvent, yet not so much that they avoid having to cut back lending activities.

Yes, that hurts, but so would the rate hikes being contemplated.

PIIGS Nations Can Start To Heal

Rather than endless short term measures to stay solvent another 6 months, they can start redirecting capital to productive means that help them sustain growth and pay back what they realistically can pay.

Restructure/Default Politically More Feasible

Because private creditors bear some of the pain, EU leaders (of both creditor and debtor nations) can more easily face their voters to accept additional pain of either additional bailout transfers, austerity, etc.

This may save us from another cycle of German waffling, as they try to play to both voters and the world. Meanwhile, markets risk panic on lingering uncertainty from failure to reach a solution.

Yes, I’m Being A Bit Superficial

The goal here is to provide an outline for the only real solution left. Greece and others will ultimately default. The core economies, IMF, Chinese, etc. will not accept endless bailouts. The lingering uncertainty risks another crisis that may not be controllable.

I’m missing some points here, and I humbly ask my readers to help fill in what I’m missing.

However, in the end, I don’t see any other way out.