Dec. 9th: The Beginning Of The End Game For The Eurozone

by: James A. Kostohryz

December 9th is a do or die date for the EU (European Union) and especially for the EZ (eurozone). For this reason it is highly likely that, in the run-up to the EU summit scheduled for this date, policy makers will make announcements calculated to restore market confidence. Indeed, mere anticipation of such announcements will tend to provide an upward bias to the market. For this reason, despite my medium term bearishness regarding the European situation, I am going into the December 9th summit with only a relatively small core short exposure.

The ultimate fate of Europe depends on the policies that are revealed on or around December 9th. I am not optimistic. The “solutions” currently being discussed will not work. In particular, the issue of “fiscal union,” which is the focus of current discussions and negotiations, is completely misplaced.

I maintain my view that by April of 2012, the S&P 500 (^SPX) will initiate a downturn that will penetrate recent lows of 1,075 and ultimately test the region between 950 and 1,020 on the S&P 500. Furthermore, I maintain my view that the European financial system and economies could begin to unravel even before the New Year.

PIIGS Are Insolvent With Or Without Fiscal Union

Contrary to popular belief, the fundamental problem faced by the PIIGS is not necessarily the size of their debts – or even of the extent of their present fiscal deficits. If those nations could sustainably grow at a healthy rate, their debt levels would be manageable.

The problem faced by the PIIGS, as detailed here, is that they cannot grow at a healthy rate or in a sustainable manner within the EU system, as currently constituted.

The above assertion is not difficult to prove.

It is projected that by the end of the 2011, the entire EZ economy is projected to have grown at a rate of 1.6%. Taking into account the EZ’s low population growth rate, this is not bad at all considering all of the problems faced by the EZ and other global economies this past year.

The problem with the EZ is that all of this growth was concentrated in just a few northern nations. The economies of Germany, Austria and Finland will each grow by almost 3.0% in 2011. The Netherlands and Belgium will each grow by almost 2.0%. The rest of the countries of the eurozone combined will grow by around 0.7%. In particular, the southern European economies grew only marginally (Spain and Italy around 0.5%) or contracted (Portugal -1.5% and Greece -5.3%).

The current account deficit for the eurozone as a whole will be about 0.7% of GDP in 2011 – again, a figure that is fully sustainable. The problem is this: Germany will have a current account surplus of 5.4%, the Netherlands 7.0%, Austria 2.5%, Finland 2.0% and Belgium 2.0%. The current account deficits for Italy, Spain, Portugal and Greece will be -3.8, -3.9, -8.0% and -9.0% respectively.

In other words, Germany and the northern countries of Europe are growing “on the backs” of southern European countries. Indeed the economic models of the northern European countries are based upon exporting massively to southern Europe and elsewhere while they do not purchase from their trade partners in equal measure. This model of economic development is obviously unsustainable.

In particular, the current account deficits of Italy, Spain, Portugal and Greece are completely unsustainable given their meager growth rates – i.e. their structural current account deficits are greater than their structural GDP growth rates. This means that given current purchasing power parity (PPP) disparities under the Euro system and the resulting current account imbalances, the private and public debts of southern European countries are growing faster than their economies are. Unless the PPP imbalances are corrected this trajectory results in inevitable insolvency.

Within the constraints of the euro system, the only way that these southern European nations could theoretically balance their current accounts would be via a massive depression and associated deflation. In theory, this would lower internal production costs and would restore economic competitiveness. The problem is that this “solution” is purely theoretical and entirely useless as a practical means of averting default and associated EZ-wide financial and economic crises. First, such a depression and deflation would inevitably lead to default on those countries’ public and private debts. Second, from a political and social point of view such a massive economic contraction and deflation is not feasible.

Thus, unless the rich northern countries are willing to finance the current account deficits of the southern countries (via the capital account or financing of fiscal deficits), the latter will be forced to leave the eurozone, sooner or later.

In either event – euro exit or deflation - the southern countries will be forced to default on their debts. And when the southern countries default on their debts the entire EZ financial system will collapse – including that of the core countries. Simultaneously the economy of the entire EZ will collapse – including that of the core countries.

Within the euro scheme, the PIIGS are fundamentally insolvent due to purchasing power parity (PPP) disparities and associated current account imbalances. This is the fundamental driver of the current crisis. No scheme currently being contemplated by policy makers is even remotely addressing this issue.

Fiscal Union Is A Fatal Distraction

All discussions leading up to December 9th are centered around the idea of “fiscal union.” Fiscal union does not address PPP or current account imbalances in any way. As such, this focus is completely misplaced.

Furthermore, “fiscal union” may sound nice, but it is simply a code word for “enforced fiscal austerity for PIIGS.”

Enforcing fiscal austerity for PIIGS in the midst of a brutal recession is a recipe for certain default. This lesson has been learned time and time again in the past 30 years, with Greece as the most recent example.

For example, the drag on GDP growth from projected fiscal budgets for Italy, Spain, Portugal and Greece in 2012 are -2.7%, -1.9%, -1.5% and -4.4%, respectively. So where will the growth come from that would allow these nations to pay their debts? It is clear that due to the uncompetitiveness of southern European nations due to PPP disparities under the euro system, net exports cannot be a driver of substantial growth for these countries. Furthermore, under current circumstances, it is to be expected that investment and consumption will contract sharply in southern European nations. Thus, the fiscal drag – on top of contracting consumption and investment - is likely to cause a massive depression and associated financial and economic collapse in these nations, with unpredictable political and social consequences.

Thus, enforcing this sort of fiscal austerity on PIIGS under the guise of “fiscal union,” will simply hasten the demise of the eurozone. Not only will it hasten economic collapse, it will accelerate political collapse as resentment builds in the southern European countries toward their northern European overlords that are “enforcing” the so-called fiscal union.


I believe that a global equities rally leading up to the December 9th EU summit is likely. European leaders will attempt to do something to placate markets and forestall financial collapse.

The problem is that soon after the glow of the summit wears off, the world will once again be faced with the fact that PIIGS are structurally insolvent and that there is no alternative in the medium term to default and at least a partial break-up of the eurozone. Furthermore, there is also no escape from the hugely disruptive financial and economic consequences that this scenario entails.

The likely sequence of the end game is as follows: Steps toward greater fiscal union will be announced on December 9th. Vague references will be made regarding the prospect for future debt mutualization that will be conditioned on the strict implementation of fiscal union. The ECB will then announce various “temporary” measures to provide liquidity to markets and alleviate pressure on European sovereign debt. However, no program of outright monetization such as an American-style QE will be announced. Markets will rally leading up to December 9th, and perhaps for a short while afterward.

Within a relatively short time of the conclusion of the summit – which could be measured in days, weeks or a few months at most - it will become apparent that due to deepening recessions, the fiscal targets agreed to at the December 9th meeting will not be met and that additional financing will be required to cover these shortfalls. At that point, an increasingly rancorous political standoff will ensue, with various PIIGS countries asking for forbearance, Germany refusing to budge, and the ECB claiming its hands are tied. Furthermore, in the midst of all of this this uncertainty, it will become painfully apparent that EFSF schemes to provide financing to PIIGS cannot be implemented as designed.

A financial collapse is likely to ensue in short order including spiking government bond yields and the failure of some major European banks. With global financial markets at the verge of an abyss and with global equity markets 20% lower than current levels, the decision will have to be made whether do monetize (or mutualize) PIIGS debt outright or allow mass defaults, bank failures and a break-up of the EZ.

As a result, 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 (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF Trust (NYSEARCA:DIA) or Powershares Nasdaq-100 Index Trust (NASDAQ: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 (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Pepsi (NYSE:PEP).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.