Why the Eurozone Will Ultimately Fracture

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Includes: DIA, ERO, EU, EZU, FXE, IEV, SPY
by: Joe Eqcome

The risks are high that there will be a fracture in the eurozone based upon simple group dynamics of the eurozone’s failure to live up to its initial promise. The question is whether it will be orderly or disorderly. The equity markets have not fully discounted the unwinding of the eurozone and as a result will likely be caught “flatfooted” disrupting equity markets early in 2012.

The current signaling by the eurozone members of a tighter union is a “red herring” provided to buy time to salvage their banks and for an orderly jettison of its weaker members. Additionally, it is a miss-management of investors’ expectations harboring dire consequences.

Why the Eurozone Will Fracture: The basis for the euro “club” is no different than the group dynamics of any social organization. Each member joins to advance their own interest under an agreement which appears to benefit all—but each for different reasons.

Asymmetrical Motivation: The problem is asymmetry in motivation among members. Take the case of the 17 countries of the eurozone. For the more powerful in the group (Germany and France) it is an opportunity to expand their influence over a wider area of politics and commerce that will enhance their prestige and economic reach.

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The weaker members, of which 13 of the 17 members’ cumulative GDP is less than that of Germany’s, are eager to join to enhance their social and economic status by associating themselves with the stronger members and their existing infrastructures.

Play By The Rules: This all works if each member is fulfilling their implicit interest under the terms of the agreement while not violating the interest of others. The strong members exercise control over the weaker members and the weaker members benefit from the membership in a broader network provided by the stronger members. (Not much different than a college fraternity or sorority.)

He’s Heavy, Because He’s Not My Brother: However, the stronger members (Germany) have no real interest in carrying the weaker members if the “whole is not greater than the sum of the parts”. The weaker members on the other hand don’t want to be worse off than when they enter the arrangement (Greece).

Whole Less Than Sum Of The Parts: The social dynamics would dictate that Germany is not going to be dragged down by the weaker members as there is no affirmative benefit to do so. The motivation now is the adverse consequences of the stronger members having invested in the weaker members through their banks without proper collateral.

Borrowing Time And Money: Notwithstanding, it makes no sense for German to save the group’s weaker members in a compact that is dysfunctional and not in its best long-term interest. All that is being bought is time to figure out how jettison the weaker members while salvaging their national banking system and possibly reconstituting a smaller group of stronger members.

This will be a painful and disruptive process but it is better than a collapse of the group under its own weight. The key is going to be managing investors’ expectations.

Membership Considerations: The stronger members should have seriously considered the advice of Groucho Marx and the prospects of adverse selection of weaker members with regards to his observation: “I won’t belong to any organization that would have me as a member.”

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