Nudge Theory: Ground Zero For 'Paneuropa'

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Includes: FXE, IEV
by: Adam Whitehead

Summary

America has a strategic interest in the reshaping of the eurozone.

Germany is currently nudging the eurozone to a position that will not include some current members.

European mutual bank deposit insurance, sovereign debt mutualization and banking union have all stalled.

Mario Draghi is being forced to detail an exit strategy from QE.

German economic and foreign policy is diverging from American interests in Europe.

Germany has been observed moving the eurozone, in its current configuration, to a point of no return. The eurozone simply cannot continue as it has done, whilst maintaining German membership and patronage. It must be noted that German economic patronage has been substantially withdrawn of late; and also that Germany has amassed twin trade and budget surpluses with its neighbors in anticipation of this moment. Something has to give and the current volatility in capital markets provides the catalyst for this to happen.

In the past, Mario Draghi has been able to throw more QE at the problem. Apparently now, he no longer has this option immediately available. His inability to apply said option, undermines his ability to weaken the Euro; which was also a valve for deflating the volatile economic and political conditions in the eurozone. Closer to home, within eurozone parliaments, the domestic populist agenda has also limited the European Union's (EU) ability to provide a comprehensive supranational solution. The institutions of the EU have therefore reached their collective political and economic limits. The demise of these institutions suggests that a comprehensive solution is out of reach at the supranational level.

What can therefore be expected are several ad hoc initiatives by nations with aligned interests going forward. This will appear to most observers as a breakup of the eurozone. It is however a transition phase. Observers are recommended to look through the headlines to discern outcomes and their associated probabilities. Observers should be mindful of the fact that the unfolding eurozone drama has a specific global context in relation to America's worldview and national security interests.

As in its genesis, Washington can be expected to have a big say in any final European outcome. Indeed if Washington is not involved, any solution will lack the credibility and legitimacy to give it any reasonable chance of success. For America, what is going on in Europe is far more significant than anything else in the world at this point in time even China.

America has pretty much got to grips with its major global threats with the exception of Europe and its implications for NATO. For now, an evaluation of the intentions and capabilities of all the players involved will be made in order to address the potential outcomes and their associated probabilities.

Jens Weidmann has been nudging the eurozone towards a post-QE phase, in which the banking system is forced to liquidate its bad debts. At face value, Weidmann's tactics seem to be entirely consistent with the Freshwater School of economics on which German monetary policy theory is predicated. A closer investigation however, reveals that German tactics are far less honorable than the face value impression suggests.

Weidmann has a traditional ally in the ultra-Freshwater Bank for International Settlements (BIS). On the Fed's normalization signal cue, the BIS went in for the kill on QE. It opined that the US economy rebounded fastest and farthest, after the Credit Crunch, because it embraced its bad debts the earliest. The US success had nothing to do with QE. Whilst the BIS supports Weidmann in faith, in practice it seems to be limited in what else it can do; other than make oblique references to the problems with QE at this point in time.

In its latest edict on bank capital adequacy requirements, the BIS took the softer approach to the subject. Capital adequacy rules will not be tightened further than what are currently in existence. This outcome is interesting, because Jeroen Dijsselbloem has been a strong advocate of tightening the capital buffer requirements from the current three per cent to four. Weidmann therefore has implicit support from Dijsselbloem. Unsurprisingly the Dutch bank regulator had no interest in tightening the capital buffer rules.

The BIS has therefore reached its limit, on what it can do to nudge forward the creative destruction phase in debt markets after the QE experiment ends. This may owe something to the fact that the BIS's Banking Supervision Committee is chaired by none other than Mario Draghi. Faced with a eurozone banking system that has yet to deal with its bad debts and sovereign debt issues, Mario Draghi is unlikely to trigger a banking crisis.

Draghi is still nudging the banking system towards a mutualised solution for its banking and sovereign debt issues. He will therefore do everything in his power to avoid a crisis at this point in time, even if it means a massive conflict of interest for him by nature of his ECB and BIS positions. The eurozone banks have therefore been spared the day of execution on their bad debts. The ECB has also been spared the day of reckoning on some of its balance sheet positions in sovereign debt that still has no foreseeable ability to pay back.

Like a true professional, Jens Weidmann has employed a new line of attack. Since capital adequacy can't be tightened, to nudge the banks towards the creative destruction phase, he is now looking directly at monetary policy. He expressed the traditionally accepted view that banks prosper when interest rates are higher. By inference therefore, the solution to the eurozone's banking problem should come in the form of higher bank profitability through higher lending rates.

Furthermore, higher interest rates should encourage banks to lend; thus creating an economic stimulus. Weidman's logic is seductive, but fails to explain what the banks will do when they have to mark to market current lending assets at higher rates of interest. The demand for larger risk capital buffers, to sustain this mark to market, is therefore the unmentioned objective that Weidmann is aiming for.

Weidmann was ably assisted by his fellow countrywoman Sabine Lautenschlager, who heads the ECB's supervisory arm. Lautenschlager is currently in an embarrassing public dispute, with her colleagues, over the expansion of QE. In her latest nudge, she opined that some eurozone banks are not managing their liquidity appropriately. This is presumably code for saying that they are too heavily reliant upon emergency funding from the ECB.

From Lautenschlaeger's words it can be inferred that she intends to probe this use of emergency liquidity further, in order to make the transgressors more reliant on alternative funding. Said alternative funding will therefore necessitate them raising more risk capital, which therefore neatly nudges the banks back in the direction which Germany would like to see.

The German coup de main was played in a show of political solidarity between Chancellor Merkel and her lawmakers. Chancellor Merkel has erected an ambush for Mario Draghi when she will play host to him at the Chancellery. Merkel will avoid breaking the taboo of commenting upon monetary policy. It is however highly likely that she will ask Draghi for a clearer road map on his exit strategy from QE.

Draghi has until now been framing expectations for expanding QE; so the introduction of the words "exit strategy" will effectively knock him off point. Once out in the public domain, the dialectic of the "exit strategy" will gather a life and momentum of its own. This momentum will slow down and possibly reverse the momentum to weaken the Euro further.

Just to add steel to Merkel's words and therein to make the trap more effective, the German legal system was incorporated into its mechanism. After acknowledging the guidance from the European Court, the German Federal Constitutional Court is now interjecting German sovereignty into the debate over QE.

Next month the German Constitutional Court will rehear five lawsuits alleging that the country should oppose the European Central Bank's 2012 bond-buying program, despite the fact that the European Court approved it. Mario Draghi may be able to debate Jens Weidmann and Angela Merkel until the cows comes home; but he must respect the Federal Constitution of the sovereign nation state of Germany (as they must also do).

This new legal twist is important because it takes a retrospective view of Draghi's previous QE expansion all the way back to 2012. If the court rules that it was illegal, then the eurozone is facing a serious legal issue. Germany could use this ruling as the precept for canceling all association and affiliation with the ECB. This legal ruling could therefore be the basis of the "Gerxit".

Germany has therefore got Mario Draghi in a very difficult position, from which it can extract concessions and compliance from him. Draghi is now facing a fork in the road. If he departs down the expanded QE road, he risks Germany walking away. If he goes down the German road, he faces losing peripheral Europe. Since his career and his current obligation is to ensure the longevity of the ECB and the Euro, it is highly probable that he must fight his conscience and take the German road. Either road leads to what has been termed as "Paneuropa" in this series of reports. Draghi therefore needs to decide where he stands in relation to it.

(Source: Seeking Alpha - Nudge Theory: Contagion And The "Paneuropa" Project - link)

Germany continues to follow the strategy of hardening the Euro to mitigate the consequences of an ugly breakup of the eurozone as populism breaks out. The cleverly laid trap for Draghi further serves to support the thesis of "Paneuropa" emerging as the core survivor and model for the eurozone of the future.

The stalemate between Draghi and the German led faction within the ECB, over the expansion of QE, is at a point which there is no consensus. The only thing that can be agreed upon is the fact that the members cannot agree. The recently scheduled release of the minutes of the last Governing Council meeting, exposed the divisions within the ECB in greater detail.

Whilst not attributing comments to any individual or nation, the minutes clearly showed that there was a significant split. One interesting point of difference was in relation to China. Thus far the slowdown and capital markets turmoil in China has yet to show up in Europe, as predicted by several Council members including Draghi. Neither has commodity disinflation negatively influenced growth; which was Draghi's main thesis for expanding QE.

In the past, Draghi has overruled internal dissent, however on this occasion he did not feel capable of enforcing his view onto the Governing Council. Draghi is therefore in the process of delicately feeling for a consensus. In his favor is growing market consensus that the decline in oil prices will afford him the opportunity to ease further.

Governing Council Member Francois Villeroy de Galhau tried his best to articulate the basis of such a consensus. According to him the ECB has the tools to act if needed, should inflation fall precipitously further. Unfortunately since falling inflation is viewed as an economic tailwind in Germany but a headwind by Draghi, the potential for a consensus is theoretical rather than realistic.

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Weidmann also has a new ally in Japan of all places. Reiko Tokukatsu, a relative value strategist at BNP, recently published a critique of the BOJ's QQE process. According to the author, QE and QQE involving negative interest rates are nothing more than wealth transfers from lenders to governments.

(Source: The Daily Shot - link)

European Commission data shows that Southern European governments have been the biggest beneficiary of wealth confiscation by QE. Jens Weidmann would no doubt point out that these are also the most politically unstable nations; lending credence to his own views on strength through prudent fiscal joy.

Italy is allegedly the biggest beneficiary of ECB QE wealth confiscation largesse. Weidmann has presumably noted with interest, Silvio Berlusconi reappearing like Lazarus to challenge Prime Minister Renzi. Berlusconi's signal, that he intends to challenge Renzi ,should not be read as meaning that he will challenge in person. He has simply sent out warning shots, to gauge both public opinion of Renzi and to flush out other potential challengers.

The last report in this series observed the growing rift between Italy and the European Commission (NYSE:EC). The flash point on that occasion was the reshuffling of a committee empowered with the mandate to deal with the immigration issue. This reshuffle created the situation in which the Italian sole representative was passed over for a Brit. Consequently, Italy is no longer represented at the EC on the immigration issue. The blowback from Italy was swift and tinged with the sense of vendetta.

The EC reaction from Jean-Claude Juncker provided some interesting context. He did away with the Enlightenment principle of fraternity; and took up the other principle of liberty in order to directly attack the elected Prime Minister of Italy. "I think that the Italian prime minister, whom I love very much, is wrong to offend the Commission at every opportunity, I don't see why he does it," Juncker said. He then opined "In truth, Italy should not criticise it too much. We have introduced (greater budget) flexibility against the will of member States who some say dominate Europe". Juncker also exposed Italy for holding up EU funding to Turkey to stem the migrant stream; thus putting into context why it had been dropped in the reshuffle of the committee on this subject.

(Source: Seeking Alpha: "Paneuropa" Re-Emerges - link)

With these words, it can be confirmed that Juncker has seen the way the wind is blowing in the eurozone. He is now hitching his own career bandwagon to what he views to be the surviving bloc after the eurozone breaks down. Juncker has just made a bid for a position in "Paneuropa". By doing so, he has given another key signal that the "Paneuropa" project exists.

The previous report, entitled " 'Paneuropa' Re-Emerges", observed Juncker swiftly changing his rhetoric. He did this in order to extend the "Mini-Schengen Zone", suggested by Jeroen Dijsselbloem, to the borders of Juncker's own crumbling empire. It was inferred that Juncker was looking for life (and a career) beyond the eurozone. His latest attack on Italy signals that he is now in process of creatively destroying the eurozone, in order to rebuild it along with his career.

Since Germany has a fiscal surplus, there is not the slightest hint of wealth confiscation. The German government does not therefore benefit directly from the ECB's QE. Neither are Germans of a mind to mutualise the debts of the eurozone, so that other nations' governments can confiscate the wealth from German taxpayers. As Tokukatsu's mainstream book shows, the criticism of QE is now filtering down from the ivory towers of academia and central banking to grass roots level. Once at grass roots level it can become a very powerful subversive force, especially in these days of populism.

A quick study, of Germany's Weimar past, will explain why Jens Weidmann is so militant on the subject of QE. It will also explain why Germany has a Federal constitution which expressly forbids what the ECB seems able to get away with in Frankfurt. Since it is unlikely that Germans will ever change their constitution one has to seriously question whether European fiscal and political union, in the form envisaged by Jean-Claude Juncker in Brussels and Mario Draghi in Frankfurt, really stands a chance. All the evidence suggests that Draghi and Juncker have been trying to nudge the eurozone in their direction. The overwhelming recent evidence also suggests that Germany has stopped them in their tracks.

Ever since the inconclusive Spanish general election results the threat to eurozone cohesion from this country have been increasing. The Catalan question is now also moving to the heart of this threat. The recent resignation of Catalan President Artur Mas only served to pave the way for a more coherent separatist government to be formed.

After the inconclusive elections, that gave no clear political or economic mandate, a political vacuum has grown in Spain. Inside this vacuum there are forces which are not only splitting the country from the eurozone, but also splitting up the country itself. Spanish politicians have looked to Brussels to provide support and leadership, but the European Union has not reciprocated.

Spanish politicians are therefore now acting in their own political interest, which has become aligned with the narrower national political interest of the disparate groups within the nation. Finance Minister Luis de Guindos signaled that Spain will now be run by Spaniards for the benefit of Spaniards when he announced that the country was no longer obliged to try and hit its Stability Pact deficit criteria. The "Spexit" can now be added to the lexicon of names for the various EU and eurozone exit initiatives at national government levels.

Spanish politicians are therefore now acting in their own political interest, which has become aligned with the narrower national political interest of the disparate groups within the nation. Finance Minister Luis de Guindos signaled that Spain will now be run, by Spaniards for the benefit of Spaniards, when he announced that the country was no longer obliged to try and hit its Stability Pact deficit criteria. The "Spexit" can now be added to the lexicon of names for the various EU and eurozone exit initiatives at national government levels.

The "Nexit" also looks set to join the exit lexicon soon, as the populist leader Geert Wilders is now the leader in the Netherlands polls. As far as he is concerned the EU is "dead"; and the first thing he will do is leave if his party is given the majority to execute this manoeuvre. Dijsselbloem's current nemesis Jean-Claude Juncker reacted, to the threat from his opponents plan for a "Mini Schengen Zone" alternative to the eurozone, by framing the Netherlands and its people as a tyrannical minority.

According to Juncker the Netherlands' threatened advisory referendum vote in April, not to recognise the accession by treaty of Ukraine, could precipitate a "continental crisis". Juncker hopes that Dutch hatred of Russia for the downing of flight MH 17 over Ukraine in 2014 is still fresh in the hearts and minds of its voters. He framed a Dutch no vote as opening the door for Russia to annexe what is left of the Ukraine. Juncker's willingness to use hyperbolic rhetoric shows just how willing to gamble he is; which therefore shows just how desperate things are within the EU.

On January 1st 2016, European Banking Union was supposed to have made a quantum leap forwards towards sustainability at the national level. As of January 1st, creditors are supposed to take the full losses when a lender collapses. Deeper analysis shows that national regulators have been able to circumvent this rule, so that "Zombie" lenders can remain alive subsisting on the ECB's QE largesse. Italy and Greece have used government aid and privately arranged debt swaps to keep banks from failing. Portuguese banking regulators actually chose which class of creditor should take the losses.

What is most surprising and therefore most interesting is that Germany itself is the main transgressor. Germany uses mutual protection schemes, to insure the spreading of bank losses, which are implicitly government guaranteed. It is therefore clear that Weidmann is happy to trigger a run on the eurozone banks, secure in the knowledge that German banks are covered. Germany clearly is happy to pick up the tab for its own failed banks, but will not pick up the tab for its failed neighbours' banks.

European Banking Union is seemingly dead in the water. Mutualisation of banking bad debts is likewise stillborn. Currently five EU parliaments have yet to ratify the Bank Recovery and Resolution Directive; and many other nations have just found ways round it.

Jeroen Dijsselbloem opined that he will be pushing laggard nations to enact existing legislation, originally legislated during the financial crisis, that should force sovereign nations to mitigate the risks within their banking systems. Until this is done, German Finance Minister Schaeuble has said that any talk of banking union and mutualisation of deposit insurance won't happen. Angela Merkel has gone even further and rejected any proposals on banking union.

Germany is therefore nudging for a banking crisis, in which sovereign nations are forced to bail out their own banks. The ECB, on the other hand, is keeping the national banking systems afloat with liquidity. A failure of the national banking systems, would then ripple through to the sovereign debt markets; at which point the ECB's holdings of sovereign bonds would be at risk. The ECB therefore clearly needs a mutualisation of banking and sovereign debt, so that it can avoid taking a capital hit that requires recapitalization.

Germany clearly wishes to see this recapitalization event, since it would effectively increase its stake and control of the ECB. 2016 therefore looks like being a year, in which the Germans nudge and the ECB pushes back. The general tightening of liquidity from the Fed's normalization process, will also increase the power of the German nudge. It remains to be seen if Mario Draghi will have the ability to push back with more QE.

To confirm that Greece is still the tail wagging the eurozone dog, Jeroen Dijsselbloem opined on the subject of the latest Greek bailout problem. Dijsselbloem was careful, not to infuriate Greek opinion, as he nudged the country towards an EU-centric bailout position. He was fulsome in his praise for the latest Greek pension reforms, but suggested that there is still more work to do on cutting fiscal spending. In his opinion, the latest bailout conditions will take months rather than weeks to sort out.

It would appear that Greece is using the threat of unleashing waves of migrants on the EU as a bargaining tool with its creditors. If the Schengen Zone is deconstructed however, Greece will lose this bargaining chip. Dijsselbloem's tactical stalling move therefore lends greater credibility to the thesis that the Schengen Zone itself is now being deconstructed. Combined with his proposed vision of a "Mini Schengen Zone" in its place, the developing "Paneuropa" narrative has greater credibility.

The last article explained that emerging German foreign policy was less antagonistic towards Russia than NATO's. NATO was in fact referred to as a "hollow alliance" in a quote from the Eurasia Group. The Dutch referendum vote on Ukraine, within the context of Dijsselbloem's "Mini Schengen Zone" and German attitudes towards Russia, will therefore be a key signal for the survival of the EU in its current form. It will also be a key signal as to what emerges as the new form of the EU going forward. Poland's new democratically elected government, a nation historically seen as a barometer for German-Soviet relations, is sending signals that the two nations are aligning their interests in the east.

The high degree of condemnation from the EU itself and the move to censure Poland, for Polish cartoons lampooning EU and German officials, signals that German and EU foreign policy is highly correlated. This act of intended censorship stands in stark contrast to the recent anniversary of the Charlie Hebdo intended censorship massacre in Paris. The mendacious EU clearly likes to pick and choose its causes; as it subjectively applies the Enlightenment principles of liberty, equality and fraternity that it was allegedly founded upon. When Greece used similar caricatures to lampoon Germany, it was financially indulged and mildly politically rebuked.

"Ostpolitik" demands a stronger reaction however. Meanwhile Charlie Hebdo remembered its fallen with a cartoon about a drowned Syrian toddler growing up to become one of the immigrants who molested German women in Cologne. The mendacity was underlined when the Czech Republic's own version of Donald Trump, opined that integrating Muslims into Europe is "practically impossible". His inflammatory comments received no swift rebuke from the EU or any European national parliament. Clearly no quarter is being given or taken in Europe these days. Poland in the meantime drifts out of the eurozone's sphere of influence towards the American version of liberty, equality and fraternity.

Chancellor Merkel herself has shifted further away, from the open German door on immigration, in the wake of the mass assaults on German women by immigrants. She now faces an open revolt from within her party and her popularity in national polls is at an all-time low. It is time for her to become a follower rather than a leader of public opinion. This shift had already forced her to avoid Davos this year, well before the attacks, the venue where the Trans-Atlantic agenda traditionally is rolled out globally.

Her move away from immigration also has logical negative implications for wider eurozone expansion. She has therefore been anticipating a transition away from the "hollow alliance" for some time. The recent German deaths, in an Istanbul terror attack, leave her with no alternative other than to pursue a more robust German foreign policy.

The weakening of NATO and the "Ostpolitik" in Germany have unnerved policy makers in Washington. So deep is the alarm that Congress has empowered the Director of National Intelligence to investigate Russian funding of European political parties that are antipathetic towards NATO. Most of the parties, allegedly funded by Russia, are nationalists and therefore antipathetic towards the EU also. European politics and economics are therefore an issue of American national security. The Cold War is definitely back on despite all words to the contrary. Congress will have its say on the eurozone of the future.

(Source: The Daily Shot - link)

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