The Latest Euro Compact: Hot, Meaningful Air

Includes: ERO, EU, FXE
by: Intangible Valuation

Needless to say, the European debt crisis is a result of the different fiscal policies across Europe. Their leaders need time to implement long-term economic integration. And so, in an attempt to calm the markets, they gave us their new "Four Essential Building Blocks" (found here (pdf)):

  1. An integrated financial framework: "Building on the single rulebook, an integrated financial framework should have two central elements: single European banking supervision and a common deposit insurance and resolution framework." (p. 4)

  2. An integrated budgetary framework: "Towards this end, upper limits on the annual budget balance and on government debt levels of individual Member States could be agreed in common. Under these rules, the issuance of government debt beyond the level agreed in common would have to be justified and receive prior approval...In a medium term perspective, the issuance of common debt [Euro Bonds] could be explored as an element of such a fiscal union and subject to progress on fiscal integration." (p. 5)

  3. An integrated economic policy framework

  4. And "strengthened democratic legitimacy and accountability"

Of course, these statements will be hot air while we wait for an interim report available October 2012, with the final report to be finished before the end of the year. While it appears they have only just begun a report, in reality they have been prepping for this political centralization of power for some time. Most indicators and reasoning point out that imbalances and political incontinence will fail to hold the euro together without tighter political and fiscal integration (like, for instance, that public deficits are encouraged by the structure of the European Monetary Union).

Indeed, imbalances still exist and are perpetuated by the way new money enters the European economy. For one thing, Greece still has a balance of trade problem, i.e., more euros are leaving Greece than are coming in.

Through the ECB, new money has flowed to the banks and then to the Greeks and other debt issuing countries. While Greek's balance of payments has improved, it is still leaking new money into the rest of the EMU.

Click to enlarge:

In most economic courses taught at university, inflation is hypothesized to enter the economy evenly. In the eurozone, this is not the case. Since Greece needs more euros than it takes in to finance its trade deficit, it needs to get those new units of currency somehow. They do it through selling debt to the banks, who then use that debt as collateral to borrow new money from the ECB. The process then repeats itself. New money is perpetually created in this manner and pumped into the 'deficit-faring' countries.

While the graph below begins just prior to the introduction of the euro, and while Greece didn't join till 2001, it still represents one of the problems of the eurozone. All these countries still experience different rates of inflation despite all being on the same currency.

The new euro currency units are entering the EMU through the countries which have a negative current account balance and run public deficits. That is, EMU countries which run larger public deficits should and do experience higher inflation generally. This is clearly indicated by the graph above and it beautifully illustrates one of the problems of the eurozone. Since inflation benefits debtors and the individuals who get the new currency before others, there is an incentive to run a public deficit in the eurozone. The debtor country benefits twice: First, when they spend the money before prices have risen in general; and secondly, when the price of goods rises across the entire economy and their debts are devalued in terms of real goods.

The new plan calling for "an integrated financial framework" and "an integrated budgetary framework" are specifically plans to try and contain this problem. Specifically, the "integrated budgetary framework", since then public deficits are dictated at a European level and the incentive to run larger deficits could (possibly) be held in check. If they cannot do either of those two things, the incentive for deficit financing will likely force the eurozone apart.

While it seems like they are "just" trying to kick the can down the road, they are also kicking the can down the road consciously. The financial markets are built for the judgment of quick results, and a fixing of the European economy will not be timely enough in that regard. Financial markets represent opinion and not fundamentals. The leaders are placating the financial markets so that they can politic their way to a sustainable budgetary framework. Without the budgetary framework, the divergent trends on the second graph above would continue.

Those inflation numbers are all under the same currency and merely differentiated by geographic location and political control--such a divergent trend cannot continue. As Herbert Stein says, "if it something cannot go on forever, it will stop."

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