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One More Spin Through the Euro Cycle

The basic facts in Europe have not changed.  Germany and France remain bitterly divided over the future of the European monetary system, and neither has the power to get what it wants.  Germany wants the rest of Europe to adopt German-style economic policies, but key countries like Italy, Spain and even France really can’t do that.  They can sign pieces of paper saying they will do it, and they can swear oaths of mickle might that they will never sin again, but they are who they are and they do what they do.

The French on the other hand cannot get the Germans to pay their debts without agreements to build a German style fiscal union.  The French continue to hope that if they can just get the Germans to sign a piece of paper, almost no matter what it says, then the money will flow from the ECB and French and Italian ingenuity plus the facts of life will gradually twist the nominally German style fiscal union into a Latin paradise.  The American government basically hopes this as well; the US prefers looser monetary policy to Teutonic rigor and is more worried about the problems of an immediate European meltdown than about German resentment down the road.

In the absence of an agreement, the French and the Germans continue to work together to try to prop the markets up and kick the can down the road.  As time goes by, and “solution” after “solution” to the European problem turns out to be a sham, the markets get more skeptical, so the French and the Germans have to develop more elaborate and convincing pseudo-solutions to buy more time.

Last week this pattern brought the world to the brink of disaster; uncertainty over the future of the euro had crippled the ability of European banks to carry out their basic business.  Foreign investors and bankers were fleeing the eurozone, and there was an imminent danger that the financial markets would stop working.

Coordinated central bank intervention to assure the dollar liquidity of the European banks took the grimmest scenarios off the table for now; that was the basic fact that led last week’s recovery on the financial markets.  At the same time, the French and the Germans came up with a more convincing looking “fix” with so many moving parts that it is taking markets slightly longer than usual to sift through the spin and the fine words to see that no progress has been made on the key issues.  Finally, and this was no small part of the rally in European sovereign debt markets, Germany backed off its demand that private investors take haircuts in any future debt issues.  Fear of Greek style debt write downs had been a major factor in the dramatic surges in borrowing costs for Italy and Spain; with that fear relieved, markets eased.

Put all that together and the European meltdown has turned from something that could happen in the next few days into something less immediate; this alone is enough to justify the rise in stock markets and the fall in bond yields in the last week.  If the world’s leaders can’t solve the European monetary problem for good, they can still keep it from blowing up this week, and that is something.

The real test will come next week as the markets and the ratings agencies chew over the results of the European summit now scheduled for Friday.  Not a single one of Europe’s major problems has been fixed.  If anything, as the potential for a recession and downgrades increases, the underlying situation is getting worse.

Last week the Europeans stage managed a beautiful pageant.  Pieces of actual good news for the markets (central bank intervention and the lifting of the haircut threat) pushed markets up, lending credibility to what would otherwise have appeared as yet another failure to resolve the problems that are killing the euro.  For a few days hope flourished that the bad times were behind us; with some good news from the US on unemployment, it felt almost as if the recovery was here to stay.

Over this coming weekend, people will digest the results of the summit.  Markets don’t want to crash; they want to believe that the Europeans will succeed.  (Via Meadia hopes the same thing, by the way.  Europe and America are two mountaineers tied together on a cliff; we do not want them to fall.)  Everyone is tired of gloomy times and bad news.  The Europeans don’t have to solve everything on Friday to turn a corner; they just need to rule out a meltdown in the next few months.

We shall see.

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  • Otiose8

    The gloomy times not to mention gloomy events are inevitable. People are just naturally reluctant to face up to what’s coming. The delay will only make the necessary adjustments worse unfortunately.

    Debts need to be written off, losses absorbed, and prices allowed to find their new real values so that the real growth can get traction.

    “Finally, and this was no small part of the rally in European sovereign debt markets, Germany backed off its demand that private investors take haircuts in any future debt issues. Fear of Greek style debt write downs had been a major factor in the dramatic surges in borrowing costs for Italy and Spain; with that fear relieved, markets eased.”

    It’s not that Germany’s demand for private investors to take haircuts was a problem. Many private holders have insurance that can only be triggered by an unambiguous event of bankruptcy. That they didn’t allow the insurance to be triggered has basically invalidated the insurance and put many banks in a difficult position in presenting their credit risk situation accurately to the markets. Net exposure has to go to gross.

    If private holders don’t take haircuts the losses will eventually have to be absorbed by public (i.e. taxpayers) one way or another (think QE and some serious inflation).

  • Luke Lea

    With enough legerdemain it should be possible to find a way to put off the day of reckoning until after the 2012 elections — by which time the major bank’s will have had time to unload their Greek exposure onto an unsuspecting public.

    The trickiest part, I surmise, will be how to bring the ECB into full partner in crime with the IMF and the U.S. Federal Reserve, the goal being to “equitably” divide the pain between European and American taxpayers.

    Once done expect Greece to exit the Eurozone with a minimum of fanfare and for few Credit Default Swaps being called into play. Citibank will be saved to lend another day!

    Am I being too cynical here? Well, these aren’t my cynical ideas — they are the ideas of European bankers I’ve been reading of late — but I hope I’m wrong all the same.

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