United States Profits and the United States Dollar

I recently discussed the recession in Europe and the impact this recession is starting to have on the United States economy.

In addition to this impact, we are now observing how the decline in the value of the Euro is impacting the profits of United States companies.

The Euro took a nosedive against the United States dollar in May and has remained weak against the U.S. currency ever since.  This can be seen in the accompanying chart.

It is not so much that the United States economy is that strong.  It isn’t. 

But, foreign exchange rates are relative and the current story is that the United States economy may not be that strong…it is just that the economies of the eurozone are that weak…and the leadership in the eurozone is seemingly subject to a similar shortcoming.

 

For much of the first quarter of 2012, the value of the Euro averaged around $1.32 to $1.34. 

In late April, but especially in May, the value of one Euro against the dollar dropped quite dramatically.  On May 11 the value of the Euro was still above $1.30.  By May 25, the value of the Euro dropped below $1.25.

The “fun” thing about this drop was that I was in Italy during this time and experienced the fall, first hand.

The more important factor is that the decline in the dollar value of the Euro has hurt United States companies as they converted the profits they earned in the second quarter of this year in Europe back into U. S. dollars. 

Interestingly, United States companies did not seem to be hit too hard by the drop in the Euro’s value in the latter half of 2011, probably due to the fact that the Euro moved much more slowly at this time and, coupled with a rise in value during the first half of the year, things seemed to “even out” for all of the year.  Also, eurozone countries had not gone into a recession until the last quarter of the year so the sales of U. S. companies in Europe remained relatively strong.

But, in the second quarter of 2012, the profits U. S. companies earned in Europe were hit pretty hard by the changing value of the Euro. 

For example, Colgate-Palmolive Co, and Dow Chemical presented evidence that the rise in the value of the dollar hurt their second quarter profits.  Colgate, for example, claimed that its bottom line was down by 9 percent due to currency issues.  Dow’s profits also were substantially lower.

Thomas Freyman, chief financial officer of Abbott Laboratories indicated impacted sales figures of his company by about 5 percent.  Yum Brands, Inc. owner of KFC, Pizza Hut, and Taco Bell, claimed that the exchange rate situation lowered profits by about $13 million in the first two quarters of 2012.  And, Snap-on Inc., stated that currency movements in the second quarter reduced sales growth by more than three percentage points. 

Why didn’t these companies establish hedges against such movements?

“The reason why you can’t offset the kind of significant foreign-exchange swings that we had in the second quarter was the speed of the change,” states Ian Cook, chief executive officer of Colgate-Palmolive. 

The thing everyone seems to agree on, however, is that if the value of the Euro remains where it is now, there will be continued losses in the third quarter of this year and possibly the fourth.

Given the political situation that exists in Europe right now, I can’t see the European economy getting much better through the end of the year.  As a consequence, I can’t see the value of the Euro against the dollar appreciating at all through by the close of 2012.

Therefore, I can only suggest that the profits of United States companies will continue to be hurt through the rest of 2012 due to the strength of the U. S. dollar against the Euro. 

Hence, we add one more reason to the list of things impacting the American economy and one more reason why the economic growth in the United States will remain weak in 2012.

The Spanish Bank Bailout

“Eurozone finance ministers reached agreement early Tuesday on the blueprint for Spain’s €100 billion bank bailout plan, a deal expected to see the first €30bn in aid from the eurozone’s €440bn rescue fund sent to Madrid by the end of the month.”

This statement appeared in the Financial Times.

However, near the end of the article, we read:

“It remained unclear whether the issue had been completely decided. Eurozone finance ministry officials gave conflicting and sometimes contradictory accounts of how the new ESM recapitalization plan would work after the meeting, and in an agreed statement, ministers said discussions on such details would only begin in September.”

Once again we hear, “We’ve done it!” followed by, “The details still remain to be worked out!”

Major issues are still being debated. 

“Germany’s finance minister said that even once the eurozone’s bailout fund has been authorized to directly recapitalize struggling banks, the lenders’ host government should retain financial liability for any losses.”

Germany is not going to be a part of a bailout plan that exempt’s those countries from the responsibility of recognizing and accepting their insolvencies.  To do so would result in Germany “writing a check” for those insolvencies…and this is not “on the table.” 

I treated this in by blogpost from yesterday, "Financial Markets Keep Pressure on Spain and Italy."  Today, the yield on the 10-year Spanish bond is around 7.00 percent and the yield on the 10-year Italian bond is just above 6.00 percent.  These yields are said to be “unsustainable” in the sense that these governments cannot fiscally afford to pay such high interest rates.

Wolfgang Schäuble, Germany’s finance minister, stated “’We expect that the final liability of the state will remain’ even once the banking supervisor is up and running.”

Then there is the question about whether or not the weakest banks in Spain will be included in the bailout plan.  If only the biggest and strongest are included in the new banking union, it will mean that the weakest banks, requiring the most financial help, will still be the responsibility of the sovereign nation. 

 It still appears as if Germany will not let the peripheral eurozone countries “off the hook.” And, in my opinion, why should the Germans put up the funds?

The problems in Europe are, and, always have been, an issue of solvency.  European officials have never really accepted that fact, always placing the blame elsewhere.  It was not a solvency issue, it was a liquidity problem.  It was not a solvency issue, it was the fault of greedy international speculators.  And, so on, and so forth.

Until European officials accept this fact and also accept the fact that “real” restructuring needs to take place within their societies, nothing is going to change. 

I can’t believe that one of the major moves the new President of France, François Hollande, made was to lower the age of state pensions from 62 years to 60 years, reversing what his predecessor had done.

I know that this move was basically symbolic, but it does highlight the mindset of many Europeans.  “We like the benefits our governments have given us, whether or not they make our life worse off than they would be otherwise.”

It is hard to see the elected officials of the impacted states in Europe accepting their responsibilities concerning the solvency issues and taking real steps to restructure how their societies work.

If Germany writes a check without any real concessions on the part of these troubled nations, nothing really is changed.  The European continent will continue to lag in productivity and growth.  Its young people will still face an unemployment rate of around 50 percent.  And, discontent and unrest will become even more common.

One keeps hoping that something will be done.  As for me, I am trying to avoid investments in industries or companies that have a major connection with Europe.  Europe, on its present path, is not the future. 

Financial Markets Keep Pressure on Spain and Italy

Monday morning and yields on Spanish and Italian bonds are rising once again to “unsustainable” levels.  The yield on Spanish ten-year bonds was around 7.10 percent and on Italian ten-year bonds was around 6.15 percent. 

There is a meeting of eurozone finance ministers Monday afternoon and the financial markets are expressing their pessimism that much will be accomplished.

This all comes after the euphoria over the European Union summit meeting that ended less than two weeks ago.

The problem?

National interests, of course. 

This has always been the stumbling block to any solution to the problems of the eurozone.

There was hope that the nations in the eurozone could focus on the issue of a banking union in the near term and, once they started working together on this, then the fiscal union could be accomplished.

But, national interests always stood in the background.

Wolfgang Münchau writes that the Summit agreement seemed to be in the right direction, but…

“They agreed that there shall be no common bank recapitalization until a full banking union is established. And the Bundesbank has reminded us that the latter is not possible without a political union.”

But, Münchau continues…

“What we know now is that Germany will not agree to mutualized deposit insurance. It cannot even agree to give the European Stability Mechanism a banking license so that it can leverage itself. If Germany cannot do the minimum necessary now, why should anybody think it can agree a political union?”

Germany, however, is not the only nation that is not giving in.  Even though the pain is great in several other nations, the reluctance to “give in” on certain special issues is great. 

As I wrote two weeks ago, some analysts have stated that the “game” that Germany is playing involves three paths, deflation, inflation, and writing checks.

To these analysts, “Germany has made a decision. They have opted for the first of the three: European deflation. The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation.“

In this picture, Germany perceives that the only way that the “periphery nations” will change the way they do business, a necessary condition for Germany to fully “buy-in” to the fiscal union, is for the pain in these periphery nations to become so great that they will finally commit to a major restructuring of their cultures. 

And, the stakes for Europe, at this time, are so high that Germany is willing to push events to the edge.  A “restructuring of cultures” is not something to be taken lightly.

If this German strategy is the “end game” then the question becomes one about the event or events that will precipitate the crisis that will result in the fiscal union.

If the yields on Spanish and Italian bonds become “unsustainable” the “final” crisis will arrive. 

Or, maybe the “final” crisis will be the second economic recession that has already begun. 

Or, maybe some “unknown” unknown will kick off the whole affair.

How much pain can Europe stand before something is done? 

One continues to think that each new cycle of pain will be the last one.  But, we are amazed at how much pain humans and human societies can absorb without changing their behavior. 

Apparently, we have not reached the limit of pain that Europe can absorb at the current time.  

Apparently, in Europe, the Pain is Not Great Enough...Yet!

Monday morning and yields on Spanish and Italian bonds are rising once again to “unsustainable” levels.  The yield on Spanish ten-year bonds was around 7.10 percent and on Italian ten-year bonds was around 6.15 percent. 

There is a meeting of eurozone finance ministers Monday afternoon and the financial markets are expressing their pessimism that much will be accomplished.

This all comes after the euphoria over the European Union summit meeting that ended less than two weeks ago.

The problem?

National interests, of course. 

This has always been the stumbling block to any solution to the problems of the eurozone.

There was hope that the nations in the eurozone could focus on the issue of a banking union in the near term and, once they started working together on this, then the fiscal union could be accomplished.

But, national interests always stood in the background.

Wolfgang Münchau writes that the Summit agreement seemed to be in the right direction, but…

“They agreed that there shall be no common bank recapitalization until a full banking union is established. And the Bundesbank has reminded us that the latter is not possible without a political union.”

But, Münchau continues…

“What we know now is that Germany will not agree to mutualized deposit insurance. It cannot even agree to give the European Stability Mechanism a banking license so that it can leverage itself. If Germany cannot do the minimum necessary now, why should anybody think it can agree a political union?”

Germany, however, is not the only nation that is not giving in.  Even though the pain is great in several other nations, the reluctance to “give in” on certain special issues is great. 

As I wrote two weeks ago, some analysts have stated that the “game” that Germany is playing involves three paths, deflation, inflation, and writing checks.

To these analysts, “Germany has made a decision. They have opted for the first of the three: European deflation. The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation.“

In this picture, Germany perceives that the only way that the “periphery nations” will change the way they do business, a necessary condition for Germany to fully “buy-in” to the fiscal union, is for the pain in these periphery nations to become so great that they will finally commit to a major restructuring of their cultures. 

And, the stakes for Europe, at this time, are so high that Germany is willing to push events to the edge.  A “restructuring of cultures” is not something to be taken lightly.

If this German strategy is the “end game” then the question becomes one about the event or events that will precipitate the crisis that will result in the fiscal union.

If the yields on Spanish and Italian bonds become “unsustainable” the “final” crisis will arrive. 

Or, maybe the “final” crisis will be the second economic recession that has already begun. 

Or, maybe some “unknown” unknown will kick off the whole affair.

How much pain can Europe stand before something is done? 

One continues to think that each new cycle of pain will be the last one.  But, we are amazed at how much pain humans and human societies can absorb without changing their behavior. 

Apparently, we have not reached the limit of pain that Europe can absorb at the current time.  

No Confidence in Europe

“Fears that policy makers will again fail to come up with a credible solution to problems in the eurozone at an EU summit this week continue to affect market sentiment and weigh on the borrowing costs of other peripheral eurozone countries, including Italy.”

Confidence in European decision makers continues to slide in financial markets.

Spain's Treasury sold €3.08bn of short-term debt on Tuesday.  Interest rates were substantially higher: The Treasury auctioned three-month bills at an average rate of 2.362 per cent, compared with 0.846 per cent at the previous sale last month, and six-month bills at an average 3.237 per cent, up from 1.737 per cent.

Italy also is caught in this market concern: Italy sold on Tuesday €3.9bn of zero-coupon and inflation linked bonds near the top end of the range. It paid 4.712 per cent to sell two-year paper – the highest since December.

Confidence is nowhere is sight.

Also, in Italy, Prime Minister Mario Monte is attempting to get legislation passed that would provide some reform for Italian labor markets.  Yet, even though the bill may be passed, no one seems at all happy with the contents of the reforms. 

And, analysts argue that the bill falls fall short: “The labor reform is inadequate because it does not address shortcomings in the labor market that stifle the economy,” writes Roger Abravanel, a former management consultant.

Still some officials continue to talk about a eurozone finance minister and a joint banking union.  Yet national interest and the desire to control a nation’s independent fiscal policy and banking system make such talk seem far from reality.

Some believe that this is evidenced by the fact that Germany and its Chancellor Angela Merkel have not fully let on what path they ultimately want to follow.  Germany, the creditor nation, “is acting as creditors always do. It wants to be paid back or put debtors through default proceeding to extract maximum benefits.”

Germany, it is argued, can ultimately achieve its goals by one of three paths: deflation, inflation, and writing checks. 

“Deflation in the periphery would eventually make it competitive, and is Germany’s favored option.  But, as we are seeing, it naturally leads to default by weaker banks and governments.”

With inflation, Germany loses because it gets paid back in cheaper euros.

By writing checks, Germany would pay off the periphery for leading an undisciplined life.  Another case of moral hazard.

To others, Germany has made a decision.  They have opted for the first of the three…European deflation.  The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation. 

But, as the quote above mentions, this would lead these nations to recognize their insolvency and the insolvency of their banking systems in their any solution they arrive at. 

Do you think this might win any friends for the Germans?

Still, it seems at this time that Germany holds the cards. Post-war Europe has been built on the premise that governments would always intervene in the economy to insure that workers would be employed as fully as possible and that economies would grow as fast as they could.  The result of this policy approach is the situation Europe now finds itself in. 

Germany may be trying to say that this post-war European model no longer works.

But, how much pain is Europe…and Germany…willing to go through to shift policy paradigms? 

Spain: Is This The Start of Something Big?

“Spain on Saturday agreed to accept a bailout for its cash-starved banks as European finance ministers offered an aid package of up to $125 billion (or €100).”

Note: this is for the banks only…not for Spain, itself…

The IMF had suggested that the minimum needed to stop the drain at Spanish banks was around $46 billion.  So, for once, it seems as if the finance ministers are finally trying to get their arms around the problem and not just “kick the can down the road”. 

After what we have seen over the last three years of so, it is easy to be skeptical.

To raise the credibility of the officials in the eurozone, this effort is going to have to be followed up by something more. 

Yes, the agreement has not really been signed and sealed yet, and I am looking further down the road. 

That, however, is the only way that credibility is going to become established.  One still shudders at the lack of leadership that exists within this community.

But, next steps are going to have to be made and they are going to have to follow right on the heels of this effort to halt the decline of the Spanish banking system.

The next steps are going to have to strongly indicate that the eurozone is following up this action with a real effort to create a European Banking Union!

This will not be a simple task, by any means, but it is the next thing on the agenda.

Yes, Europe needs a new unified fiscal authority to keep the eurozone together and to stabilize the euro.  This will be an even greater task than the building the European Banking Union.

The banking system needs to be saved first and this must be done in the short run.  The fear of a run on European banks seems real and this fear must be dealt with before we get to the sovereign debt issue.  Thus, full attention must be given to the issue of a banking union for it is the short run issue of consequence right now!

A major issue that will overshadow much of the debates relating to the creation of a European Banking Union is the giving up of sovereignty over banks that now reside within national jurisdiction.  That is, each individual nation in the eurozone is going to have to give up something very dear to them in order to achieve the creation of a banking union.  This surrender involves centuries of history, pain, dislike, and, in some cases, outright hatred.

Can the officials get over this hang-up?  Can they put the past behind them in order to save the future? 

Creating a banking union, however, is just the start.  If there are national issues that must be given up in creating a “federal” banking union, these issues pale when one considers what these nations must give up to create a “federal” government that oversees and controls the spending and taxing and so forth that have formerly been completely under the control and oversight of the individual nations themselves. 

But, it seems to me that there is very little to choose from in the present situation.

Let’s consider three possible outcomes from the current state.  First, a European Banking Union is formed followed by the formation of a federal European government that oversees and controls spending for the eurozone. 

Second, the eurozone falls apart and the individual nations now making up the union go on their merry way.

Third, some nations form a banking union and a federal government and other drop out of the community.

To me, the suffering and pain that would accompany the second and third choices would be very substantial.  The second and third options are just not pretty!

But, human beings can be very self-destructive at times and make choices that are stupid and against their own best interests.

In my mind, there is no real choice.  Somehow, someway, European officials are going to have to form a European Banking Union and are then going to have to follow this up with some kind of federal government that deals with the combined fiscal issues of the eurozone.

Therefore, I am pleased to see the discussions concerning the rescue of the Spanish banks going forward.  I am hopeful that these discussions will be followed up by the formation of a European Banking Union. 

Then, the big task…a federal European government that will discharge the responsibilities of the eurozone with respect to the fiscal affairs of the community.  Of course, this federal government will also have to deal with the restructuring of economies, work-rules, pensions, and so forth.

Seeing real, credible movement on the part of European officials, I believe, will be seen positively by international investors.  If these investors react positively to the movements to create a European Banking Union and then to the further efforts to create a federal European government, I believe that financial markets will rise and this will provide the support and encouragement for the project to continue. 

If this process gets started the European officials must not let the momentum or the international investment community will lose heart and argue that the officials were not fully into the idea in the first place.  Skepticism will set in again.

I see the possibility of getting started on the European Banking Union, however, as a real opportunity.  The issues here are not as great as those connected with the formation of a federal European government.  So, this is a chance to start on issues that are smaller and are clearer. 

The important thing is to get the process jump-started and then build on the momentum.      

Can Europe Really Reform and Restructure?

Europeans, apparently, don’t want any further integration.   The Pew Research Center in eight EU countries found that “the public is more doubtful about EU membership and the single currency and is shifting decisively against handing Brussels more power over national budgets.”

I have jut returned from two weeks in Italy.  The following comments represent some of the impressions I gathered on the trip.

National divisions are just one reason, although a major one, for the continued failure of the European Union to reach some form of resolution to the ongoing financial crisis.  Whether these divisions can be overcome in the longer term is, of course, a concern of many that a unified solution can be achieved. 

But, there are many other hurdles that work against moving Europe into some greater form of common union.

So much public attention has been given to the fiscal affairs of the national governments and rightly so.  But, there is another aspect to these fiscal affairs that go beyond the ability of the governments to repay their debts.  This other aspect is the social framework that has been built up in these countries through the actual spending that has taken place.

I have often discussed some of the structural problems in the United States created by government spending aimed at keeping people employed in the jobs that they have been working in and to build up government payrolls at the local level, as well as at the national level, to keep people employed and happy.  The consequences of these kinds of policies include rising levels of under-employment, reaching maybe 20 percent of the working age population, and bloated state and local government budgets supporting excessively generous hiring practices and underfunded pensions.

Well, from what I saw and the people I talked with, when compared with Europe, the United States is a “Scrooge” when it comes to this kind of behavior!

And, if the United States has an un-employment rate a little over 8 percent and an under-employment rate of around 20 percent, what is the situation in Europe where countries face 20 to 25 percent government measured un-employment?  What is the level of under-employment in these countries?

In addition, what is the situation in the bloated government bureaucracies and the school systems in these European countries?  The university systems in these countries are, to me, frightening.

Another truly amazing thing to me is three-hour lunch hours…mandated!

What about the spread of information technology?  This, of course, is one of the major things driving modern society.  Read an interesting article that appeared in the New York Times yesterday.  “Italy remains well behind most other West European countries in the reach of the Internet….”

I was discussing the use of information technology in the financial field, especially in banking, with a very advanced thinking Italian, someone who has spent quite a few years in America.  His comment was that Italy was many years behind the United States banks in adopting modern computer technology to daily banking transactions.

And, everywhere I saw industrial zones created to support manufacturing employment with empty parking lots and houses and business buildings standing uncompleted with nothing around them to indicate that activity would return to them soon.

The one thought I took away from trip was that although Europe has a fiscal crisis to deal with in terms of getting their financial affairs in order, the much bigger problem faced by the Europeans is the need for the reform and restructuring of the way they do things.

Modern technology is being used in these European countries, but the technology is being used to maintain a lifestyle that existed in another century.  This is not unlike some radical religious groups that use modern information technology to retain a hold on their medieval social practices. 

In my reading of history, the advance of information technology always wins.  The advancement may be diverted or delayed for some period of time but the spread of information always triumphs in the end. 

The transformation is not easy and will not be easy in the case of Europe.  There will need to be much social change along the way and the existing structure of classes, intellectual as well as wealth and business, along with the current philosophies pertaining to labor unions and governments, will put up substantial barriers to the changes that are needed. 

An example of this given in the New York Times article quoted above is the efforts made by former Italian prime minister Silvio Berlusconi to protect his media business empire from intrusions of the Internet.

The whole world is going through massive changes and no one group, organization, or nation, is going to be able to avoid the changes.  I knew many of the countries in the eurozone were behind the curve in this transition.  I have argued that Europe seemed to be devoid of the leaders needed to guide their countries through this period.  But, my recent trip has made me more pessimistic about the ability of the European Union to throw off their blinders and actually carry out the reform and restructuring that is needed. 

A conclusion like this can only make one more pessimistic about investing in Europe.  I like to think of myself as a value investor that invests for the longer term.  In terms of Europe, therefore, the longer term, in my view, just got that much longer.   

The US Bond Market and the Situation in the Eurozone

In my last post, I wrote about the bond market in the United States and how the European situation is impacting the structure of yields in US financial markets.  My conclusion was that the “flight to quality” being experienced in world financial markets has led to a situation in which the supply of funds to United States financial markets has resulted is extremely low long-term interest rates and a negative yield on the US Treasuries inflation-adjusted securities (TIPS). (http://seekingalpha.com/article/551121-what-are-the-bond-markets-trying-to-tell-us) 

The question then becomes, if the extremely low long-term interest rates are a consequence of a “flight” of funds from European markets and this condition will last in some form until the European Union “gets it act in order” what will be a condition of Europe “getting its act in order”?

Over the past two years or so the efforts of the European Union to resolve the sovereign debt crisis has “kindly” been referred to as “kicking the can down the road.”  No one seemingly wants to “get their hands around the situation” and work to resolve the crisis.  Consequently, the crisis lingers on with recurrent bouts of national concern like that now being focused on Spain. 

It should be obvious by now that “kicking the can down the road” is not going to end the sovereign debt crisis in Europe. 

The current direction in which European elections are headed seems, if anything, a step backward in the process.  But, Europeans are tired of all the austerity.  They want to throw existing policymakers out of office and elect someone else…it doesn’t really seem to matter who.  And, we are seeing this played out in this weekend’s elections in France and Greece.  This following the situation in the Netherlands where the existing government was defeated, the 10^th such government to lose power since the debt crisis began.  

Tom Sargent, an economist who won the Nobel Prize last year, suggested in his Nobel Prize winning acceptance speech that the current problems being faced by the nations of the eurozone are similar to those faced by the United States as it was trying to become a unified country in the late 18^th century.  The European Union now is like the US under the Articles of Confederation at that time.  The US had to become a unified country under a Constitution and establish its fiscal credibility before it could operate as a nation among the other nations of the world.  Sargent suggests that Europe must achieve the same goal. (http://www.nobelprize.org/nobel_prizes/economics/laureates/2011/sargent-lecture.html)

While the fiscal crises of the states was going on during this period in the United States there was also a banking crisis going on in the private sector, a lot of it caused by the credit problems faced by the states.

Taking the experience of the United States as an example, one can argue that the only way the European Union is going to “get its arms around the problems” is to form a fiscal union amongst it members that will supplement the monetary union that is already in existence. Many anticipated this next step when the original monetary union was formed. (http://www.ft.com/intl/cms/s/0/50a1f9fe-9466-11e1-8e90-00144feab49a.html#axzz1tp5ngu6K)

However, the fiscal union implies more.  A federal union of countries is going to have to establish its credit standing in the world which means that it will have to be able to issue debt with the “joint and several liability” of the eurozone backing it.  Of course, this implies that the new fiscal union of eurozone countries will conduct it budget operations on a sound basis. 

Furthermore, the eurozone is going to have to move to save European banks.  The European Central Bank cannot solve the whole problem through its “liquidity” efforts.  The countries of the European Union are going to have to provide funds directly to the European banks that need them.  This will not be inexpensive in the short-run.  Hopefully, over the longer run the European Union will get a large portion of the funds back.

European banks are even in worse shape that United States banks.  Bloomberg Markets magazine has just released its list of the strongest banks in the world.  There are only four European banks in the top twenty: two from Sweden, one from the U.K. and one from Switzerland. (http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html)

Whoops!  None of those banks are in countries in the European Union.  Seems like the strongest banks in the world are not in countries that have pursued the policies of credit inflation that have created huge amounts of debt.

The problem is: who is going to lead Europe into a fiscal union?

Angela Merkel, the German Chancellor, has indicated that that is the direction in which she is headed.  Yet, it is not altogether clear that the German people will accept a fiscal union because so much of the load of the new union will be placed on Germany.  Furthermore, you have the move to new governments within the European Union that “anti-austerity” and “anti-German.”

Still, Germans have benefitted more than any country in Europe from the monetary union and from its reunification and from integration with other European countries.  Germany stands to continue to benefit from “more Europe” rather than less. 

And, this is true of the rest of Europe.  It is not an easy path to a new European future, a united Europe, but it will, in the end, produce the greatest amount of wealth and prosperity for the continent as a whole. 

This is a massive undertaking.  A movement in this direction will not resolve all of Europe’s growth problems, its unemployment problems, or, its real estate problems in the near term.  To stay separate, however, in my mind, is almost unthinkable.  We might get a taste of this soon in Greece if a new government comes to power that cannot follow up on the conditions of the recent bailout.  If the new government is unable to deliver, the European Union may ask for it to withdraw.  My sense is that this would be pretty bad.

In terms of the United States bond market, I believe that it will not take the full consolidation of the European fiscal union to reverse the flow of funds coming into US financial markets.  What is needed, however, is some credible leadership to arise in Europe that can achieve some credible gains in movement toward the union.  Given the elections coming up this weekend and in the near term, it is hard to see such leadership ascending.  So, it may be awhile before yield relationships return to more normal levels.        

Europe Still Bubbles

The headlines coming out of the weekend: “Italy warns Spain over budget” (http://www.ft.com/intl/cms/s/0/70fbb99c-768e-11e1-a6f3-00144feab49a.html#axzz1qE3JX1ju); “Germany ready to boost size of firewall” (http://www.ft.com/intl/cms/s/0/85911faa-767f-11e1-8e1b-00144feab49a.html#axzz1qE3JX1ju); Europe’s bailout bazooka is proving a toy gun” (http://www.ft.com/intl/cms/s/0/3e736dd2-74d9-11e1-ab8b-00144feab49a.html#axzz1qE3JX1ju); “Greek bond yields jump as trading in credit default swaps put on hold (http://www.ft.com/intl/cms/s/0/55db7e7e-74ca-11e1-ab8b-00144feab49a.html#axzz1qE3JX1ju).”  And so on, and so forth.

Bets on Intrade.com, recently, put the odds of the European fiscal union cracking apart by the end of 2013 at a little more than 36 percent.

There are all sorts of scenarios that picture the demise of the current arrangement.

But, there is one major thing that seems to keep holding the union together: the fact that the cooperative structure added to the common market has provided the vision of an economic bloc that can be competitive in this modern world with the other major economic areas of the world like America, China, Brazil, Russia, and India.

Combination is better than separation.

Yet, the path to deeper integration and greater centralization of the fiscal authority is ugly. 

One reason for this is that the countries of the eurozone have centuries of history, of wars, of hatred, of irrational biases to get over.

As the recent movements on the Greek crisis showed, the shadow of the past was not far from people’s minds as references to the Nazis and German domination bubbled up into the debate.

The past is not going to be forgotten…and there is a lot of it.

Yet, here in the 21^st century, the economic reality of the situation, I believe, will win out.  The eurozone will hold together for the alternative, small, separate states competing against each other and “biggies” of the world, is not a real choice.  And, most officials in Europe, I believe, realize this.

One continuing problem in the effort is that these European officials repeatedly fail to “get their arms around a situation”. 

The “good” news over the weekend: “Germany is set to bow to international pressure and allow a temporary increase in the eurozone’s financial ‘firewall” this week, to prevent the crisis in the region’s periphery spreading to other member states.” (See “Germany ready to boost size of firewall” cited above.)

The “bad” news: the “rescue umbrella” is not big enough.” (See “Europe’s bailout bazooka…” cited above.)

The “umbrella” may be able to handle any problems coming from the smaller states, like Greece and Ireland, but it would not be able to handle Spain…or Italy.

The Italian prime minister, Mario Monti, is concerned about this and warned Spain that it should not back off from fiscal efforts and weaken its “budget-cutting credentials.” (See “Italy warns Spain…” cited above.)

But, financial markets still reflect the uncertainty about what is happening.  Greek bond yields reached new post-bailout highs on Friday as yields on Portuguese bonds remain quite high and those on Spain’s bonds rose by about 30 basis points toward the end of the week. 

The rise in the yields on Greek debt spilled over to the credit default swaps market as investors showed fear that the CDS trigger process might be subject to some immediate payout problems.  There was additional concern that this issue could impact other eurozone bond markets. 

So, the process of integration continues.  And, as mentioned above, the process is not pretty.

It is hard for sovereign nations to give up their fiscal powers, especially when their elections are so dependent upon the “free lunches” that politicians promise to the voters.  Yet, this is where events are leading.

It is going to be a bumpy road and there are many ways that the “end game” could be played out, but, in my mind, one way or another, the euro will survive and Europe will eventually prosper because of it.