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.  

European Fiscal Union and European Banking Union

An apparent first step was taken last week to create a banking union for the eurozone.  Although a lot of details were left out of the agreement and a lot of questions were not answered about such a union, hopes were raised that such an initiative would lead to more details and more answers.

One of the big hopes that attached itself to the possible creation of a European banking union is that it would help to produce a working-relationship amongst the 17 European nations included in the effort to then move on toward the creation of a European fiscal union. 

“Making it work is critical.  In the short term, a signal of tighter regulation in the future—along with bailouts for troubled banks—is needed to stem the flight of capital from countries with banking problems, which threatened to spread to financial institutions throughout Europe,” writes James Kanter in the New York Times.

“In the longer term, by agreeing to cede power over banks, European countries hope Germany will trust them more and eventually stand ready to share eurozone debt, which could help them ease austerity measures and adopt pro-growth plans to revive their struggling economies.”

To “share eurozone debt” will require that the eurozone countries agree to some kind of fiscal union.  

Nothing, however, was accomplished last week concerning this “sharing” of eurozone debt.

“Countries led by Germany agreed to allow a new, permanent European bailout fund to recapitalize banks directly…In exchange, Germany and its allies won more rigorous centralized authority over lenders.”

In essence, Germany gave up nothing and yet accumulated greater relative authority in Europe over bankers should such a central banking union actually be formed. 

The early interpretations of last week’s summit agreement were that Italian prime minister Mario Monti trumped German chancellor Angela Merkel.

Further readings are tending to go the other way.

Not only did Germany achieve more say in any European banking union that is formed, it also gave away nothing in terms of promising more money for any kind of European fiscal union that is formed. 

Wolfgang Münchau writes in the Financial Times that the most important event that took place last week was the statement by Ms. Merkel that there would be no eurozone bonds “for as long as I live.”

To Münchau, this statement reveals, that Ms. Merkel “is not serious about political union.”

And, this leads back to a point I made in a previous post.  

“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.

Europe is in the midst of a big experiment in Game Theory.  But, one has to decide what form of game theory is being played.

Some analysts argue that the game being played is that of “Chicken.”  In the game of chicken, the goal is to make someone else get out of the game first.  The game is only played once and there is potentially only one winner.

Another game is called “The Prisoner’s Dilemma.”  If the Prisoner’s Dilemma is played only once, everyone comes out with a bad result.  However, if the Prisoner’s Dilemma is perceived as a long-term game that is played over and over again, the players in the game can “cooperate” and all can reach a better solution over time.

If the European situation has evolved into a “Game”, the question then becomes, “What game is Germany playing?  Chicken or The Prisoner’s Dilemma?” 

If it is “Chicken”, then the eurozone certainly will fail.

If it is “The Prisoner’s Dilemma” then there is hope that a “cooperative” solution will be achieved. 

But, that means that for a banking union and a fiscal union to be formed…nations must give up some of their sovereignty really cooperate in the solution.

However, this last solution is a very difficult one for proud, sovereign nations with histories of “non-cooperative” solutions going back centuries, to do.

In this sense, using the formation of the United States as a proxy example for the European nations to form a federal fiscal union does not exactly fit.

Still, a first step has been taken.  I hope that further steps follow.  I believe that we all will benefit from Europe having a single currency, a banking union where all European banks have a single regulatory authority and deposit insurance is available to all institutions, and a fiscal union where the countries of the eurozone cooperate on budgetary matters.

Such an result is, obviously, not a foregone conclusion!     

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.