The Debt Crisis Goes On and On

When it comes to a debt crisis almost everyone seems to quote from the book “This Time Is Different” by Carmen Reinhart and Kenneth Rogoff.  A debt crisis takes a long time to create and it takes a long time for a debt crisis to unwind.

Yet, no one seems to heed this conclusion.

Instead we hear that we need more monetary stimulus, a QE3, before the upcoming presidential election in the United States.  We need immediate tax cuts.  We need fiscal stimulus.  We need an export policy to spur on the economy.

Let me repeat the conclusion written above: it takes a long time to create a debt crisis.

In my mind it took the United States approximately fifty years to create its debt crisis. 

Now, the second part of the equation: it takes a long time to unwind a debt crisis.

How long?

Jamil Baz, chief investment strategist at GLG Partners, a part of the Man Group, suggested that the current debt crisis “will take a minimum of 15 years for the economy to reach escape velocity and attain a level consistent with healthy growth.  This is because debt levels need to come down by at least 150 percent of GDP in most countries.  History suggests that you cannot reduce debt by more than 10 percentage points a year without social and political dislocation.”

Fifteen years!

Geeeeeeeeeee!!!!!!

Over the past five years, the debt situation has gotten worse.  According to Mr. Baz, for eleven the eleven developed countries most mentioned when it comes to the debt crisis, the weighted average of government debt to GDP has risen from 381 percent in June 2007 to 417 percent at the present time.

Deleveraging, at least in the public sector, has not taken place during these sad economic times…in fact, just the opposite has occurred.

And, when you add on the private debt the situation has deteriorated even more amongst these developed nations.

Why aren’t businesses hiring?  Why aren’t people spending?  Why aren’t government policies working? 

Because, Mr. Baz argues, deleveraging has not even started yet! 

All we have heard is a lot of hot air escaping from the balloon.  But, the balloon is not taking off and will not take off as long as there is still substantial deleveraging left…in the United States…and in most of the rest of the developed world.

And, when the debt begins to be reduced…watch out for economic growth.  The International Monetary Fund has estimated that, under current circumstances, every dollar cut from government deficits will lead to a two-dollar reduction in GDP.  This multiplier effect is higher now, the IMF states, than it was before 2008…four times higher!

The policy tools that people are turning to are not effective.  Additional government stimulus, or even the talk of it, points to even more debt being created which, in a cumulative way, just adds to the problem.  Monetary stimulus that creates inflation to reduce the real value of the debt will just result in higher bond yields that would raise the costs of servicing the debt and this just will exacerbate the problem.  And, policies to cause exchange rates to fall to jump-start an export-driven recovery are being tried by just about everyone with no one winning the game.

Fifty years of credit inflation…here in the United States…and in Europe…have created the debt crisis.  More of the same policy will only add to the crisis…not solve it. 

But, for fifty years, public officials would not listen to warnings that more and more credit inflation would result in a situation like the one we are now in.

Another five…or, ten…years of credit inflation will not heal the situation!

Unfortunately, there are no good, painless solutions. 

The ironic thing is that interest rates are so low in this situation!  The ten-year United States Treasury issue is trading just under 1.50 percent.  The ten-year German government bond is trading around 1.25 percent. 

The investment community is so spooked by the debt crisis that the “safe” bet today is in either US Treasury securities or German Bunds.  And, some US Treasury indexed bonds are trading at more than a NEGATIVE one percent rate of interest.  The ten-year indexed bond is trading around a NEGATIVE 0.60 percent.

In economics, everything is relative.

However, officials don’t acknowledge the problem.  Debt is subject that is best not discussed.  For most of the past fifty years, debt has not been present in aggregate models of the economy…academic, private, or government models. 

Still, it takes a long time for a debt crisis to become the dominant factor of an economy.

Unfortunately, it takes a long time for the debt crisis to subside.  This debt crisis will not be over when the next president of the United States is elected.  In all likelihood, the debt crisis will not be over when a president of the United States is elected in 2015. 

Maybe it is time to acknowledge this problem and really start to deal with it.  We have seen what continuing to ignore it does.   

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.  

Real Estate, Especially Commercial Real Estate, is Still a Major Problem

Over the past two years or so, I have continually written about the problems that exist in commercial real estate lending, especially the problems faced by many commercial banks in the United States. 

Many commercial banks, especially the less than gigantic ones intent on growing and becoming more of a force in their local or regional areas, turned to the commercial real estate area over the past decade to “scale up” their organizations.  These larger loans allowed the “smaller” banks to increase their asset size quite rapidly and, given the means and the encouragement of the regulators, could finance this loan growth by “purchased” funds rather than rely upon “local” deposit growth. 

Of course, many of these organizations knew little or nothing about commercial real estate.  But, they could hire an “experienced” commercial real estate lender and then, with the support of their regulator, could write a policy document on their commercial real estate lending operations and forge bravely ahead to greater fame and glory.

Oh, and these “experienced” commercial real estate lenders could also begin a program of securitization of larger loans so as to create fees for the bank and sell some of the asset value off to other investors around the world. 

These commercial real estate loans still haunt the commercial banking system.  Since many of these loans, securitized or not, were “bullet” loans, the banks could continue to carry these loans at “book value” on their balance sheets and not have to deal with them until they matured…five years after they were originated…or seven years…or ten years. 

And, as has been typical of commercial bankers, the lenders could always justify carrying the loans at full value until maturity, even though the borrowers experienced problems, or, in some cases, were actually in trouble with the law.  Bank lenders are the most optimistic people in the world when it comes to explaining how a loan that doesn’t look so good…will be paid off…in full!

As many readers of this blog will attest, I have constantly argued that we still do not have a full understanding of the real value of bank assets…and one of the reasons that this is true is that commercial real estate lending has become such an important part of the balance sheets of US banks.  And, given the nature of these loans, they still remain at “book value” on the balance sheets, which in many cases, is nowhere near the “market value.”  And, in the case of “bullet” loans, will not be assessed a more realistic value until the loans reach their maturity.

I have supported this argument with two pieces of information.  First, commercial real estate lending at all commercial banks continue to decline…sometimes substantially.  Whereas there appears to be some leveling out of lending in other areas, even in the residential real estate area, commercial real estate lending continues to decline at all asset levels in the banking industry, but especially in the “smaller” banks.  Commercial banks are extremely reluctant to step up their commercial real estate lending…my argument being that there is so much trouble on balance sheets in this area that financial institutions just don’t want to introduce more complicated loans into their operations.

Second, I have argued that one of the major reasons that the Federal Reserve has pumped so many excess reserves into the banking system is to provide sufficient liquidity to the banks so that they have as much opportunity as possible to “work out” their problem loan portfolios, or, if this is impossible, to allow the FDIC to “close” banks in as orderly fashion as possible so as to avoid a disruptive, cumulative problem for the banking industry. 

So far, this latter effort has been extremely successful.  The FDIC has only been closing about one bank a week over the past year and another one-to-two banks are leaving the banking industry per week over this time due to being acquired.

The problem in the commercial real estate area is highlighted in a recent article by Floyd Norris in the New York Times, titled “Commercial Mortgages Show How Bad It Got.”  Although Norris focuses on commercial mortgage-backed securities, the problem experienced by the commercial banking industry is similar.

“Now the first of the mortgages that were securitized in 2007 have started to come due, and it is becoming clear just how bad many of the loans were.  The time when investors were most eager to buy turns out to have been the worst time to do so.

Commercial mortgages—unlike residential ones—are seldom issued for periods of longer than 10 years, and often for as little as five.  Many require no principal repayments during that period but call for the entire amount to be repaid in a balloon payment at the end of the loan.  So it can be at maturity when the bad news arrives.”

It is estimated that of the loans from 2007 due to mature in 2012, less than 30 percent will be paid off in full.  And, other loans, maturing in seven or ten years can present problems in 2014 and in 2017.

Many of the loans originated in 2007 were justified…just like in the residential area…by expected, but very optimistic, increases in rental values.  Well, rental values in commercial properties, just like in the prices of homes, had been going up for years.  Obviously, they would continue to increase!

Now, Norris reports, “more than 10 percent of loans in commercial mortgage-backed securities portfolios are delinquent.”  The worst category?  “Apartment loans with a delinquency rate of 15 percent.”

Furthermore, “Borrowers are current on their payments on less than one-third of the $3.1 billion of loans still left in the securitizations, and more than 80 percent of the properties securing those loans are thought by Wells Fargo, the trustee for the securitization, to be worth less than the amount owed.”

The bottom line is that commercial banks…and other investors…are not “out-of-the-woods” yet in terms of finding out the value of their assets.  And, the worst of the worst are those banks that went heavily into this commercial real estate lending in the “boom” years, not really knowing what they were doing. 

I believe that this fact is one of the major reasons why commercial banks are not really lending much at this time and why the regulators…the Federal Reserve and the FDIC…are acting so gently with respect to the banking system.  These regulators do not want to precipitate any more problems in the banking system than they are dealing with at the present time. 

If my analysis is correct, then I believe that it will be very difficult at this time for the Federal Reserve to stimulate a faster rate of expansion of loan growth within the banking system and, consequently, it will be very difficult for monetary policy to stimulate a faster rate of economic growth.  A healthy banking system is needed for a healthy rate of economic growth. 

And, this conclusion also holds true for Europe.  Given the state of the banking system in Europe and the problems that exist there relative to past lending in the real estate area, central bank efforts to stimulate the economies of the eurozone will have very little success.  The lowering of interest rates by the ECB and others, to me, is more for show than anything else.          

All is Quiet on the Federal Reserve Front

Another quiet week at the Federal Reserve.  This month was very similar to last month…and the month before…and so on.

In terms of monetary policy the Fed is doing very little.  There seems to be very little the Fed can do at this time. 

The economy is still growing…but is growing quite slowly.  The recently revised figure for real GDP growth stands at 2.0 percent, year-over-year.

In terms of the state of the economy, the Fed can do next to nothing to get the economy growing faster before the Presidential election.  President Obama…what you see is what you get!

Chairman Bernanke and the Fed stands ready to act if things go south.  Again, there is very little the Fed will be able to do at this time before the election, but, if the economy begins to get worse, the Federal Reserve is prepared to do something to show that it is “on the watch.”  That is the least it can do to help the sitting President.

And, the Federal Reserve continues to keep an eye on the banking system.  I continue to interpret the stance of the Federal Reserve as one that aims to preserve the health of the banking system. 

I still believe that the banking system is not that healthy.  Therefore, in my view, the Fed continues to keep the banking system “well liquefied” so as to allow the banks to work out their asset difficulties as smoothly as possible.  The banking system continues to shrink due to bank closures and through consolidating acquisitions.  The FDIC is doing a very good job in overseeing the reduction in the number of banks in the banking system.

This banking policy, however, is dependent upon the Federal Reserve keeping plenty of excess reserves in the banking system.

In the banking week ending June 28, 2012, excess reserves in the banking system totaled $1,427 billion, roughly equal to the amount of excess reserves that were in the banking system on March 28, 2012 ($1,489 billion) and the amount that banks held on December 28, 2011 ($1,471 billion).

The Federal Reserve just does not want to “shake this tree.”  Bad dreams of 1937, I guess.

In order to achieve this relatively constant level of excess reserves in the banking system the Federal Reserve has basically done very little in supplying new reserves to the banking system and has consistently worked to offset operating factors that a could increase or decrease the excess reserves in the system.

There are two factors that should be mentioned, however, because these are things the Federal Reserve has had to “work around” in order to keep excess reserves relatively constant.

One of these has to do with the European financial situation.  In order to support European central banks and the European banking system, the Fed provided liquidity swaps to the European Central Bank, the Swiss National Bank, and the Bank of England.  In the latter part of 2011, these liquidity swaps increased quite rapidly as the financial condition of the eurozone deteriorated. 

Since the end of 2011, however, the central bank liquidity swaps originated by the Federal Reserve dropped substantially, falling by almost $73 billion. 

This removes reserves from the banking system.  And, in some way the Federal Reserve had to offset this movement in order to keep excess reserves in the banks relatively constant.

This the Federal Reserve did…quietly…and efficiently.

The other “overt” action the Fed took was to allow currency in circulation to increase by almost $35 billion over the past six months. 

Ever since the recession hit in late 2007, the public has been demanding cash holdings at a record rate.  Year-over-year, for example, the currency holdings of the public rose by over 8.0 percent, a rate that has been maintained for much of the past five years. 

This, demand for currency is not a good sign!  It is a sign of individuals, families, and businesses keeping cash-on-hand to help them meet their day-to-day needs.  This is money used by people in economic distress, not people who are employed and economically healthy. 

The Federal Reserves supplies currency to the banks and the public on demand.  Thus, it must operationally replace the currency it supplies in order to keep excess reserves relatively constant.  This is has been doing, not only the last six months…but over the last twelve months…and over the last five years.

In addition to these activities, the Federal Reserve has also altered, slightly, the composition of its securities portfolio.  Over the past six months, the total funds in its securities portfolio has hardly changed, but the Fed has substituted Mortgage Backed Securities in its portfolio for United States Treasury securities and Federal Agency Securities.  Over the past six months, the Fed increased its holdings of Mortgage Backed Securities by almost $18 billion but had allowed its portfolio of Treasury securities and Agency securities to decline by a little more than $18 billion.  This action was to help keep mortgage interest rates low to support the housing market.

In aggregate, the Federal Reserve kept a pretty “even keel” over the past six months continuing to help stabilize the banking industry and see that there was plenty of liquidity in the financial system to support further economic growth if it occurred.  The operations the Fed engaged in were primarily “offsetting” actions to keep the excess reserves in the banking system relatively constant.  In this, one could say that the Fed was very successful.

Talk still abounds about another round of quantitative easing, QE3, or more of “operation twist” or some other Fed action.  I continue to believe that the Federal Reserve can do very little at this time to achieve more growth out of the economy.  I further believe that the Federal Reserve will achieve little more in stabilizing the banking system by injecting more reserves into the banking system. 

The Fed does need to stay alert for signs of another recession in the United States, particularly given the recession now occurring in Europe and the slowdowns taking place in the economies of China and India. 

Consequently, I believe that the Federal Reserve should remain quiet…as it has for the past six months.  There is very little positive it can add to the economy right now.  In my mind, central banks are doing their best job when things are relatively calm and adjustments are taking place without a great deal of intervention by the regulators.  So, as of this minute…I am happy with what the policy of the Federal Reserve seems to be.     

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!