Friday, December 2, 2011

Europe Revisited

A great week for equities, both in Europe and the US. Is the crisis over? What's driving the markets?

The simple answer to both questions is: I don't know.

Let's try to figure out what the market drivers might be. The first big boost to the market was the coordinated Central Bank action to lower the cost of buying dollars. This launched the Dow on a 490 point upward ride that to many seemed hardly justified. And then outlines of a Grand Bargain began to emerge: first in a speech by European Central Bank head, Mario Draghi, calling for a "new fiscal compact", and hinting that with this in place, the ECB would loosen the pursestrings; then it was Sarkozy's speech on Thursday saying it was time for all the Eurozone countries to step up, to agree to new, more intrusive rules on supranational measures to ensure fiscal discipline, and thereby save the Euro; and finally today was Angela Merkel's turn to make the case for a new, disciplined financial structure for the Eurozone, as the only way forward.

Sarkozy and Merkel will meet on Monday, leading up to a Eurozone summit on Friday. I believe the markets believe an agreement will be reached on a "new fiscal compact" for the Eurozone, and with that agreement, the ECB will open up its big guns and begin broad-based, Eurozone-wide sovereign bond purchases to keep rates down and provide liquidity.

So now we must ask two more questions: will a deal be reached, and will the ECB then agree to be the lender of last resort?

My quick answers: a better than even chance a deal will be reached, but, in my view, a less than even chance that the ECB will then open up the printing press. The result would be generally positive for the markets.

Here's my problem: I think the fiscal compact for the Eurozone, designed as it will be to ensure minimal deficits and enforce fiscal discipline, is a horrible idea. And I strongly believe it will be rejected by a number of countries, possibly even its co-author, France, if it makes it to a popular vote.

Why horrible? If you exclude Greece, which really has behaved very badly on almost every dimension (overspending by the government, hiding true government debt levels to gain Eurozone entry, unaffordable social welfare programs, massive tax evasion), the other GIIPS countries have not been fiscally out of control. Italy came into the Eurozone with 120% public debt/GDP and was actually working that down, until the 2008 Crisis. Italy, Spain, Ireland, and Portugal have run consistent Current Account deficits, which they got by buying lots of good stuff from Germany. Pre-2008 private markets were financing these trade deficits. After 2008, when the private "hot" money dried up, these trade deficits had to be financed by the government sector, causing a blowout in public deficits.

I do not think these countries should be forced to endure years of austerity, huge amounts of unemployment, just to force down wages to make them more competitive with Northern Europe. Italy, Ireland, Portugal and Spain need ongoing, permanent "vendor financing", providing a predictable way to support their import purchases. This financing, possibly coordinated by the European Investment Bank, would take the form of direct investment in the countries. This way these countries could keep public deficits under control, and they would not get caught in the austerity/deflation trap.

If Merkel's idea of a fiscal compact is not modified in some way to provide financing for intra-Eurozone trade imbalances, I believe it will be rejected by voters in a number of Southern European countries. This will provoke a Eurozone breakup, and quite possibly a huge financial mess.

What am I looking for short term? First, will a deal be reached next Friday? If so, will the ECB become a consistent buyer of sovereign bonds? Then, what is the popular reaction in South Europe to "putting themselves under the German fiscal discipline yoke." And through it all, are the banks (where liquidity is drying up) staying alive? And finally, how bad is this austerity-created recession in Europe going to be?

Do I think Europe will muddle through? Quite possibly for a while. But if the all stick-no carrot approach to a new fiscal compact is not changed, a crisis cum true credit event will happen in Europe before the 2012 elections.

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