Will Europe Muddle Through?

It's possible, but my bet is no, although for at least the rest of this week, it may look like all the problems are behind us.

Take a look at this chart from today's markets, about an hour ago, from Zero Hedge.

Equities have screamed up in the last week, but short term Treasuries carry a negative interest rate, and have done so for two months. Tyler Durden, author of Zero Hedge, calls this market divergence between equity and credit "schizophrenic". Only a few minutes after Durden put up this chart, S&P announced Germany, France, Austria, the Netherlands and Finland were being put on 90 day negative credit watch, with the chance that their AAA ratings would be knocked down to AA. The S&P immediately gave up half its day's gain.

So what's the story? What narrative is at play here?

There's an EU summit this Thursday night and Friday. Today Sarkozy and Merkel met and came to agreement on the "fiscal compact" Europe needs going forward. Remember that Mario Draghi, head of the ECB, hinted broadly last week, that if there were a new "fiscal compact" to ensure budget discipline in Europe, the ECB could consider "other measures", which the market has taken to mean serious buying of sovereign debt. So with Merkel/Sarkozy, or Merkozy now on the same page, the assumption is that the other 15 countries in the Eurozone will go along with the new compact, and, beginning next week, the ECB will begin to buy. Hence happiness in equity land, and even falling bond yields on Spanish and Italian debt.

So, are we there yet, Mom? I do not think so. The S&P announcement is emblematic of the powerful cross-currents Europe faces, and I will try to explain a bit more.

Take a look at this picture:

This is Italian Labor Minister, Elsa Fornero, on Saturday announcing the key elements of the new Italian austerity plan. Not often do we see a Minister of State in tears. She was presenting the significant sacrifices the Italian people will have to make as part of the austerity program. In this case, she is trying to announce the raising of the retirement age for women from 60 to 66 by 2018. A big change.

Italy's austerity plan follows Greece ( country continues to miss ever tighter, lower budget deficit targets), Ireland (doing fairly well, as exports picked up) and Portugal (planned targets not being achieved). A mixed picture at best. Belgium and France are reviewing austerity budgets. Chances are the austerity budgeting will spread into North Europe soon.

Will this work? Will the deficit monster be tamed through budget cutting? Quite simply, the answer is no. As budgets are cut, economic activity shrinks, and revenues for the government shrink more than expenses do, and deficits rise. And then you are stuck in a deflationary debt spiral, moving down in a self-reinforcing spiral of increasing deficits. Deficit reduction needs growth, especially if your trading partners are contracting as well.

A bad plan. All stick and no carrots. All discipline, no support. It is generated from the morality story being told that North Europe (Germany, Austria, the Netherlands) are good economic actors and South or Mediterranean Europe is bad. This is just wrong in the cases of Italy, Spain, Portugal and Ireland. Before 2008 and the Lehman crisis, they were running modest deficits or primary surpluses. Their "sin" was to buy too many German goods, which pre-2008 was funded by other European capital flow. These stopped cold after 2008, and government deficits picked up the slack, leading to the current crisis.

Why doesn't Germany remember what happened at the end of the 1920s' when Wall Street capital flows ceased, driving the country into deep recession and depression? That's just what Germany and Austria have done to South Europe post 2008. A bad story. What we need is vendor financing and continued investment in the South, not arbitrary austerity imposed from outside by faceless Eurocrats.

Prediction: the summit this Friday will be a success. The 17 countries in the Eurozone will sign on to the new "fiscal compact". The ECB will begin to support the market more forcefully. Equity markets will move further up...until the next shoe drops. When and in what form exactly, I can't say. Among the possible candidates are: S&P downgrades France and possibly Germany. One or more banks seize up. Some Eurozone country says "No deal". Recession hits big time in early 2012; countries miss their budget targets; and the ECB pulls back.

One or more of these events could cause the market to see that an austerity only plan will fail, and that the ECB is neither able nor willing to carry the whole load. Markets will tank. Greece will default, possibly others. And we will have a true mess on our hands.

Most people are betting I am wrong, and that we will "muddle through". I think Europe is heading for the rocks.