Merkel Has the Bazooka, Not Bernanke

The eyes of the financial markets are on Federal Reserve Chairman Ben Bernanke, who will give the Federal Reserve's unofficial annual Financial State of the Union Address at the Kansas City Fed's Jackson Hole conference on Friday, Aug. 26, 2011. Bernanke will almost surely announce one policy measure or another. QE3 is unlikely; QE2 has turned to be largely a bust. The Fed may well choose something like adjusting the mix of maturities of its bond portfolio, shifting toward greater emphasis on the long end in order to push down longer term interest rates. Such a shift may moderately reduce longer term rates. But those rates are already lower than a snake's belly. So the impact of a portfolio shift on economic growth isn't likely to be more than a sacrifice bunt.

Bernanke's problem is that the markets expect him to expend all ammunition. Primarily because of Bernanke's own predilection toward policy action, and his predecessor's issuance to the financial markets of the Greenspan put, the Fed no longer has the option of holding its fire. The markets expect the Fed to maintain its covering fire, and have priced continuing Fed activism into the market. In effect, the Fed has already fired all its ammo, and will be punished with a market rout if it fails to fire. Bernanke surely knows this and is mustering his now meager forces on the firing line.

Governmental action can give the markets a lift when it's unexpected. The one thing the markets don't expect is for Germany and France to sign off on the concept of Euro bonds. At the moment, the world's biggest economic problem isn't America, but the European Union and its spiraling debt crisis. Things have been going from bad to worse, and may lead to another financial crisis a la 2008. Perhaps the one clear way out of the mess would be for the EU to combine and issue Euro bonds, community-wide debt to replace the sickly sovereign debt of profligate members like Greece, Ireland and Portugal, and possibly Spain and Italy. But Euro bonds would amount to a massive transfer of wealth from Germany, and to a lesser degree France, to the weaker nations. The German electorate has yet to wrap their brains around this concept, and it may take a few centuries before they do. They can't simply hand over the wealth--that would feel like they were held up. But imposing strict fiscal controls over beneficiary nations would bring back images of storm troopers goose stepping into foreign capitals. For some reason, many European nations have a problem with this.

Nevertheless, Merkel holds the bazooka. She can surprise the markets by endorsing Euro bonds. It's doubtful she will. But if we're going to have a big upside surprise this August, it will come from Germany, not Jackson Hole.