Where Europe is Heading

Italy has just called for the issuance of Euro bonds that would substitute for the sovereign debt of individual EU member nations. An EU-controlled entity would issue these bonds in exchange for the sovereign debts of each member nation, and could impose continent-wide taxes to pay off the Euro bonds. Greece, badly battered by the debt crisis, shouted a heartfelt "amen" to Italy's proposal.

The UK seconded the sentiment, proposing fiscal union for the EU. Fiscal union is about effectively the same as the Euro bond concept. Why would Italy, Greece and the UK publicly talk up European unity? Because they can see the handwriting on the wall. Unity is, in their view, the only alternative to the septic tank.

Germany, on the other hand, is reaching for as much garlic as it can find, in the hope of warding off fiscal union. It would have to pick up most of the tab for true European fiscal unity, and the German electorate has yet to wrap their heads around that concept.

Europeans basically have two options. One is to unite. They would become something similar to the United States, with a continent-wide government controlling fiscal policy and having taxation powers. The current nations would become more like America's states, controlling local matters but subordinate to the bureaucrats and legislators in Brussels. While Europe would probably never be as tightly united as America under the Constitution (that is, after the Civil War and the adoption of the 13th, 14th and 15th Amendments), its survival would require greater union than achieved by the original thirteen American states under the Articles of Confederation.

Europe's second option would be for Germany and maybe other fiscally strong northern EU nations to leave the EU and strike out on their own, issuing their own national currencies again. Germany would probably strengthen economic ties with Eastern Europe, the Baltic republics, and the southeastern portions of the former Soviet Union (such as Ukraine, Moldova, etc.). These nations are of historical German interest, dating back even to the excursions of the Teutonic Knights during the Middle Ages. Southern European nations would be left on sidelines, muttering something about dancing with the one you brung.

Germany's chancellor, Angela Merkel, and France's president, Nicholas Sarkozy, meet on Tuesday, Aug. 16, 2011. With all this talk of European union, the media will fixate over their every smile, frown, and arched eyebrow. Merkel, more than anyone, will be the decider. Although she has talked the talk on requiring southern European nations to pay their own way, she has reluctantly slid down the slippery slope toward comprehensive EU assumption of the sovereign debt of member nations. It would be politically impossible for her to reverse course now (although she won't openly support Euro bonds because that would be political suicide). A change of political control in Germany would required for option two. That's not yet likely, although it's possible. Political turmoil there would translate into more stock market volatility in Europe and America.

More than anything else, Europe's response to its sovereign debt crisis will dictate the direction of Europe's and North America's economies and stock markets. Europe's recent piecemeal ban on naked short selling of bank stocks is akin to shooting the messenger. But the EU approach to its debt crisis has certainly been lathered with expediency. Next week, the EU may stir up a good deal of market volatility. The U.S. Congress can't do its share to screw things up, since it's thankfully out of Washington for the August recess. Keep an eye on events across the pond.