Pan Europeanism's Gambit

It would appear that a group of key European leaders combating the EU financial crisis have coalesced around the banner of Pan Europeanism.  Mario Draghi, head of the European Central Bank, has positioned the ECB to start financing struggling EU governments.  This is a paradigm shift from past ECB policies, and moves the ECB toward the money printing mode of the Federal Reserve and the Bank of England.  Recently, Angela Merkel, Germany's Chancellor, has spoken of cutting Greece a break on its austerity obligations under the terms of the EU's bailout for that nation. Such magnanimity is at rather sharp odds with her tough stated positions not many months ago.  The recent election in France of Socialist Francois Hollande shifted the EU's political center of gravity toward more accommodative measures--Hollande's notion of austerity is to raise taxes on the wealthy and give them a taste of austerity. 

The award of the Nobel Peace Prize to the European Union may be the latest move in the gambit to persuade skeptical northern European taxpayers of the need to keep the EU together.  The point is that failure to stay together will raise the specter of another continental war.  Although actual war seems highly unlikely in today's non- and often anti-militaristic Europe, the subliminal message is clear. 

The Nobel award is like a mutual admiration society of Pan Europeanists high fiving each other. The political in-crowd on the continent has to be very pleased with itself at the moment.  But the baseline problem for saving the EU remains whether or not northern European taxpayers are prepared to foot the bill for keeping the whole shebang together.  If not, the $1.5 million or so that comes with a Nobel Prize won't matter.  An interesting question is who will the EU select as its representative to receive the award.  Here's betting it's Angela Merkel, who needs political cover.

What's Behind the ECB's Unlimited Bond Buying Program?

It's kind of hard not to smell a rat in Mario Draghi's proposal for the European Central Bank to make "unlimited" purchases of sovereign bonds of troubled EU member nations. According to the proposal, the ECB will buy an EU member's bonds if the member requests assistance and submits to fiscal oversight by the EU. The latter, however, has been the problem with Greece. It doesn't want to submit to the EU's fiscal oversight. And when it did agree to terms demanded by the EU, it failed to comply with them. In return, Greece has been given break after break after break. It effectively defaulted months ago, but the EU papered the default over with a loan workout that forced creditors to sustain losses (which they may have recouped via credit default swaps, so the losses actually fell on the writers of the CDSs or their unfortunate direct, secondary or tertiary counterparties who held the ultimate risk of loss). Stated otherwise, the EU has supported Greece without Greece having to do the full austerity dance it was supposed to do.

The two countries that Draghi's proposal was aimed to help, Spain and Italy, insist that they will not submit to fiscal oversight by the EU (for domestic political reasons). If they really mean it, that means they won't get bond buying assistance from the ECB. Possibly, their hardline insistence that they won't ask for help (and thereby submit to central oversight) is a bluff, meant to get Draghi to drop the fiscal oversight condition. They could simply let market forces push their bond yields higher. That would shove the EU closer to the brink. Draghi might then drop the fiscal oversight condition when the markets threaten to go haywire. Of course, the bluff isn't really aimed at Draghi, who seems amenable enough to U.S. Fed-style money printing, but at the Germans and other northern Europeans of the frugal persuasion. The Greeks have proven themselves adept at brinksmanship with Germany and its economic allies. Spain and Italy have little incentive to be any more austere.

Germany may be wealthy enough to bail out Greece. But it can't bail out both Spain and Italy, which have much larger economies. So a move by Draghi to drop the fiscal oversight condition could lead to German withdrawal from the EU. That could be catastrophic. But writing blank checks to Greece, Spain and Italy could be catastrophic for Germany, and one can't expect Germany to knowingly sign up for a catastrophe. Mario Draghi may be playing a most dangerous game, and he'd better play it well or the abyss will beckon.

How the Financial Markets Enable the EU Sovereign Debt Crisis

Imagine Barack Obama or Mitt Romney saying, "If re-elected/elected President, I'm going to do everything I can to restore prosperity and full employment, and, believe me, it will be enough." The stock market's reaction would be neutral to negative, and a lot of people, perhaps most, would laugh and suggest the candidate try out as a joke writer for the Tonight Show.

Last week, the head of the European Central Bank, Mario Draghi, vowed to do everything he could to prevent the collapse of the Euro zone and added that "it will be enough." He offered no details on what he had in mind. The stock market rallied and Euro zone interest rates dipped. The next day, the leaders of Germany and France, Angela Merkel and Francois Hollande, rose from the chorus and shouted "Amen" (while also skimping on details). The stock market rose again, with the Dow Jones Industrial Average closing over 13,000, a threshold it hadn't crossed since May. In the last two trading days of the past week, the Dow rose almost 400 points (or 3.15%)--all because a few EU leaders swore on a stack of sovereign bonds that, by golly, they were going to something or other really good.

This follows a pattern that has persisted throughout the EU sovereign debt crisis. Storm clouds gather, interest rates rise, and stocks fall. European leaders, alarmed by the market action, issue rosy press releases, promising rose gardens while avoiding any detailed explanation of how salvation will be attained. Stocks rise while interest rates fall. Everyone is happy.

But, then, reality inserts itself. The baseline problem with the EU debt crisis is that the sovereign liabilities in questions are simply too great for the debtor nations to repay. The question is where the losses will fall--on creditors, citizens of debtor nations, taxpayers of wealthy EU nations, issuers of credit default swaps or other interested parties? The intractable tussling over this essential and, for some, existential, question forces examination of ugly details revealing that there are no easy answers. Bottom line: someone needs to give up a shipload of real wealth to pay off the debts. There are no volunteers. Stocks again fall and interest rates again rise.

But the EU's leadership has learned that the financial markets respond to talk therapy, and talk is cheap. If they talk interest rates down, even if only temporarily, they can stall on making the hard choices needed for true resolution. Politicians have never met a hard choice they wanted to make. So they yak their way to a brief respite, and fiddle until the markets waver again. Meanwhile, overall debt levels among EU nations keep rising while Europe slides into recession. There's something wrong with this picture. But, as long as the financial markets display an appetite for b.s., the EU's leaders will keep serving it up.

The EU Fighting Market Forces

A fundamental reason why EU bailouts repeatedly belly flop is that the EU is trying to work against market forces, rather than harnessing them to its advantage. The most recent 100 billion Euro "bailout" of Spain consisted of a press release promising a large sounding amount of money, with no details about where the money would come from or on what terms. Evidently, the idea was to use a big number to impress the bond vigilantes into simmering down. But the BVs are much better poker players than the EU's top ministers, and sniffed out the bluff in one trading day.

The baseline reason why the EU is in debt hell is that it's growing too slowly to service the outstanding amounts of its sovereign and quasi-sovereign debt (the latter including bank liabilities which national governments are legally or de facto obligated to cover). The simple solution to this problem is to boost economic growth. The time-honored way of fostering growth is to increase the nation's international competitiveness and thereby rev up its domestic production. This would be done by devaluing the currency and lowering wages. Governments would cut back on deficit spending, so as to begin the process of deleveraging. These adjustments are economically painful and politically difficult. But they put debtor nations in the position of using market forces to their advantage. This generally leads toward the path to recovery.

The EU's policies to date have focused on fighting bond market forces with "bailouts" that consisting of c0mbatting debt with more debt. Profligate nations are told to adopt policies aimed at austerity. But the European Central Bank won't devalue the Euro, so part of the normal path to recovery isn't being taken. Profligate nations are told to attempt dramatically painful cuts in government benefits and pay, without the assistance of a devalued currency. But too much drama is offputting and we are seeing the consequences in anti-austerity movements across much of the EU. These protest movements, in Greece, France and elsewhere, could lead to the break-up of the EU, as German taxpayers are likely to balk at ponying up the hundreds of billions of Euros it would cost to preserve the EU. The bond markets aren't fooled, and private sector money is gradually staging a run on Euro-denominated debt owed by any nation whose creditworthiness is in question. Only massive purchases of sovereign debt by debtor nation banks (which in turn may need bailouts themselves if things get stinkier) are keeping the credit markets open for some of the bigger spenders in the EU.

By trying to flimflam the bond markets while not effectively making the underlying economic adjustments that would lead to renewed growth, the EU continues to run off the road into the ditch. As we learned in the 2007-08 collapse of the real estate and mortgage markets in America, when conditions become extreme enough, basic economic forces prevail over government band-aids. To preserve the EU, everyone has to make painful sacrifices. People in profligate nations must accept lower wages and government benefits, along with much greater control over their governments' spending by the bureaucrats in Brussels. People in wealthy nations like Germany must accept significantly increased tax burdens to help their struggling neighbors through the crisis. The entire EU must accept the notion that the Euro should be devalued, by a lot and quickly.

The EU can't declare de facto bankruptcy because so much of its sovereign debt is held by its own banks that defaults would send its banking system swirling down the porcelain goddess. Of course, that wouldn't actually happen because national governments in Europe would bail out their banks. But the bailouts would require a new round of sovereign debt, thus perpetuating the not at all virtuous cycle.

The citizenry of Europe were told that the European Union would bring prosperity. These political promises now hinder effective resolution of the problem. Once promised prosperity, the citizens won't allow the politicians to take it away. But economic cycles have not been (and cannot be) repealed. Every society built on promises of permanent prosperity will eventually be hoisted by its own petard (see Soviet Union, Communist China for further reading). China and its much lower wages represent a path that won't be acceptable to Europe's bourgeoisie. The United States, with its bona fide national identity, will be difficult for Europeans, who are provincial deep down, to emulate. Indeed, it took a bloody civil war for America to truly become one nation. Europe won't go that far, not after the two world wars in the 20th Century.

The breakup of the Soviet Union may well illustrate what will happen to the EU. The Soviet Union was a historical experiment in fighting market forces, and it failed spectacularly. The EU won't fair any better in the end.

The Cost-Benefit Mismatch of Monetary Policy

This past week, the two largest central banks--the Fed and the ECB--signaled that they would not run the monetary printing presses on overtime in the immediate future. The stock market promptly wailed, shrieked and then threw its pacifier across the room, recording its worst week in 2012. Once again, we see ever so clearly that the financial markets are dependent, above all, on government policy.

With political dysfunction in the U.S. and Europe the rule, not the exception, government policy has largely boiled down to central banking monetary policy. And that policy suffers from a mismatch of costs and benefits that makes it seem more attractive than it really may be.

When a central bank loosens things up, financial markets respond at warp speed. All asset classes rise in value. This increased correlation among asset classes, which has often displaced the more traditional inverse relationship between stocks and bonds, and between financial assets and gold, has made investing more a matter of guessing when central banks will run the monetary printing presses than of conducting any research or evaluation of economic fundamentals. But central bankers feel good because they can see tangible results of their policies in seconds, while receiving hardly disinterested applause from bankers and other Wall Streeters.

The full impact of monetary policy on the economy tends to take about 18 months to emerge. If policy is loosened at the risk of triggering inflation, the inflationary effect will manifest itself months and perhaps over a year after the loosening is implemented. The downsides of monetary policy, therefore, appear well after the financial markets deliver their huzzahs.

Enjoy now, pay the price later. Do people like to indulge too much in something that delivers positive feedback now while imposing costs later? Well, does a bear sit in the woods?

Central bankers, being human like the rest of us, are at risk of succumbing to the crack-like euphoria delivered in milliseconds by the order flow of today's high-speed computerized trading systems (which account for about two-thirds of market volume). The cost of cranking out low-cost credit isn't felt until later, much later. Some of the incumbents at central banks today may not even be in office when the downsides pop up.

This mismatch of costs and benefits from monetary policy may skew policy preferences, especially among central bankers predisposed to act rather than wait. Certainly, some central bankers resist the allure of short term positive feedback. It's been well-publicized, if sometimes anonymously sourced, that disagreement exists among members of the Fed's Open Market Committee, and between the Fed and the ECB. But an unmistakable trend in recent years of central banks to deliver stimulus, even at the risk of sparking inflation in the longer term, makes one wonder if the mismatch of costs and benefits of monetary policy might not be working mischief.

Are the European Central Bank and the Stock Market BFFs?

The suddenness of this week's stock market drop, coming after a meteoric rise this quarter, can't plausibly be attributed to the usual suspects. We are told that fears of slowing economic growth in China and a probable recession in Europe are the culprits. But those fears existed one, two, five and thirteen weeks ago. Why would the market drop now?

The 21st Century financial markets are all government, all the time. If you want an explanation for puzzling market activity, look at government activity. In the past three months, the European Central Bank has printed something like $1.3 trillion worth of Euros. Not that you'd get anyone at the ECB to admit it was printing money (an anathema punishable by torture on the rack in Europe). But the ECB would admit that it's been making a lot of three-year loans to European banks with interest set at 1%, while accepting as collateral all kinds of hinky paper (not necessarily excluding matchbook covers, burger wrappers and junk mail). The banks taking out these loans were facing potential credit crunches, so with the ECB making loans on terms that the private markets probably wouldn't extend, one needn't have a lot of imagination to conclude that the ECB has printed a lot of dinero in the past three months.

All that moola has to go somewhere. The borrowing banks deposited a lot of it back with the ECB, to boost their cash reserves against more handwringing over the European sovereign debt crisis. But one suspects that quite a bit of it may have gone across the pond into the U.S. financial markets, where stocks have been frothy because of improving economic data. And the fact that last year the U.S. Federal Reserve extended dollar-denominated credit lines to national central banks in a number of European nations would only make it easier to convert Euros into dollars that can be invested in U.S. stocks.

But recent signals from the ECB indicate that it won't be extending more of these three-year beauties. Since financial markets respond, first and foremost, to cash flows, the prospect of no more foreseeable money printing must be discouraging. All good things end eventually, and we know from recent financial history that no asset rises in value indefinitely. While money is fungible and definitively proving that the ECB's money print puffed up the U.S. markets isn't easy, the past twenty years demonstrate that the most reliable way to jack up stocks is for central banks to shovel money off their loading docks. And the same twenty years demonstrate that this isn't the path to lasting prosperity. So look both ways before diving into stocks.

European Central Bank Bets the Ranch

The European Central Bank has evidently been taking EU sovereign debt as collateral, even as it expands its balance sheet to a record size in order to finance the EU's banking system. Taking sovereign debt as collateral bets the solvency of the ECB on the solvency of the EU. In the event of a sovereign default, the banks borrowing from the ECB may well not be able to repay their debts to the central bank. The ECB might theoretically try to sell its collateral to recover its losses. But the very act of selling the sovereign debt would likely push down its value, impair European banks all the more, and further weaken the ECB. The ECB, for practical purposes, may be making uncollateralized loans when it takes EU sovereign debt as "collateral."

The ECB surely realizes this. But it may have little choice, since Europe's banks probably have limited amounts of other assets they could tender to the ECB as collateral. Without the ECB's loans, the European financial system would probably have to pull back on lending, forcing an economic contraction at a time when Europe desperately needs growth to escape the claws of the sovereign debt crisis. So the ECB probably has little choice but to bet the ranch. Its hopes of repayment rest primarily on whether or not Europe grows. Europe's prospects for growth depend heavily on whether or not its governments can institute effective fiscal policies. Given the EU's political dysfunction, one cannot help but wonder whether the ECB will lose the ranch.