The Fed's International Data Dichotomy

The Federal Reserve Board is meeting to decide whether or not to raise interest rates.  The costs and benefits of its decision, whichever way it goes, will fall to a large degree along international borders.

Most of the data favoring a rate hike are domestic.  The U.S. economy is growing, moderately but steadily (especially after data revisions).  Unemployment has fallen to the level generally regarded as full employment.  Jobs growth continues, not at a blistering pace but indicative of continued expansion.  Inflation is very low, but if you strip out energy and food prices (which are volatile), the rest of the price structure is pretty close to the Fed's 2% target.

Most of the data arguing against a rate hike is from overseas.  Chinese stocks have been volatile and China's growth is slowing.  Europe's and Japan's economies are  barely growing.  Emerging nations and commodities producing nations are on the ropes, with many facing shrinking economies.  The Greek debt crisis has temporarily simmered down, but the most recent "resolution" was just another kick of the can down the road.  So we can be confident that a Greek default will loom anon, and we'll have to revisit familiar angst.  A rate increase will strengthen the dollar, which will possibly exacerbate these international problems.

Much of foreign anxiety stems from the fact that the dollar is the international medium of exchange.  The entire world uses the dollar in numerous trade and cross-border transactions.  The Fed's monetary policy unavoidably affects people in distant lands.  A rate hike may help the domestic economy by easing asset distortions and increasing certainty (and desperately desired income for savers).  It is likely to have a negative impact overseas.  No wonder the IMF and other voices reflecting foreign perspectives argue against a rate hike.

What will the Fed do?  Most likely, not even the Fed knows before its meeting.  We've been told that its decision is data dependent.  What we don't know is how it weighs and balances the data.  What data receive greater consideration?  What data are downplayed?  What thought is given to the effect of the Fed's decision on foreign relations? Central banking is distinct from diplomacy, but the Fed can't ignore foreign concerns.  A rate hike will produce smiles and frowns, mostly on different sides of the border.  After World War II, America became the pre-eminent economic power in the world, and it cannot now avoid the consequences of its dominance.

Is Greece No Longer a Risk?

In the last few days, the upstart government of Greece formed by Syriza Party leader Alexis Tsipras has completely reversed itself and signed up for a bailout from the EU that requires far more austerity than Greek voters rejected in a referendum just a week ago.  By all appearances, the EU rammed the ultra austere package down the throat of the Greek left-wing party, flattening Syriza's contentions like a tractor trailer rolling over a marshmallow.  We've had months of hand-wringing and teeth-gnashing over the dangers of a Grexit, and financial markets have shuddered every time Greece appeared to be heading out of the EU.  The EU's peremptory demands at the last minute might seem to have been a high-risk roll of the dice that somehow went in the EU's favor.  Or the EU knew that Greece had no leverage and made the Greeks take everything the EU wanted.

Considering how cautious the EU has been in the past, giving Greece two earlier bailouts totaling some $250 billion, it isn't probable the EU was bluffing in this round of talks.  That would likely mean it believes it has built a shield wall around its banking system that could withstand the consequences of a Grexit.  Stated otherwise, Grexit may no longer be thought to be a major risk to the European financial system. 

Even though the EU and Greece announced a "deal" today for a bailout, it's not at all a firm agreement, but rather a process for pursuing the possibility of more European assistance to Greece.  First, Greece has to adopt a number of austerity measures dictated by the EU.  Next, the parliaments of individual EU member nations have to approve further bailout talks.  Then, Greece will get interim financing that will keep it barely afloat while it and the EU yak for more months, maybe many more, to try to reach the final terms of a third bailout. 

There are many contingencies in this process, and it's quite possible the process won't lead to another bailout.  In that case, Grexit will follow.  But will it matter?  The EU seems to believe that Grexit wouldn't be a disaster, or it wouldn't have taken such a seemingly high risk negotiating position.  If it's right, then Greece will be mired for a long time in austerity and hard times one way or another.  And if the EU is wrong, then watch out, because a European financial crisis could lead to many, many bad consequences for a lot of people.

Ode To Greece's No Vote

Greek voters said "no" to the EU's latest bailout proposal, defiantly rebuffing another round of austerity. Democracy spoke, but the fat lady has yet to sing.  With a nod to Gilbert and Sullivan, this is how the song might go:

Here's a how-de-do.
If I vote for you,
When the time comes to make payments,
You will tell them we have ailments,
Default will ensue.
Here's a how-de-do,
Here's a how-de-do.

Here's a pretty mess.
In a month or less,
Greece will add some extra drama
By reviving the old drachma.
Banks will be distressted.
Here's a pretty mess,
Here's a pretty mess.

Greece's state of things
Is to life it barely clings.
Paying its debts with devotion
Doesn't seem to suit its notion.
More depression it brings.
Here's a state of things,
Here's a state of things.

No one knows what will be the result of this crisis.  Just remember that, no matter what, a good gyros makes for a fine meal.

Greece, the EU and the Power of Fiat Currency

Greece is evidently going to hit the financial skids next week.  The EU appears to have stopped bargaining (as have the Greeks, who now want to put the issue of austerity in exchange for another EU bailout to their voters).  Without bargaining, there won't be a deal.

How did things end up this way?  One perspective is that, by entering the Euro Zone, Greece gave up a lot of power and put itself under the control of the EU.  When a country issues its own currency (i.e., fiat currency), it has considerable control over its currency's value in relation to other currencies.  If the country slides downhill economically speaking, it can devalue its currency and export its way out of trouble.  The Japanese have done this for decades, and the Chinese and other developing nations are endeavoring to emulate the Japanese. 

But what if the country, instead of issuing its own currency, uses another medium of exchange?  Historically, gold and silver, and sometimes copper, served such a role.  But a country that uses an independent medium of exchange can't devalue its way out of a recession.  It has to find another way; and sometimes it can't.  That's why the industrialized West moved off the gold standard in the 20th Century.  It prevented them from using central bank policies to recover from economic downturns.

Fiat currencies have a very bad image among many in the political right.  Gold standard conservatives fear that governments will inflate the wealth of citizens away for reasons of political expediency.  They rightly point to the morass of post-World War I Germany, when the Weimar Republic did that, resulting in widespread malaise and paving the way for fascism. 

But gold standard adherents forget a basic principle of economics:  goods become widespread in the market because people demand them.  Fiat currency is simply another good, and people demand a lot of it.  It serves as a medium of exchange, and no major economy can exist without a copious supply of the medium of exchange.  Gold was extremely scarce in Colonial America, and deer skins (i.e., buck skins, from whence came the term "buck"), tobacco and other goods served as an alternative to gold.  Various commercial promises to pay, such as drafts, promissory notes, banker's notes, and the like, also came to be used in lieu of gold.  Fiat currency was government's way of simplifying the problem of lack of gold and silver that could be used as media of exchange.

Fiat currency also conferred power. When the American Revolution began, the Continental Congress issued paper money in order to finance the rebellion.   This paper was subject to inflation, and considerable controversy eventually surrounded its use.  Nevertheless, the Continental Congress' ability to issue fiat currency helped to sustain the Revolution.

The U.S. government in the 19th Century outlawed the issuance of bank notes and other private currency and substituted the greenback in their stead.  Although the U.S. government clung to the gold standard, it devalued the dollar against gold once the Great Depression began, and took the dollar off the gold standard during the economic difficulties of the early 1970's.  In other words, gold wasn't really the standard.  The dollar was worth what the government said it was worth, not what the market price of gold happened to be.

The power of fiat currency became vividly clear during the Great Depression and World War II.  The U.S. government began to borrow in large amounts (i.e., engage in deficit spending) in order to alleviate the Depression.  Then, it borrowed enormous amounts to finance the war and defeat fascism.  After World War II, the U.S. government flooded the free world with dollars, so that there would be a currency to replace the British pound as the world's reserve currency.  The U.S. government derives enormous power from the fact that the dollar is the world's reserve currency.  People in other countries have to pay attention to America, because America's currency keeps the world's economy going.  Even in the Communist bloc, the dollar mattered.  As Communist economies flagged, the dollar became the underground, but de facto real, currency in many Communist nations.  Communism's legitimacy was in part undermined by the strength of America's fiat currency.

Greece is in a real fix, because its citizens don't want austerity, but they want to remain part of the EU.  Reality is that they are damned if they do and damned if they don't.  Staying in the EU will require agreement to the EU's demands for more austerity, which will probably worsen Greece's depression.  Leaving the EU will also likely mean that the Greek depression will worsen.  Who's at fault for this mess is a complicated question, but the answer, in short, is like Agatha Christy's novel, Murder on the Orient Express.  Everyone involved in and with the EU is responsible.  And there's no easy way out of the mess, for anyone.

But a larger point is that fiat currencies aren't good or evil.  They are a tool, one that can be used productively or counter-productively.  We need to watch what the Fed is doing--closely.  But let us recognize that much of America's strength comes from its fiat currency. 

The Low Euro: Greece's Salvation?

Greece is within a few weeks of running out of money to pay its debts.  Default looms, and it could cause financial disruption in Europe and around the world.  Yet the Greek government and the Euro bloc are at loggerheads in an Alphonse-and-Gaston routine where true compromise is as commonplace as hen's teeth.  Sounds like Congress.  Meanwhile, the rest of us wait for Godot. 

Luck, however, is part of life, and both Greece and the EU are very lucky.  In its current state of economic extremis (and Greece is suffering the equivalent of the U.S. Great Depression of the 1930s),  Greece would want to depreciate its currency.  If it could do so, depreciation would make its export businesses more competitive and bring in tourism.  But Greece, being part of the Euro bloc, has no control over its currency.  The European Central Bank calls the shots for the Euro. 

Serendipity would have it that the ECB decided recently to engage in quantitative easing (i.e., the buying of Euro-denominated bonds in the open market) as a way to stimulate the EU's stagnant economy.  Quantitative easing is one way of printing money, and the Euro has fallen by about 25% as a consequence.  A 25% price move is an elephantine move in the currency markets, and changes all kinds of economic relationships.  European exports just got gussied up in a big way, and European tourism is now a bargain compared to a year ago. 

Greece doesn't export a lot outside of Europe, but it is one heck of a tourist destination.  If given some time, Greece's tourist business will probably pick up.  Some of Greece's exports might be shifted to non-Euro bloc nations.  Greece might have a shot at recovery.

Much of the problem is that neither the EU nor the Greek government trust each other.  Definitive resolution is impossible without trust.  The result has been a steady kicking of the can down the road every time Greece and the EU have to negotiate.  This time, however, if they kick the can down the road (which is one possible outcome of the current impasse), the consequence may be positive.  If Greece has a couple of years to turn itself around using the low Euro, it may have a shot at recovering enough to satisfy the EU's debt collectors.  But will the EU and Greece muddle through one more set of negotiations?  If everyone were rational, they might pull it off.  But then again, if everyone were rational, they wouldn't be in the mess they are now in.

Politics Keep the Economic Crises Going

We are vividly reminded today that the economic crises bedeviling the world are political in nature.  The election deadlock in Italy, with leftists likely to control one house of the Italian Parliament, and rightists and leftists apparently in  a draw in the other house, is a vote against austerity and centralization of the EU's governance. Although the political nuances differ from Greece's initial anti-austerity vote last year, the Italian election, like Greece's, signals that numerous voters have yet to learn the words of the pan-European version Kumbaya.  Another election in Italy may well be needed, or the country will be unable to stay on track to meet the EU's expectations.

In America, sequestration now seems almost a certainty.  The arbitrary cuts imposed by sequestration were supposed to be unpalatable to either party, and would therefore incentivize both parties to cut a real deal.  Fat chance of that in these days of political dysfunction.  Truth is there won't be a real deal.  That's why the Dems and Republicans kicked the can down the road when the fiscal cliff loomed and the debt ceiling threatened to descend like the Sword of Damocles.  The government right now can do little more than bring its foot back for another kick.  The one silver lining in the clouds is that the economy seems to be recovering to some degree.  The better the economy does, the lower the deficit will be.  We should hope and work for economic growth, because that is the only politically feasible solution to the budget deficit.  The federal government needs to repair and upgrade infrastructure, adopt a pro-growth immigration policy, work hard to cut the growth of health care costs (perhaps the biggest expense in future federal budgets), and work toward supporting and expanding educational opportunities while reducing the cost of education.  (Internet-based instruction may be a great way to educate at much lower expense, and should be encouraged and supported.)  The current squabbling in Washington over budget cuts and tax increases is a game of musical chairs that no one can win.  We have to take a different approach.

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.

Over There at the EU Crisis

Paralysis now grips Europe. The EU has no solution for its sovereign debt-banking-economic crisis. Greece is in a political netherworld, with a second election to be held this month to determine, perhaps, if the electorate can choose a government.

But Greece is a side show. Spain now occupies center stage, with a banking crisis that the country itself cannot solve. Although Spain's sovereign debt is, proportionately speaking, no greater than Germany's, enormous losses from a collapsed real estate market have overwhelmed Spain's banks. The government, directly and indirectly, is in the process of taking over its banking system. But it cannot handle the shipload of liabilities it is assuming. So it has turned to the EU.

The EU, in its familiar, inimitable fashion, wallows in dysfunction as it squirms around to find someone to pick up the tab. The European Central Bank, by holding interest rates steady today, has signaled its firm intention not to take responsibility for the messes made by politicians. Most of Europe's politicians have raised their eyebrows in the direction of Germany. But the Germans fear, not irrationally, that they are being asked to pick up the tab not only for the table, but for the entire restaurant. Any bailout of Spain's banks would surely entail greater EU (read, German) control over Spain's banks. That may or may not be acceptable to the Spanish, since German control over Spain's credit spigots means German control over Spain's economy.

Not surprisingly, hints and even calls for American action have grown. It's not at all crazy for Europe to look westward. In 1917 and 1941, the United States called its men to arms in order to end world wars emanating from Europe's endemic political dysfunction. Over 400,000 Americans made the supreme sacrifice in Europe during these two wars and American taxpayers coughed up many, many billions of dollars to stop Europeans from killing each other. In 1947, America adopted the Marshall Plan, an extraordinary act of generosity that propped up a Europe devastated by war and prevented much of the continent from falling under Soviet control. Surely, it's quite rational for Europe to expect America to step up again and reach for the tab. We've fostered the greatest case of moral hazard in human history, and now have to live with the consequences.

But America has its own problems. The vituperative animosity between Republicans and Democrats, well-exemplified by the bitterness of Wisconsin's recall election, prevents the President and Congress from taking effective action before this fall's presidential election. Action thereafter, even if possible, may be too late.

That leaves the Federal Reserve. Market players twitch their ears around, hoping for any sound of Chairman Bernanke warming up his helicopter. We know from the 2008 financial crisis that Bernanke's default setting is to act. That setting isn't going to change in the foreseeable future. Whether or not the Fed can do anything effective is a different question. More QE might temporarily support the stock markets--and, naturally, that's Wall Street's underlying motive in encouraging an activist Fed. Never mind the spectacle of America's capitalists par excellence looking for more government intervention. But there's little reason to think that QE III will save Europe. The sources of the badness in Europe's bad debt won't be cured by Fed purchases of dollar denominated debt.

Is there any way the Fed could have an impact in Europe? The answer is maybe, but it would involve replacing the Euro with the U.S. dollar. Since the Fed can (and perhaps will) printed unlimited quantities of dollars, it could buy up Euro-denominated debt if the sellers would accept dollars. Because the EU crisis involves the heart of the European financial system (banks, central banks and sovereign debt), the result would be to make the dollar Europe's continental currency. Not necessarily for all daily spending at the supermarket and the gas station, but at least for all significant central banking, interbank and monetary policy transactions. With the dollar the only financial asset in the world that is readily available to provide a measure of stability to Europe, conversion from the Euro to the dollar may be the one card the Fed might effectively play.

Europeans wouldn't readily cotton to such a notion, because it would recreate the 1950s and 1960s, when the dollar played such a role and the United States exercised extra-sovereign power over Western Europe. But it might be the way the Fed, being the only central bank in the world with the inclination and capacity to act, could prop up Europe.

In essence, the EU faces a choice between dissolution, German dominance, or in this perhaps far fetched scenario, American dominance. Given the history of the past century, in which America was the most generous and benevolent of super powers, what do we think Europeans might prefer? Germany's stubborn insistence on its world view during the current crisis has, however unfairly, brought back in many European minds images of jackbooted stormtroopers and civilian killings by screaming Stuka dive bombers. But American intervention, if it occurs, would stir memories of raw, inexperienced GIs by dint of sheer determination and courage pushing their way through murderous German fire onto the heights overlooking Omaha Beach, and continuing from there to liberate a continent. A European return to the dollar may be the only real choice left. Time will tell.

The Bank Run Deposit Insurance Doesn't Protect Against

A slow motion run on banks in Greece, Spain and other distressed Euro bloc nations has been taking place ever since the sovereign debt crisis blew up two years ago. Recent news reports indicate it has accelerated, particularly in Greece. The top 1% and others in distressed nations have been moving money to banking havens such as Switzerland and Luxembourg, and stable nations like Germany and the UK.

Depositors have two reasons to flee banks in troubled countries. One, those holding deposits exceeding the 100,000 Euro limit on deposit insurance in the Euro bloc have much to lose if their local bank collapses. Two, depositors in any nation that potentially may depart the Euro bloc confront the risk of compelled conversion of their deposits into a new, depreciated currency. Greece presents a vivid example of the latter problem. Conversion back to the drachma could sharply reduce the value of Greek bank deposits. There is no deposit insurance that protects against losses sustained when one's home nation drops out of the Euro zone and adopts a depreciated national currency. Some Greeks have been withdrawing Euros from ATMs (presumably to pad their mattresses). Others have been moving Euros electronically to safe haven nations.

The capital mobility created by the adoption of the Euro facilitates such bank runs. Since the Euro bloc, by definition, eliminates the problems of currency conversion, moving funds from one Euro bloc nation to another is easier than in the bad old days of national currencies. The upside of increased capital mobility is that money was supposed to go where it could earn the highest return, which was thought to promote economic efficiency and greater overall prosperity. The downside is that capital can more readily flee ugly situations, even if it's needed to help finance a nation's way out of ugliness.

The European Central Bank might be able to stop the burgeoning bank runs. The core mission of central banks is to promote depositor confidence. The ECB seems to have been lending many billions of Euros to Greek and Spanish banks. But it won't print money, and that limits its options if the run quickens. The Euro bloc, a 21st Century financial innovation, may have laid the foundation for an old-fashioned 19th Century financial panic. Time will tell.

Fools Among the Holders of Greek Debt

A couple of months ago, most holders of Greek government debt reluctantly agreed to a deal to take a loss (called a "haircut" by the financial cognoscenti) of about 75% of the nominal (i.e., face) value of the debt as part of the second bailout package offered to Greece by the EU. Another aspect of that deal was the Greek government would institute austerity measures in order to reduce its future need for debt. The coalition government then governing Greece, a pushmi-pullyu shotgun marriage of two opposing parties, solemnly agreed to the austerity measures.

Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.

Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.

Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.

Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.

With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.

But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.

In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.

The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

The Greek Debt Crisis and the Failure of Credit Default Swaps

The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."

If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.

Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.

When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.

Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.

Italy: A Financial Run in the Making

If you ever wanted to see what a bank run looks like, you can watch the 1946 film, It's a Wonderful Life, starring Jimmy Stewart, or you can watch Italy. Greece's deterioration in the past few weeks laid the foundation for Italy's distress. As Greece was sucked down the drain, Italy began wavering, and then wobbling. Now, yields on Italy's bonds are skyrocketing, exceeding 7%. That's the range bond yields for Greece, Ireland and Portugal reached before those nations went down the tubes. Italy isn't literally a bank, and holders of Italian bonds can't go to the counter and make a withdrawal. All they can do is sell in the secondary market for whatever price is available, and lots of them are.

Rumor has it that the ECB is buying Italian bonds in an effort to stabilize the situation. But that would be a temporary measure. The ECB by itself is a wee bazooka, unless it starts printing money and that's not allowed by its charter. The EU has already announced that it has no plans to bail out Italy. Indeed, its bailout fund, the EFSF, doesn't have enough money to bail out Italy. Nor does the IMF. Nor do the Chinese or the Brazilians. Eyes will inevitably turn toward America. But the political situation here precludes a fiscally funded bailout for Italy. And the Fed, which has no compunctions about printing money, can't print Euros. Its bazooka uses different ammo.

Italy is on its own, and Jimmy Stewart is no longer around to step in and calm things down. It's up to Italy to persuade the fixed income vigilantes that it can pay its debts as they fall due. That's a tall order in this time of Euro-skepticism.

Compared to Italy, Greece has a small amount of sovereign debt outstanding. Yet Greece's problems were enough to knock down a major European bank, Dexia, and a significant American brokerage firm, MF Global. If Italy's bonds maintain their downward trajectory, it's entirely possible that more financial firms will fail. Sadly, we don't have enough readily available information about the bond holdings, derivatives exposures and counterparty risks of financial institutions to easily predict which ones might be in trouble. That lack of information exacerbates the potential for systemic risk. Volatility reigns supreme in the financial markets.

The European Union's Only Option

The downfall of George Papandreou, prime minister of Greece, illustrates the European Union's only option for survival. Germany and France dictated the terms of the latest iteration of the bailout for Greece, which included tough austerity requirements and a 50% haircut for creditors. Both Greeks and creditors squawked, but ultimately knuckled under. Then, Papandreou threw a wrench in the works by calling for an ad hoc national referendum on the deal. Why he latched onto this misguided notion remains unclear. Whatever the reason, it threw the financial markets into a tizzy.

The prime ministers of Germany and France summoned Papandreou to be chewed out in Cannes. Most likely, George didn't get much time to work on his tan. Back in Athens, he called off the referendum. His next move was to maneuver for a coalition government, while his opposition called for snap elections. Germany and France stepped in again and made it clear that they wanted Greece to have a unity government that would implement the terms of the revised bailout.

Next thing you know, Greece is announcing that it has reached a tentative deal for a unity government. Tomorrow, Greek politicians will spar over who their next national leader will be. It won't be Papandreou.

What's happened in Greece was dictated by Germany and France. The Greeks weren't given a choice. They were told what bailout they would get and what governmental process they would use to implement it. In essence, Germany and France have assumed supervisory political control over Greece. This--the political unification of the EU--is the union's only chance for survival. Economically speaking, the EU's continuation depends on a transfer of wealth from the well-off nations of northern Europe to creditors of the more profligate EU members. The price of this transfer is political domination by the north.

Germany's been through this once before. When the Berlin Wall fell, prosperous West Germany unified with moribund East Germany. West Germany paid a very high price in bringing its formerly Communist sibling into the world of free enterprise. But the West Germans wanted unity and they were willing to pay for it. Now, Germans depend on the Euro Zone to sustain their prosperity, and they are gradually coming to realize their reluctant willingness to pay for the survival of the EU. The continued fecklessness of Greece and its government in dealing with the crisis has forced Germany and France to take charge. By the most contorted of processes, the EU is evolving toward political unity.

It's not inevitable the process will continue. Other nations are in trouble. Italy is the next target of the sovereign bond vigilantes. Interest rates on its bonds are rising sharply vis-a-vis German bonds, and it has recently agreed to be monitored by the IMF. Many Italians are irked by this infringement on their sovereignty. If Greeks and Italians feel put upon enough, they can simply leave the EU. That might seem highly irrational, since it could lead to the collapse of their financial systems and steep recessions. But let's not forget that twice in the last century Europe descended into horrific world wars that killed tens of millions of people. Europeans are eminently capable of highly irrational and self-destructive behavior.

No one knows all this better than the Germans, who were the most irrational and paid an enormous price for their self-destructiveness. That's why they're willing to pick up the tab now for the profligacy of their neighbors, but only if they can exercise political control over the spendthrifts. The question is whether Europeans, with their vast cultural differences--far greater than those between folks north of the Mason-Dixon Line and those to the south--can achieve the compromises and concessions needed for lasting political unity. The post-Communism breakups of Yugoslavia and Czechoslovakia tell us that Europeans don't always have a preference for political unification. Expect a bumpy ride in the financial markets while the EU works things out.

The Greek Referendum: What European Union?

Is there even such a thing as the European Union? The Greek prime minister, George Papandreou, has just announced an impromptu referendum to be held toward the end of this year, in which the Greek people will decide if they will accept the austerity and other measures required by the EU's bailout of Greece. The referendum was not previously mentioned by Greek leaders to the EU, and the EU is displeased, to put it mildly. It's holding back a bailout payment of 8 billion Euros that was to have been given to Greece in mid-November. Greece hasn't back down, and EU leaders are suggesting that Greek voters be asked to decide whether or not Greece should remain in the EU. Who knows? The Greek electorate may respond with a digital salute.

The Greek prime minister also faces a no confidence vote this Friday, Nov. 4, 2011. His legislative majority has been shrinking, and he officially has just barely enough votes to survive. If the no confidence vote fails, Greece will hold early elections. Those could further delay implementation of the EU's bailout plan.

The referendum and no confidence vote throw a massive wrench into the EU's governance "process." As it is, the EU has no established way to deal with a problem like the ongoing sovereign debt crisis, in which its very existence could be threatened. Europe's leaders have been winging it, meeting every week, and issuing innumerable upbeat press releases to manipulate the financial markets upward. Somehow, this ad hoc process produced a back of the envelope bailout that might at least delay the day of reckoning. But all the EU's efforts have now been suspended by the unexpected announcement of the Greek referendum and no confidence vote.

The referendum and no confidence vote demonstrate that there simply is no European Union. At its moment of greatest crisis, the fate of the EU rests on a snap decision by a Greek politician to hold a plebiscite and a no confidence vote. No one else in the EU signed off on this sui generis procedure. Yet, the EU, its currency, its financial system and its economic fortunes rest on the political vagaries of a country whose GDP is maybe 2% of the EU's GDP. There isn't a European Union. The EU has no rules, no governance process, no decision makers and no efficacy. It's like a group of people who have jammed themselves onto a very small life raft and are working against each others' efforts to keep the thing from tipping over.

If the EU blows up, the rest of the world will be dragged down as well. All this because of the political dysfunction of a nation with 0.5% of the world's GDP. That the fate of the European Union, and the world's financial system and economy, should rest on the electoral process of a small nation like Greece suggests that the interconnectedness of the world's financial system and economy has gone too far. Technology, derivatives and other linkages allow capital--and more importantly, financial risk--to flash around the globe almost instantaneously. While that's good when life is copacetic, reality is that some days are rainy. Today's hyperquick, hyperactive, and opaque financial system guarantees not only that capital flows immediately to the most attractive profit opportunity, but also that risk and financial contagion move equally fast in unpredictable, and therefore unhedged, ways. It may be time to establish significant limits on the extent to which financial risk can be palmed off. When faced with risk, people have a tendency to become responsible. But when you can pass the hot tamale to someone else, expediency trumps maturity. What we desperately need today is responsible behavior.

The only firewall left for the financial system is the taxpayer. Because taxpayers are becoming increasingly stressed, central banks have printed or will resort to printing money. This isn't a solution, just a kick of the can down the road. The Greek prime minister's decision to hold a referendum and no confidence vote serves as a reminder of a truth that is rarely acknowledged: there is no way of the current financial crisis without serious pain for everyone. The Greek prime minister is asking Greeks to grow up, face the fact that they will have to endure tough times, and agree to take their castor oil. Sooner or later, the rest of the world will have to do the same. But their politicians and other leaders continue to spin tales of Lake Wobegon, where everyone is in the top 1% and occupies only executive suites.

The EU's New Bailout: Who's the Sugar Daddy?

The EU's new bailout plan may be a somewhat clever bit of financial engineering. But one wonders if it isn't too clever by half.

For political purposes, holders of Greek debt "voluntarily" agreed to 50% haircuts, giving Greece about 100 billion Euros (or $140 billion) of debt relief. It's important that the haircut be deemed voluntary, or credit default swap counterparties (i.e., insurers against a Greek default) would have to make payments to holders of Greek debt. Such payments could make the contagion spread farther out into the financial system and financing costs for other weak EU member nations could rise. Plagues are harder to contain the wider they extend, so preventing this deal from triggering a requirement for CDS payments was deemed essential.

How voluntary the haircut is depends on how much you avert your eyes. With the heads of the German and French governments directly "discussing" the issue with them, Greek debt holders may have received considerable official guidance as to where their hearts and minds lay. Since most Greek bonds are held by banks that are "volunteering," those banks won't seek payment under their CDS contracts. The nonbank holders of Greek debt could do so, but they don't hold so much that they couldn't be paid off in full if necessary without disturbing the waters tumultuously.

Of course, CDS dealers may be alarmed tonight. If CDS holders can't recover in a scenario such as today's, there would be little incentive for them to continue buying CDS's, and the CDS market could collapse. Some might think that would be a good thing. While most financial industry bigwigs, economists and politicians would say that the connectedness of the world's economy and financial system is good, there can be too much of a good thing. With so much of the international financial services industry devoted to shifting risk around, instead of helping real businesses raise capital, it's reasonable to ask whether financial interconnection has been taken too far.

But we digress. The haircut banks will take on Greek debt will be softened. Greece will issue 100 billion Euros of new debt for the remaining 50% of the old debt that isn't being written off. This new debt will be supported by 30 billion Euros (or some $42 billion) provided by the EU as collateral. In other words, the EU is absorbing 30% of any losses on the new debt. But where will the EU get this 30 billion Euros? The EU's rules preclude central bank printing of money.

That leaves you-know-who to foot the bill.

The big banks in the EU will be required to boost their capital by a combined 100 billion Euros (or $140 billion) over the next eight months. This should help create a firewall around the EU sovereign debt crisis, and hopefully prevent it from spreading beyond the weak nations that are already on the ropes. One minor detail, though: where will the 100 billion Euros come from? Although EU banks might be required to refrain from paying dividends, and try to issue new stock to raise capital, it's doubtful they can put together 100 billion Euros in the next eight months. With the tens of billions of losses these banks are facing from Greek and other debt, they may not have that much in the way of profits to add to capital. And what legion of private investors would want stock of the pigs in a poke that the EU's banks have become?

That leaves you-know-who to recapitalize the EU's sick banks.

The third component of the new EU bailout is the leveraging of the remaining uncommitted 250 billion Euros in the EU's bailout facility created last year, the EFSF. Apparently, this money will be used to guarantee 20% to 25% of the value of new bonds to be issued to replace dodgy debt of shaky EU members. Because of the guarantee, it is hoped that bond vigilantes will accept lower interest rates on the new debt that will alleviate the financing costs of the spendthrift nations that are dragging down the EU. In theory, this isn't a bad idea. All we need now is a trillion or so Euros (or about $1.4 trillion) to invest in the new leveraged bonds.

Rumor has it that China and Brazil might help to bail out the EU. China has a $6 trillion GDP and Brazil's is $2 trillion. It's hard to envision these two developing nations trying to explain to their own less well-off citizens why anything approaching $1.4 trillion of their wealth should go to bail out the much wealthier citizens of the EU. China may kick in a few tens of billions, Brazil somewhat less. But that would leave well over a $1 trillion to go.

Politics prevent the U.S. from directly providing any assistance. The IMF, with a balance sheet in the range of $400 billion, couldn't bite off a real big chaw of the needed $1 trillion plus. And with the effectiveness of CDS's to offset default risk now in question, what army of private investors would touch these puppies with a ten-foot pole? Perhaps the EU's banks could be persuaded to "voluntarily" buy some of this sh . . . stuff. But at this point, the EU's banks aren't much more than conduits for losses to fall on you-know-who.

That leaves you-know-who to pick up the tab.

Taxpayers of the wealthy EU nations may be approaching a state of bailout fatigue. Add up the $42 billion in collateral for new Greek bonds, $140 billion for bank recapitalization, and $1 trillion or more for leveraged bonds, and you get $1.2 trillion plus. The good burghers of Germany, the Netherlands, Austria and the other wealthy EU nations will, at a minimum, scowl deeply when they realize what the new EU's new bailout means. Perhaps they'll cough up the money. Then again, when this much is involved, they may balk.

Without solid sources of funding, the EU's new bailout is the same as the emperor's new clothes. Clever financial engineering doesn't amount to jack if there isn't enough funding to make it work. And even if you look high and low, it's hard to find the EU's sugar daddy.

The Failure of Bank Stress Testing

The EU sovereign debt crisis has put the lie to bank stress testing. Stress tests--analyses that supposedly test a bank's ability to survive one or more hypothetical financial crises--have been used by American and European regulators in an effort to evaluate the strength of banks. The American tests weren't followed by the immediate bailout of tested banks (although TARP, bounteous Federal Reserve subsidies and credit lines, and politically driven changes in accounting rules were much more important to their survival than stress testing).

Europe's tests were embarrassingly less accurate. Weeks after passing the first round of stress tests last year, major Irish banks needed government bailouts. Dexia, a Belgian-French bank that just got a bailout, passed the stress tests twice. This summer, stress test results announced in July indicated that only eight European banks failed, having a combined capital shortfall of 2.5 billion Euros ($3.5 billion). Now, as EU leaders squabble over the terms of the next humungous bailout, current estimates of the capital shortfalls of EU banks range as high as 80 billion Euros. To go from needing 2.5 billion Euros this past July to perhaps 80 billion a period of three months is suggestive (to say the least) of flaws in the testing process.

Comically, Europe's banking regulators are about to conduct a third round of stress tests. Major European banks are reportedly trying to shrink their balance sheets and beef up their capital in anticipation. But what's the worry? Based on our experience with the past two rounds of stress tests, we already know what results will be announced. All that's need is for the EU's regulators to figure out what assumptions are necessary for them to sound Panglossian.

You can make stress tests come out any way you want, by using the right assumptions about how bad the financial markets will get and how to value assets. Europe's stress tests might provide good fodder for the opening monologue on the Tonight Show. But don't bet your badly battered retirement savings on them.

The EU Paper Shuffle Continues

The Dow Jones Industrial Average closed up 272 points today, mostly on rumors of an EU bailout plan in the works. As always, the market buys on the rumor, and hopes for good news.

News reports, however, indicate the EU is mucking around with another paper shuffle. The European modus operandi ever since the Greek sovereign debt crisis blew up has been to shuffle and exchange pieces of paper that increase total debt levels without solving problems. Last year, a bailout fund was created, which allowed private sector creditors to ease out of the septic tank while drawing EU member nations and their taxpayers deeper into the muck.

The latest gossip seems to focus on creating a special purpose vehicle, capitalized by the EU bailout facility, which will issue bonds to finance its bailout activities. The funds raised by issuing these bonds will be used to buy up hinky sovereign debt of potential deadbeats among the EU's members.

An interesting feature about these bonds is that they will be useable with the ECB to collateralize borrowings by European banks. This makes the SPV's bonds attractive to EU banks. Those would be the same banks that hold hundreds of billions (or is it trillions?) of Euros of dodgy sovereign debt. By investing in SPV bonds, they'll place themselves in a virtuous (from their perspective) circle where funds they give to the SPV for its bonds will circle back to them as the proceeds obtained from selling toxic debt to the SPV. Stated otherwise, they'll swap snake droppings now stinking up their balance sheets for valuable bonds that can be used as collateral for ECB loans.

It's a very special special purpose entity that, immediately upon inception, is deemed sufficiently creditworthy to serve as an issuer of collateral acceptable to the ECB. Ordinarily, only gilt edged quality securities can be submitted to the ECB for loans. But this special purpose entity is indirectly capitalized by all the EU members, and implicitly is backed by all of them. Of course, no one in a position of authority will acknowledge that the EU's members explicitly or implicitly back the special SPV's bonds. But saddling the ECB with risky collateral could very possibly blow up the entire Euro zone. So, like it or not, the EU would create its own sovereign debt analogue to Fannie Mae and Freddie Mac. Losses from the SPV will land, one way or another, on the good burghers of Northern Europe.

The apparent purpose of the SPV is to be a "bad bank" which scarfs up toxic assets from commercial banks to clean up Europe's banking system. That's not a bad idea, in theory. Such an approach worked in the early 1990s to pull the Scandanavian countries out of a financial crisis. A tough question, though, is who gets to pay Tuesday for the losses that have been sustained today. European leaders have been shuffling and swapping paper since the early stages of the crisis, in the hope that kicking the can down the road would keep the ship afloat until Europe's economies revived and grew enough to produce the wealth to pay for the losses. Unfortunately, Europe's economies, and most of the rest of the world's economies, are slowing or stagnating. Recession may loom. In such a scenario, losses can't be absorbed by economic growth. They have to be allocated among debtors, creditors, taxpayers, or a rich uncle somewhere. Except that there is no rich uncle anywhere--China and Japan might toss in a few nickels each, but not the hundreds of billions needed for a workable bailout. And among debtors, creditors, and taxpayers there is nary a shred of selflessness to be found. This is like a bunch of people at a bar, slyly maneuvering to slip out before the tab comes, sticking the last guy to leave with the bill.

The EU will no doubt try to make the latest bailout sound as elegant and clever as possible. But look beyond all the proposed vehicles, entities, bonds, exchanges and facilities, and focus on who gets stuck with the tab. If the shlemiel won't be able or willing to pay up, then the transaction is just another kick of the can down the road that allows overall debtloads to increase, and pushes the EU farther into the abyss. And right now, no one is bellying up to the bar with a fistful of cash.

The European Union: All For . . . Well, Let's Think About This

Like the middle of a horror movie, this weekend's inconclusive meeting in Poland of Europe's finance ministers revealed growing realization of how scary the EU's sovereign debt problems have become. The ministers couldn't agree on how to stop Greece's plunge toward white water. But did they did acknowledge the need to strengthen the capital positions of their banks. In plain English, this means they haven't figured out how to put out the forest fire. But they are leaning toward building firewalls around their own borders.

This subtle shift toward self-preservation is a small step back from Greece's outstretched hand. Just a few months ago, European leaders loudly, if not entirely convincingly, proclaimed all for one, one for all. Now, their eyes flick nervously from side to side as they maneuver to see who gets the hot tamale (read, the cost of yet again bailing out the Greeks). Private capital is vamoosing from the markets for the sovereign debt of weak EU member nations. The ECB has stepped in by buying, or lending against, the dodgy debt. But that can't continue indefinitely, as the ECB isn't supposed to be a bailout fund. Greece has repetitive failure syndrome when it comes to meeting the conditions for bailout monies from the EU. While Germany and France have thus far dispensed enough bailout funds to prevent Greece from technically defaulting, they can't continue writing blank checks forever.

Some of the finance ministers testily rejected suggestions by U.S. Secretary of the Treasury Timothy Geithner to increase leverage for pan-European bailout funding, and to apply greater fiscal stimulus. Of course, it's their money he wants them to spend, and their national wealth he'd put at risk. So he's not quite the hit as was, say, George Marshall.

What the EU would be willing to do--the $64,000 question--remains a mystery. Perhaps the ministers like it that way. Last week, the stock market rallied almost 5% on nothing more than gossip, whisper and innuendo about European intentions to do the right thing, or something like that. If a few leaks and whispers to journalists can turn the markets around like this, why spend any money on bailouts? Just keep gabbing to the financial press, prop up the markets, and wink at your constituents while gullible stock investors make you look good.

Europeans are very good at inaction. As long as the stock market responds so deliriously to talk therapy, expect the EU to yak ad nauseum. There's nothing like a free ride, and last week's stock rally cost the EU nothing. One might harbor suspicions about stock valuations based on politicians babbling. But, then again, as we know from the tech bubble and the real estate/mortgage bubble, markets love bubbles. The European sovereign debt crisis will bubble along until some unexpected singularity pops up and the bubble painfully bursts. Then, investors will once again learn that irrational hope doesn't translate into financial gain.

But, in the short run, the EU and other government officials, ever Pavlovian, will dangle faint glimmers of hope. Today's market is all government, all the time. Take government out of the picture, and the market tanks. Knowing that, the Fed will reincarnate the "Twist" at its meeting this coming week--not the dance (perish the thought of Fed Governors dancing), but a lengthening of maturities in the pool of Treasury securities held by the Fed. This maneuver is meant to make the yield curve undulate, with shorter term rates rising a bit while mid-length maturities drop. Whether it will actually stimulate the economy is open to question, but one suspects that the Fed's main goal is to keep stock investors giddy by at least creating the appearance of not sitting on its hands. (Parenthetically, the Fed's Twist will flatten the yield curve, and a flat or inverted yield curve is often taken by market prognosticators as a sign of an impending recession; but interest rates are now completely controlled by government fiat, and entrails aren't likely to mean what they used to mean.)

The G-20 is meeting toward the end of the week. This consortium of large economies provides the EU and the U.S. with another public relations opportunity to hint at succor for distressed EU member nations. While it's doubtful that the G-20 will offer more than vague expressions of concern, you can bet that it will do a little fan dance for the stock market to lure in those investors desperately seeking any straw to grasp. One could fairly observe that this silliness can't continue forever. But market bubbles last longer and rise higher than anyone might reasonably expect. And this is a government bubble. Politicians, being quintessential windbags, will bloviate as long as anyone is around to listen. So this bubble might last for a while. But when the government bursts--and all bubbles eventually burst--who will provide the bailout?

Why the EU Has No Policy Options

Why has it been so difficult for the EU to resolve its sovereign debt crisis? Because it has no policy options.

Fiscal policy is limited by the EU's ostensible restriction of government deficits to 3% of GDP. Virtually all EU members, including powerhouse Germany, have violated this commandment. With deficits already exceeding 3%, EU members can't go Keynesian (more so than they already have).

The European Central Bank, guardian of the Euro, is constrained by its charter to promote currency stability, meaning that it is duty bound to keep inflation low. At 2.5%, inflation in the Euro zone is moderate. But the ECB can't take the low road of expediency and inflate the Euro in order to ease the burden of repaying the EU's sovereign debt and make the Euro zone more competitive internationally. Aside from violating its charter, the ECB would rile up the Germans, for whom inflation is anathema and perhaps cause enough to leave the EU.

Germany was the wealthiest proponent of the EU, and created the union in its own image. Fiscally prudent and indefatigably vigilant against inflation, the EU allows member nations to combat excessive debt only by enhancing the productivity of workers and elevating economic growth. A very German solution, but not all of the EU is German or inclined toward that persuasion.

So what's left? Right now, talk therapy is being offered. Rumors of Chinese interest in Italian bonds surfaced first. These preliminary discussions are less than first touted, focusing on strategic investments in Italian companies than Chinese purchases of Italian government bonds. In other words, the Chinese are trying to cherry pick the best of Italy's assets in a moment of Italian weakness. That ain't a bailout in anyone's book. The Chinese premier has also made noise about Chinese support for EU debt, but only if China gets improved trade access to Europe. That's just talk for now. Europe's immediate cash flow needs won't be served by this proposal.

Rumor mongers also proffer tales of Brazilian and other BRIC interest in Euro zone sovereign debt purchases. But these eager whispers appear to be just an agreement to meet and talk next week in Washington. The market has bobbed up and down the last couple of days. Its modest rises may be little more than short covering by hedge funds that don't want their butts fried in case some outside money actually wants to bet on Euro debt.

Outside money would appear to be Europe's only hope. It can't use fiscal policy, nor can it deploy monetary policy. But outside money may be far from a panacea. It can be profitably invested in EU sovereign debt only at a discount, something that by definition would preclude a bailout. And, even if the BRICs are willing to lend a helping hand, the hundreds of billions (and maybe more) of hinky Euro sovereign debt may defy the best of BRIC intentions. The BRICs are growing quickly, but don't by themselves have the sheer financial horsepower to haul Europe back from brink.

Europe remains a wealthy part of the world, with substantial economic resources. Europeans won't have to live on air. But the vision of living ever larger indefinitely into the future dangled by EU enthusiasts is as mythical as the chimera. The only way for the EU to survive is to endure a long, painful test of shared sacrifice and loss, leavened only by disappointment and disillusionment, before a true United States of Europe can be forged. And it's far from clear that Europeans will meet that test.