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.

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.

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 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 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?

Is the EU Sunk?

Is it even possible to solve the European debt crisis?

An old adage goes, "lie to me once and shame on you; lie to me twice and shame on me." The financial markets seem to have taken that thought to heart, and now disdain the half-measures peddled by Euro zone leaders as solutions to the crisis. These leaders aren't stupid or uninformed. They know the score. The fact that they won't get to the bottom line suggests the bottom line is ugly.

A standard measure of a nation's ability to service its sovereign debt and still maintain healthy economic growth is that the debt be no more than 60% of GDP. Indeed, the EU theoretically requires new members to have a debt-to-GDP ratio of not more than 60%. What is the reality?

Today, the debt-to-GDP ratio of the EU as a whole is around 90%. Germany, which would be the locomotive for any true EU rescue of its spendthrift members, has a debt-to-GDP ratio of about 80%. Not the best starting point for a bailout. Moreover, Germany's GDP amounts to some 22% of the EU's GDP. With Greece, Ireland, Portugal, Spain and Italy all going the way of dominoes, it's doubtful Germany has the ability to uplift all the sinners.

These figures understate the extent of the problem. The European banking system is one of the largest creditors of the dodgy debtor nations, and would very possibly be insolvent if things fell apart. Indeed, the simple exercise of marking to market European bank holdings of EU debt would likely indicate that the major European banks are insolvent. So the EU would have to guarantee the indebtedness of the major European banks. That would include vast amounts of interbank borrowings, commercial paper, repurchase transactions, and other debt, and all derivatives liabilities (an almost unknowable quantity given the opacity of the derivatives market). How much more would that add to the EU's burdens? It's hard to say, but the amount could easily run into trillions (of dollars or Euros, take your pick).

Measured by typical standards, it would appear that the EU couldn't save itself even if it wanted to. There is, however, one way out. That would be for the European Central Bank to print vast amounts of Euros to create inflation, drive living standards down, and make the Euro zone more competitive worldwide. Such a course of action would violate the ECB's charter, which requires it to stabilize the Euro. Many Europeans surely realize now that the mandate to stabilize the Euro gave profligate EU members an arbitrage opportunity. In other words, they could take the path of expediency, and borrow at the lower rates fostered by a stable Euro in order to raise their living standards. These lower rates were available because the markets assumed all Euro denominated sovereign debt was implicitly guaranteed by Germany and the other economically strong EU nations. With access to unduly cheap credit, the spendthrift nations could live large without having to work hard for the productivity improvements that otherwise would have been required. Give people a choice between hard work and expediency, and what precisely do we think they will do?

Amending the ECB's charter to allow it to inflate the Euro would contradict the most strongly held German imperatives. Rampant inflation after World War I, coupled with enormous war reparations to the victorious Allies, put Germany economically in extremis and opened the door for National Socialism. Germans today would have to stop being German in order to consent to inflation.

The hard data shows the EU is swirling in the porcelain bowl. The political realities of implementing the only feasible solution--inflation--require that Germany, the most powerful EU member, cease being German. Where is there daylight at the end of the tunnel? The EU seems to be gradually realizing how deep in the septic tank it's sunk. The question now isn't how to get out, but whether there even is a way out. And the answer doesn't look pretty.

Is This Any Way to Run a European Union?

The latest bailout for Greece has bogged down because one EU member, Finland, beset by domestic political opposition to more handouts to Greece, insisted on cash collateral for its portion of the bailout. In other words, cash loaned by other EU members to Greece would be given to Finland as collateral for Greece's obligation to repay Finland. Amazingly, Greece agreed to Finland's demand. Even though Finland's share of the bailout was only 2%, it would get better terms than other EU members. Greece violated a cardinal principle of negotiating a workout of its debts: that similarly situated creditors be treated equally.

When the word got around, several other EU members balked at participating in the bailout unless they, too, got cash collateral. Needless to say, the entire bailout package began swirling in the porcelain bowl, because funds Greece would receive from the EU's bailout mechanism wouldn't be used to repay current liabilities but instead recycled to other EU members as collateral. How, then, would Greece avoid defaulting on its current liabilities?

Germany and the Netherlands quickly planted an IED under the Finnish collateral proposal. That preserved the principle of equal treatment for all members. But it leaves Finland's political problem unresolved. Large numbers of Finnish voters want to tell Greece to take a hike. Without collateral, or some other protection, Finland may refuse to sign off on the bailout. Because EU rules require unanimity, Finland by its lonesome can torpedo the entire deal.

Germany, the most powerful member of the EU, stands by the unanimity requirement, even though a collapse of the EU from a failure of the bailout proposal could visit extremely painful consequences on Germany. The unanimity requirement protects Germany, too. Otherwise, it might be forced to relinquish a large part of its wealth bailing out more profligate EU members simply by a vote of the majority. Germany, too, wants eat its cake and have it too by preserving the option to blow up the bailout if the terms are too costly for Germany.

From a traditional creditor's viewpoint, Finland's position makes sense. Greece, for the most part, has been dealing with its sovereign debt problem by swapping maturing debt for longer term debt--i.e., rolling its obligations over. Swapping paper for more paper doesn't repay debt. It simply extends maturities. If Finland had collateral, it could seize the collateral in the event of nonpayment and step off the paper swapping merry-to-round. If Greece lost collateral, it would lose real value, and the prospect of such a loss might focus its attention on truly paying down its debts. As long as Greece has the option of swapping paper and holding onto its true wealth, it can continue to make promises instead of keeping them.

To appease the Finns and others, the EU is looking into some sort of collateral for the bailout. But how much of its wealth will Greece put into hock? Unless it pledges the Acropolis, Greece can't fully collateralize all its debts. Reality is that Greece, mostly for political reasons, simply cannot repay its debts in full. The EU won't confront this reality. Its rules, which protect its creditor members, enable this head in the sand outlook. Fully protecting creditors isn't how commercial creditors do a loan workout with a troubled borrower. They make concessions, take some losses, maybe take an equity interest to have some upside potential if the borrower survives, and hope for the best. The EU's pro-creditor governance structure makes a true workout of Greece's problems essentially impossible. Paper is swapped because it's the only way for everyone concerned to pretend they're doing something.

This is no way to run a continental union. Something has to give. The EU has no mechanism for kicking members out, even if they violate the rules. So it's stuck with Greece, which has no incentive to leave as long as it's rolling paper over. Germany isn't ready to walk, either, because it has so much to lose. Perhaps secession by other members will be next. Finland and other small member nations may conclude it's best for them to vamoose, reverting back to national currencies that may be strong against the Euro. The rest of the EU won't stop them. Europe lost tens of millions of people in two horrendous world wars in the last century. Secession wasn't accepted by the United States but 21st Century Europeans won't fight any Gettysburgs, Vicksburgs or Peterburgs. If a few small nations succeed on their own, then other prosperous EU members will be under enormous pressure to skedaddle. As more members hightail it, Germany won't be able to support the entire edifice by itself. The EU, poorly designed and too inflexible to deal with the risks of the real world, will then go the way of the Titanic.

The alternative will be for Germany to write checks to profligate EU members--big ones. West Germany did something like that once before, to finance unification with East Germany. Whether it will do that again, this time for non-German peoples, remains to be seen. But, if you're not the betting type, avoid long term investments denominated in the Euro.

European Credit Default Swaps: EU 15, Speculators Love?

An undercurrent of the EU sovereign debt crisis is that the Euro zone nations detest the speculators they believe have been gambling on the outcome of the Greek and other bailout efforts. Hedge funds and perhaps some investment banks dabble in credit default swaps protecting against defaults by various Euro zone nations as a way to gain speculative profits. While CDS's may have originated as hedging instruments, just about any financial instrument can be used to speculate as well as hedge. And CDS's, like many derivatives, can be traded on a leveraged basis, which makes them all the more appealing as speculative investments.

Euro zone governments loath speculators in CDS's of EU member nations' debt. Although CDS's nominally take their value from the market for the underlying financial instrument, there is a belief that derivatives markets can affect the markets for underlying financial instruments. In other words, a lot of CDS speculation on a Greek default might push the value of Greek bonds lower, increasing the potential for default by raising the market interest rates Greece must pay. The toxic interaction in the 1987 U.S. stock market crash between stocks and a type of derivatives contract called portfolio insurance fuels such beliefs. Portfolio insurance purported to guarantee the value of portfolios. Mutual funds, pension funds and other institutional investors flocked to this product (which is now extinct). When stocks dipped on Black Monday (Oct. 19, 1987), portfolio insurers began short selling underlying stocks in order hedge themselves against further stock drops. That short selling only increased the downward pressure on stocks, which triggered more selling and short selling. This increased selling impelled more short selling by portfolio insurers, which served only to fuel more panic. The market dropped a total of 22% that day, the greatest percentage drop ever, not excluding the 1929 stock market crash.

The EU's second bailout for Greece involves an expectation of a "voluntary" bond exchange by private holders of Greek debt for longer term debt, something that underlies the credit agencies' view of this bailout as a default. This exchange will entail a 20% loss for those holders. The exchange feature would lower the market value of Greek bonds and, perhaps, might be the sort of thing against which a CDS holder would expect protection. But the International Swaps and Derivatives Association, a trade organization composed of derivatives dealers, has decided that CDS obligations will not be triggered by the second Greek bailout because it doesn't change the terms for all holders of Greek debt. In other words, if a hedge fund holds a CDS on Greek debt and was hoping for a payout because the EU's bailout, part deux, would be considered a default by the rating agencies, it's out of luck.

How many speculators have been hurt by this decision, and how large their losses are, is unknown. The amount is probably not trivial, because all the volatility surrounding the Greek debt situation would provide a plenitude of speculative opportunities. Don't expect a lot of publicity about these losses. The speculators, knowing the EU member nations are probably quietly gloating over this victory, have plenty of reason to lick their wounds in silence. And don't be surprised if the EU, in the next bailout of Greece, Ireland, Portugal or whomever, doesn't try to structure things so that CDS's payment requirements again aren't triggered, and the speculators get spanked again.

With the Second Greek Bailout, Will Greece Become Germany or Germany Become Greece?

The second Euro zone bailout for Greece confirms what was pretty clear from the tea leaves: the political leadership of the EU intends to stand behind all the public debt and all of the banks of all its members. This bailout gives the can another kick down the road, pushing back debt maturities but still leaving Greece facing an unsustainable debt load. While there is a provision for an exchange of bonds by private holders that would involve a 20% loss for them, that's a pretty generous deal considering that these bonds traded at a 50% discount in the open market. You can call it bailout light. The bond exchanges won't do much to reduce Greece's total debt load. More bailouts loom.

The Greek Bailout, Part Deux, necessitates more austerity. A nation where the public sector is 40% of GDP, Greece is looking at years of constraint in government spending. Politically, that will be a challenge. But the alternative--departure from the Euro zone to pursue other interests--would be worse. So Greece will have to man up and tighten its belt. Right?

Well, not so fast. The second bailout requires closer political supervision of Athens by Brussels than ever before. The same will be true for Ireland, Portugal and other nations, if they tap into the brave new bailout facility. The Euro zone is cruising toward political union. For a while, no high ranking European officials will say so. But political union is essential to prevent the bailout process from fostering an ever bigger sovereign debt bubble. Otherwise, the bailees could allow their public debt to keep growing, and stick the costs on their wealthy northern European benefactors. Greece, therefore, must become Germany.

But will it? There are obvious cultural, historical and linguistic differences between the two nations, differences that have existed for thousands of years. There are also lingering memories of World War II, in which Greece suffered under harsh German occupation. Greece won't transform itself over the next five years into the new Pomerania.

The very concept of political union implies a melding of traditions and cultures. All member nations of the EU will have a political voice, and they will have to listen to each other. All will influence the others. Such is the case with political amalgamation. The Roman Empire, at its indolent, libertine, epicurean peak, was a far cry from the relatively simple, disciplined world of Cincinnatus. America, the world's melting pot, has grown far from the spare, repressed, colorless culture of the Puritans, absorbing words, foods and values from wave after wave of immigrants. As the EU becomes the United States of Europe, Germany will absorb ideas and values from other members, including Greece. Southern Europe will also change to more closely resemble its northern neighbors. But the final outcome is unpredictable. Consider Daimler-Benz's acquisition of Chrysler Corporation.

Daimler-Benz merged with Chrysler in 1998. The idea was to give Daimler-Benz a bigger presence in North America, while joining Chrysler with a company that had much higher product quality standards. The Mercedes vehicles of the 1980s and early 1990s generally had excellent reviews for quality, reliability and safety. Chrysler, it was hoped, would become Mercedes.

That didn't happened. During the decade that Daimler-Benz was affiliated with Chrysler, Mercedes' products frequently got mediocre reviews for quality and reliability and Chrysler's products remained as crummy as ever. (See Consumer Reports.) In other words, Mercedes became Chrysler. Things got so bad the two companies went their separate ways.

Maybe Germany will become Greece. With a raucous, unruly union on its hands, Germany may find it easier to defer problems than face the pain of resolving them. The second Greek bailout's tack of pushing debt maturities back--another kick down the road for the can--doesn't portend well for a Germanic EU. Actual reduction of Greek and other sovereign debt loads is the litmus test for the EU's viability, and that fat lady ain't singing yet.

It will be up to the legislatures of individual Euro bloc nations to approve the second Greek bailout. Chances are they will, maybe with a teaspoon or two of rancor. The chances of a major financial crisis from the EU's sovereign debt problems have diminished for a couple of months, perhaps. But don't let your guard down. The American debt ceiling squabble is accelerating rapidly from 60 to 120. Ireland and Portugal may take their hats into their hands, and line for their second turns at the bailout trough. Ours is a world living on borrowed money, and consequently, we're never truly in control of our lives.

The Moveable Greek Debt Crisis

The Euro Bloc's strategy for dealing with the Greek (and Irish, Portuguese et al.) debt crisis is becoming increasingly clear. Stall for time, bring in new bailout money, hope for economic growth (with the prospects murky), and hope that taxpayers can eventually be persuaded to bear a large portion of the cost of default.

First, let's be clear that the Greek debt crisis isn't a sovereign debt crisis as much as it is a European banking crisis. The major Greek, German and French banks all hold large amounts of Greek debt. A Greek default would imperil these banks, especially if the Greek debt crisis has a domino effect of putting Irish, Portuguese, Spanish, Italian and whatever else debt (which many banks also hold) under stress. German and French taxpayers would have no choice but to bail out their own nations' banks. That would put a lot of bees in their bonnets.

Even worse, the European Central Bank holds a lot of Greek debt (and debt of other EU member nations). If Greek debt defaults, and especially if there is a domino effect, the ECB could become insolvent. This would mean the collapse of the Euro. That would be a very bad thing.

The Euro bloc has been assiduously cultivating the Chinese, holders of $3 trillion of foreign reserves they need to invest somewhere. The Chinese have bought their fill of dollar-denominated debt, and are looking for alternatives. They have been willing to toss some capital at Greek debt, knowing that the goodwill they get in return is worth more than the losses they'll sustain. But China won't fork over the amounts of money needed to resolve the European debt crisis--their foreign policy is focused on expanding their influence and advantages. Marshall Plans aren't on their agenda.

By the skin of its teeth, the Greek government has signed off on more austerity, paving the way for bailout funding of $17 billion to pay debt coming due this month. The EU has been working on a second bailout package of over $100 billion because Greece has more debt coming due this year and over the next three years which it can't pay. The second bailout was to have been arranged this month, but German insistence on some private sector absorption of losses forced the EU to push back the timetable for completion to September. (The losses would take the form of reinvestment of some current bond repayments into new long term--30-year--debt, but that's economically tantamount to a loss.) Although the Germans and French have been talking about "voluntary" acceptance of losses, the rating agencies have been saying that if it looks, walks and quacks like a default, they're going to call it a default. A default would trigger an immediate banking crisis in Europe, with major banks and the ECB circling the big bowl.

One could say we have a rating agency crisis. The rating agencies, having been revealed to be fools (and maybe worse) during the mortgage crisis, are trying to do the one thing that debtors don't want them to do--be candid. Oddly, in this instance, it's the creditors who are squealing the loudest, because candor will expose the fragility of their banking system and dump shock and awe on their currency.

It remains to be seen who will prevail in this struggle. The rating agencies will come under astronomical amounts of political and commercial pressure to somehow look the other way as the Europeans cover their debts and currencies with fig leafs. Prior history does not auger well for the rating agencies to continue demonstrating backbone. But if the rating agencies can't bring themselves to kiss this pig, we will likely see repeated episodes of stalling and delaying on the question of private sector losses, while the rating agencies are hauled into back alleys, and are threatened direly and offered inducements of many varieties. The can will receive many kicks down the road while the total amount of unpayable Greek debt increases and then increases some more.

Of course, such a dynamic cannot continue indefinitely. But the ending is impossible to predict. One can only rest assured that it will be ugly.

One positive note for America on the eve of its national holiday: the Euro isn't the world's reserve currency and won't become such as long as the sovereign debt crisis threatens to gut the ECB on a moment's notice due a downgrade by the rating agencies. The U.S. Federal Reserve will maintain its as large as necessary currency swap arrangements with other central banks to provide continued availability of dollars, ensuring some stability in international finance, and perhaps just as importantly, preserving the supremacy of the dollar.

Thus, European debt dysfunction allows the dollar to continue its reign as the world's reserve currency. This would be especially so if the administration and Congress resolve the looming debt ceiling problem in a timely manner. The sovereign debt crisis exposes the Euro's true vulnerabilities to Europe's fractured politics. The dollar, for all its problems, still stands tall, and will continue to stand tall if America can demonstrate political maturity. Happy Fourth.

Externalities and the Dysfunction of the Money Markets

Money is invested through mechanisms that appear to be markets. One observes supply (savings), demand (from borrowers and other people offering investments), and price (interest rates, dividends, IPO pricing, etc.). These mechanisms are even called the "money markets." But they're not really markets. At best, they're dysfunctional markets. The reason is externalities.

Externalities are costs not included in the pricing process. A familiar externality is air pollution from cars. The bad consequences of car pollution fall on people who, for the most part, are not involved the purchase of a car. That is, almost all the people who breath the pollution aren't involved in the sale of the car and can't demand a portion of the sale price to cover their damages and loss from the pollution. So cars, before the days of pollution controls, were underpriced in relation to the costs they imposed. More of them were sold because of the underpricing, and the problem of pollution was exacerbated.

The solution to this particular externality was emissions controls imposed by law. First, states where pollution was acute, like California, stepped up regulation. Then, the federal government joined the act. Cars today pollute at a tiny fraction of the rate of their predecessors 50 years ago. The muscle cars of yore were true classics, but you would literally choke if you got too near the exhaust pipes.

The externalities of the money markets have become all too apparent in recent years. Overly aggressive lending, in real estate, to municipalities, and to sovereign nations, coupled with negligence in risk management by banks, created enormous amounts of financial risk. Opaque derivatives markets multiplied these risks, and intertwined them in ways that regulators cannot comprehend. The effect of such interconnectedness is that any debt crisis must be ameliorated through government intervention, often at substantial cost to taxpayers. There no longer are market solutions to financial crises.

The potential for socialism in medicine pales by comparison to the socialism that has crept into the financial system. Prices for money are no longer set by market forces. Central banks dictate the price of money. These dictated prices do not incorporate the costs of government bailouts and other interventions. Thus, enormous externalities have emerged in the financial system. Banks, hedge funds and other financial firms lack the incentive to constrain their wilder and crazier sides, because they don't pay the price of catastrophe. How would people drive if they didn't have to pay the premiums for auto insurance?

We saw this in the financial crisis of 2007-08, when real estate lending reached maniacal levels because the rewards for mania, but not the risks and costs, were placed on the people (bankers and others) who behaved like maniacs. We see this today in the sovereign debt crisis in Europe, where the costs of high risk sovereign lending by Europe's major banks are being allocated in a mad scramble between creditors, taxpayers, government employees, retirees and other EU member nations, similar to a game of musical chairs. Except that there are almost no chairs, and the music is death metal.

Bank regulators are trying to boost capital requirements, in an effort to reduce the need for bailouts and other government aid. The FDIC has been trying to nudge up the premiumss paid by banks for federal deposit insurance. Banks, needless to say, are pulling every political string they can reach to avoid bearing the true costs of their business. After all, why be responsible if you can hire lobbyists and buy politicians to get rid of the large expense of true responsibility?

With central bankers keeping interest rates low and with bank regulation comparatively light, lenders have the incentive to be reckless, and borrowers have the incentive to be profligate. Externalities proliferate as a result. The straightforward way to internalize much of the externalized costs would be to raise capital requirements and interest rates. Fat chance that's going to happen, at least in a way that's meaningful. For the foreseeable future, we will have government administered price controls in the money "markets," with prices too low, and burgeoning externalized costs.

Externalities cannot be imposed indefinitely in ever increasing amounts. The innocent bystanders eventually get so mad about taking collateral damage that they fight back. In the case of air pollution, it was through substantial (but effective) government regulation. In the case of taxpayers and citizens looking at the high price of bailouts and austerity, political rebellion ensues. Today, demonstrators in Athens became rioters. Conservatives in Germany protest further bailouts for Greece. In America, Tea Partiers harp about federal deficits while liberals (and some conservatives) decry the government's failure to rein in too large to fail banks. The spirit of NIMBYism runs strong in these declamations. The essential point just about everyone makes is that "I" don't want to bear the costs.

Central bankers have been kicking the can down the road, hoping that their easy money policies delay the pain of the externalities long enough for the economy to revive and wash the pain away with brisk growth. But their very policies of artificially lowering the price of money makes things worse. Borrowers will borrow more to buy time, and bankers, relieved by the central banks' intervention of the need to manage risk, are glad to lend more, record more apparent "earnings" and pay themselves larger bonuses. The amount of externalized costs rises. Yet the economy responds only haltingly to these massive money prints.

It's clear there isn't going to be a singular event involving fishes and loaves. We'd probably be better off to take the pain of the losses embedded in the financial system, and get them behind us. Countries that took this approach (the "adult choice"), like Sweden in the early 1990s, have done well thereafter. Countries that externalized losses and tried to pretend they didn't exist (the "adolescent sulk") have bogged down (for further reading, see Japan). Anyone familiar with current events in Europe and America knows which way these nations are going, and it ain't toward a character building experience in the wood shed.

Central banks could start easing our way out of this mess by sharply increasing bank capital requirements and moving interest rates up. In so doing, they would begin to internalized today's virulent externalities. But experience teaches that they'll have no more than moderate success at elevating capital requirements. And by all indications, Ben Bernanke and his colleagues won't ever raise interest rates. The only central banker to bring true integrity to monetary policy, Paul Volcker, remains an outcast among his peers. The only bank regulator to emulate Volcker, Sheila Bair, is likely to share his fate. It's hard to predict how things will end. But if we keep increasing the amounts of externalized costs, the ending won't be fun.

If Europe Wins the IMF Election, Europe Could Lose

The contest for the managing director post at the IMF has become a duel between Christine Lagarde, France's Minister of Finance, and Agustin Carstens, the head of Mexico's central bank. Lagarde is favored. Since the IMF was founded at the end of World War II, its top position has always been held by a European. Its international finance counterpart, the World Bank, has traditionally been headed by an American. Thus, the Allies in World War II divided the financial world, circa 1945.

Now, things have changed. The emerging markets members of the IMF are growing restless. They fear that Lagarde will be too Euro-centric in dealing with the European sovereign debt crisis, allowing the borrowers to control the lender. Many support Carstens with the hope of maintaining international balance. Since the emerging markets members are growing much faster than the European members, their influence is on the rise.

If Lagarde wins, the commitment of emerging markets members to the IMF could weaken just at the time the world needs strong international financial institutions. If Carstens wins, reality is that he would probably have to assist weak European nations to about the same extent as would Lagarde. The major banks of the world evidently have a great deal of exposure to the European sovereign debt morass, and the IMF, even if headed by a Mexican, would have little choice but to ride to the rescue. Such an IMF could do so with much less risk of offending emerging markets nations. And if Carstens would impose tougher conditions than Lagarde, that might be a good thing, as the European Union is by all appearances a one-trick dog that can only kick the can farther down the road.

The IMF is one of the few means by which emerging market powers like China, Brazil, India, South Korea and others provide aid to Europe. Having per capita income levels much lower than Europe's, the emerging markets nations can offer Europeans little or no direct aid lest they rile up their own citizenry. If their commitment to the IMF sags, its capacity to lend to needy nations could diminish.

The U.S. is in the hot seat. It likely has the voting power (16%) to turn the election one way or the other. America has deep financial and economic ties to Europe. Even though the Euro is a rival to the dollar, America would be deeply affected by any European financial crisis. But America's austerity driven politics today preclude any direct bailout. There won't be a 21st Century Marshall Plan. The IMF, indeed, is one of the few ways America can assist Europe. The smart play might be for the U.S. to support Carstens. After all, China holds trillions of U.S. dollar denominated securities. Brazil has recently been a fairly significant buyer of U.S. Treasuries. A rift with emerging markets nations is hardly in America's interests. We might soon need a bailout ourselves, and if so, it won't come from Europe.

The (Second) Summer of Bernanke's Discontent

Today must have been tough for Federal Reserve Chairman Ben Bernanke. In public remarks at a conference in Atlanta, he didn't say anything. For a Fed Chairman who has made a priority of increasing transparency, having no news to announce was bad news.

Bernanke repeated the Fed's standard litany of the past two and a half years. Short term interest rates will remain at zero for an extended time, and the Fed stands prepared to "respond as necessary" to developments in the economic recovery. This isn't news. His acknowledgement of the economy's slowdown shouldn't have been news, either, although it did seem to contribute to a market drop at the close. The big problem, though, was that Bernanke didn't promise to wear a red suit and come down the chimney imminently with another bagful of gifts. No QE3. No other legerdemain that would amount to money printing. No promise to support current asset values.

Let's face it. The market, and economy, are addicted to government bailouts and subsidies. Everyone wants a federal guarantee for everything. Businesses want the Federal Reserve money printing press running 24/7 before they'll add a single person to the payroll. Investors want to see truckloads of cash moving off the Fed's loading dock before putting a penny in stocks. The big banks want the government's too-big-to-fail subsidy, but not the increased capital requirements and regulatory compliance costs that logically come with the unlimited support of taxpayers. Bernanke wanted to encourage people to invest in risk assets, but in actuality he's accomplished just the opposite. No one truly wants to take a risk any more. There's an easier way to make money--get Washington to guarantee profits.

Bernanke offered talk therapy, predicting that the economy would grow in the second half of 2011. He may be hoping that, if he can't add more money to the financial system to buy a recovery, he can psyche Corporate America into hiring more. But we've been stagnant for too long, and the Fed's been wrong on its predictions too many times.

Without financial methadone from Washington, the withdrawal symptoms could be painful. Scant growth, a good chance of rising unemployment, and falling stock prices. If the Fed adds more stimulus, the spectral presence of rising prices would shadow its every move.

Across the pond, the Euro sovereign debt crisis will either end badly, or worse. Wealthy northern Europe will absorb profligate Euro bloc member debt (possibly with a few token pennies thrown in the pot by creditors) and greater political power will be centralized in Brussels, or the Euro will go down in history as a very costly example of wishful thinking. Whatever the case, there won't be any stimulus to the U.S. economy from Europe. Economies in Asia are also slowing. We're on our own. What will happen?

We've already seen this video. Last summer, the same problems were tossing the economy and stock market around like rag dolls in a tornado--fading federal stimulus, sovereign debt crisis in Europe and everyone on Wall Street looking for a federal promise of profits. Ben Bernanke stepped up to the plate at the Federal Reserve's annual August conference in Jackson Hole, promised QE2, and hit what looked for a while like a home run. It's curving toward the foul pole now, but we don't yet have an official ruling from the umpire. If this summer follows the same path of economic stagnation and malaise in the stock markets, expect the Fed to step up to the table, bet its chips on a hard 8, and roll the dice one more time.

What Are They Not Telling Us About the Euro Debt Crisis?

The European Union is scrambling to put together a second bailout for Greece, which would follow the bailout granted last year that everyone now admits isn't enough. See http://www.cnbc.com/id/43219315. The insufficiency of last year's bailout isn't exactly a surprise, since financial markets Cassandras were predicting its failure almost as soon as it was announced. But the celerity of Bailout, Part Deux is notable. Even though objecting conservative political groups in northern Europe have grown more vociferous, there seems little hesitation on the part of Europe's mainstream leaders to gather planes, trains and buses to take more bailout money to Greece. A second, and speedier than the first, bailout only heightens the hazardous morality of the situation. For all practical purposes, every Euro bloc nation is assuming responsibility for all the sovereign and bank debt of all other Euro bloc nations.

What gives? People don't cover the debts of other people they can't control without powerful reasons. Even if Europe's banks have stupidly overextended loans to Greece--and Ireland, Portugal, Spain, Italy and all the other troubled Euro bloc nations--one wonders why they can't take appropriate haircuts on that debt, recapitalize the dumb banks, and move on. The U.S. just largely did that with its banking system to get past the mortgage market morass. While the process was painful and very costly, and left us with high unemployment, the financial system survived. Exactly what is it about Europe's sovereign debt crisis that is so scary?

It may depend on what we don't know. Importantly, the derivatives markets continue to be opaque. Unknown are the size and concentration of credit default swap and currency derivatives exposures that might be affected by a Greek default (which we assume would trigger falling values for Ireland's, Portugal's, Spain's and perhaps Italy's and Belgium's debt). Because derivatives contracts can be traded on a highly leveraged basis, the costs of a Greek default could be multiplied many times over by speculative enthusiasm in the derivatives markets. And because there are no organized exchanges or clearing houses for most derivatives contracts, it's very difficult to find out whether this multiplicity of risk, if it exists, is appropriately dispersed or disastrously concentrated a la AIG, circa 2008.

Even though many European politicians are making noise about soft defaults and other largely symbolic concessions by creditors, the European Central Bank has very firmly stated it will not accept any bailout that involves a restructuring of Greek (or other dodgy) debt. The ECB's resolute refusal to agree to any restructuring whatsoever is another twist in the entrails that indicates something, like a snake pit of derivatives exposures, is mucking up the situation.

We learned from the 2007-08 financial crisis that what we don't know could hurt us. One would hope that financial regulators and other government officials have moved up the learning curve. Perhaps they have. Perhaps they're keeping mum to avoid triggering a run on their banks. It seems that a deep fog has settled over the European financial system, and the costs and ramifications of the Euro sovereign debt crisis might end up gradually emerging, dank and fetid, like a monster from a swamp, except this might be a real swamp and it could be a real monster.

Did Dominique Strauss-Kahn Just Mess Up the Derivatives Market?

In the arrest in New York yesterday of Dominique Strauss-Kahn, the managing director and head of the International Monetary Fund, on charges of attempted rape, unlawful imprisonment, and a criminal sex act, the financial press got a rare tabloid-quality story. Financial reporters may be gleeful now, having an opportunity to step back from EBITDA, NAV, SIPC, CDO, and MERS, and turn to allegations of an international financial leader, buck nekked, lying in wait to ambush a hotel maid, chasing her down a hallway and generally behaving like he follows Attila the Hun on Twitter. All reporters need to be good writers, but the truly successful ones have the hunter's instinct for knowing when to pounce. Strauss-Kahn, who might have thought he was the hunter, surely has no trouble hearing the howling of the pack closing in on him.

As a matter of law, Strauss-Kahn remains innocent until proven guilty. But the charges seem to have blown up his political prospects--he had a good chance of becoming the next president of France. And his career in finance is impaired. Another consequence is the new, enlarged bailout for Greece that the EU has been working on may be delayed. Strauss-Kahn, an internationalist who was sympathetic to bailouts, will have trouble getting bail for himself, let alone Greece. He was arrested four hours after the alleged crimes, while seated in a jetliner at JFK International Airport minutes away from leaving for Paris. That's a prosecutor's wet dream (whoops, sorry) for arguing against bail. And it's kind of hard to organize an EU-wide sovereign bailout if you're sitting in jail, eating baloney on white, WWII surplus canned fruit, and week-old brownies. A day of that and never mind haute cuisine. A Croque-monsieur and a demi de biere would seem pretty good.

The IMF says it will soldier on with work on the bailout. And surely it will, because international financial organizations don't justify their existence by saying no. But one can't help but wonder whether some players in the derivatives market who bet on a bigger Greek bailout are wondering if they're going to get margin calls. Even if the arrest of Strauss-Kahn doesn't move credit default swap prices a lot, most traders who play with derivatives mainline margin credit. A little price move can sometimes f . . . foul things up. Strauss-Kahn's arrest by itself won't trigger a financial crisis. But it's something that everyone dealing with the EU sovereign debt morass really didn't need.

There is no derivatives contract covering the risk of the head of an international financial organization being charged with acting really sexy in a wolfish way. No matter how much Wall Street's financial engineers churn and crunch data, there will always be some risks that won't be accounted for. That's why banks and other financial institutions need to be well-capitalized. Even if the next head of the IMF is already well on the way to beatification, you can never completely know when the elephant that is the real world is going to plop a heap of dung on your head.

Slow Mo Euro Woes

High ranking Greek officials have several times in recent days strenuously denied that Greece is considering leaving the Euro bloc. The strength and frequency of their denials leaves the distinct impression that Greece is thinking of leaving the Euro bloc. Although bailed out last year, Greece is still struggling. Maybe it's all just a wink and a bluff, but the Greeks seem to have gotten somewhere. Late last week, high level Euro bloc finance officials conceded that Greece would likely get a sweeter bailout.

The Irish government, fresh from being bailed out just six months ago, has put in its claim for more porridge if the Greeks get more. Seems that when it comes to bailouts, the bailees expect most favored nation status as a matter of course. The Euro powers will be hard put to deny the Irish equality in handouts, as an Irish departure from the Euro bloc could be as damaging as a Greek withdrawal. And it seems likely that Portugal, which just signed up for a bailout, would get an improved package along with Greece and Ireland.

The Euro crisis is pretty much playing out as predicted last year--the bailouts were inadequate and the bailees would return to the trough for more. Germany, France and the other wealthy EU nations will pony up. Their own banks hold large amounts of Greek, Irish, Portuguese and other funky EU sovereign debt, and a dissolution of the EU, even partial, could trigger big losses.

At the same time, however, the political waters in Europe have become more treacherous. A recent election in Finland, of all places, signaled that the anti-bailout interests are growing in influence. One might dismiss that as due to something in reindeer milk, except that anti-Euro groups through Europe are rising in the polls. The pro-EU politicians are drawing out the bailout process, apparently hoping that doling out the pain gradually over time will make the bailouts easier to swallow. But that also brings the problem back into the headlines time and again. The EU is bogging down in repetitive bailout syndrome. Whether its strategy of rationing pain slowly works, or becomes the death of a thousand bailouts, remains to be seen. The keys to EU prosperity--balancing the union's economic imbalances and spurring greater growth--seem consigned to the back burner. That gives the political scalawags room to dance, and they'll choose a danse macabre for the EU if they can.