How the Financial Markets Enable the EU Sovereign Debt Crisis

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

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

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

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

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

Hedge Fund Money Managers

In Hedge Fund Market Wizards, author Jack D. Schwager explores the trading styles and techniques of 15 current or former hedge fund money managers. The book, provided without charge to this writer by publisher John Wiley & Sons, Inc., presents interviews with each trader featured, along with commentary by the author. The traders, whom the author believes to be highly successful compared to their peers, include some who are well-known in the financial community and others who are not. The interviewees are variously active in one or more of the major financial markets, including stocks, bonds, commodities, and derivatives. Some trade hundreds of times a day, holding positions for as a little as a few moments, while others are value investors, seeking in some cases to outsmart their peers by outlasting them.

The featured traders were asked to explain the keys to their success. Each has a different story. Some got their start as elementary school age kids. Others drifted into trading. Some manage billions of dollars of investor funds. Others deliberately limit themselves to tens of millions. Their ranks include academics, attorneys, accountants and college dropouts. While their paths to success varied greatly, all were persistent, patient, open-minded and willing to learn from mistakes, and loss averse. The last trait may be the one that the ordinary investors have the hardest time emulating. Each trader featured in the book has stringent ways of limiting losses, and learned to pull the plug on losers quickly, even if doing so meant admitting error and taking a few hits to one's ego. Most, perhaps counterintuitively, weren't terribly greedy. They would start taking profits without trying to score the maximum gain possible. Making some gains, and then looking for another good opportunity, is generally preferred over squeezing the last penny of profit from any given position (with its concomitant risk of overplaying one's hand).

Some of the traders employ rigorously defined parameters. Others apparently rely mostly on their intuition. But they weren't all numbers crunchers and screen watchers. One, perhaps not illegally, got some nonpublic information about a public company from a U.S. government agency. Another (mentioned but not interviewed), hoping to profit from the impending collapse of the real estate market in 2007-08, may have convinced an investment bank to create a derivatives based investment relating to real estate assets the trader suggested, believing those assets to be weak and to provide a good shorting opportunity.

Who would benefit from reading this book? Other traders, for one, just to get an idea of what their peers are thinking. Much of the material in the interviews is already well-known to money management professionals, but the ways that successful traders mix and match the kaleidoscopic inflow of information and ideas into the financial markets can be insightful. Of course, one cannot expect that the interviewees revealed everything they know and do. No good trader would do that. Not if he wanted to keep making money in the markets.

Potential hedge fund investors--in other words, accredited investors--would find the book helpful in revealing the enormous variety of money management styles and techniques. As author Jack Schwager emphasizes, you can't rely on past performance as a certain indicator of future performance. You have to look at investment approaches and risk management, and find a manager with whom you are comfortable.

Ordinary investors might find the book insightful, not because they could use most of the trading techniques discussed. Hedge fund managers do a lot of stuff that you shouldn't try at home. But reading the book can help crystallize an individual's thinking about his or her personal investment approach. As Mr. Schwager highlights, it's important to invest in ways that you find comfortable, to learn from your mistakes, to adjust to changes in the markets, to limit losses, and to find out how you personally can be successful.

The book presumes a considerable degree of financial literacy on the part of the readers. The author is an experienced money manager and tosses around many terms and concepts familiar to the cognoscenti that aren't defined in the book. Have a good Web browser handy if you don't know the lingo of the financial markets. In addition, very little math is presented in the book. But mathematical concepts underlie the financial markets. If you don't have a facility for arithmetic and a basic understanding of statistical analysis, you won't follow the discussion much of the time. Beginning investors should start their reading elsewhere.

One limitation of the book is that it casts little light on high speed computerized trading, which comprises the majority of today's stock trading volume. The impact of algorithmic trading by the millisecond, particularly on the perhaps decreasing number of live humans active in the markets, is a crucial question and problem as we look toward the future. Answers are difficult to discern, but badly needed. Humans can't possibly keep up with machines that trade faster than the blink of an eye, especially when the algorithms deployed are dynamic (i.e., they can change on the run). If Mr. Schwager can coax some high speed traders into talking for his next book, he might well do investors and the financial markets a considerable service.

LIBOR: Good Enough For Government

The Libor price fixing scandal keeps growing. Following Barclay's payment of $450 million in a settlement with regulators, word now comes of a U.S. Department of Justice criminal investigation into the morass. http://www.bloomberg.com/news/2012-07-15/libor-probe-may-yield-u-s-charges-by-sepetmeber.html. Indictments may come soon. Private civil lawsuits galore have been filed. The potential liabilities of the banks caught up in the scandal could run tens of billions, and maybe hundreds of billions if the price fixing is shown to have taken place over a sufficiently long period of time. If the latter were proven to be the case, many of the world's major banks would possibly be insolvent. Which would mean that the world's financial system could be at risk of collapse. Taxpayers on both sides of the Atlantic should brace themselves for yet another bailout of the major banks.

A crucial reason for the enormous potential liabilities is derivatives. (Yes, derivatives have done us in again.) The big banks that participated in setting Libor were often major dealers in the derivatives markets, and many of their products were based on Libor. That meant that they were exposed whether Libor was rising or falling. If they manipulated Libor up, one set of customers and/or counterparties would be injured (and therefore have a right to sue). If they manipulated Libor down, another set of customers and/or counterparties would be injured (and therefore have a right to sue). Since the price fixing could violate U.S. antitrust laws, the defendant banks may face liabilities for the treble damages permitted under the antitrust laws. Trebling the effect of the bad behavior could mean big, big money.

Vast legions of lawyers are now licking their chops at the prospect of suing or defending big banks with respect to the Libor mess. Their retirement accounts will reap rich harvests. Many will finance their childrens' higher educations with the fruits of their Libor engagements. And the modestly paid attorneys working on the government side of the cases can burnish their resumes with high profile cases.

If we want to reduce the likelihood of such windfalls for the legal profession--and, incidentally, enhance the integrity of the financial markets--we must find a better way to determine Libor. The British Bankers Association, a private organization that doesn't appear to be subject to direct government oversight, currently presides over the process of determining Libor. It's done a lousy job. Time to do a Trump and relieve BBA of this responsibility.

What's the best candidate for the job? The U.S. government. Not exactly the most obvious choice, but better than the alternatives. The private sector methodology for determining Libor was too easily infected with agendas and ulterior motives driven by the profit imperative. Government statisticians don't face such pressures. Admittedly, government statistics aren't perfect. But their methodologies are publicly known. We can praise or criticize those methodologies, and work to improve them. But we don't have to worry about price fixing.

One U.S. government statistic, the Consumer Price Index, plays a role in the economy comparable to Libor. Social Security benefits are adjusted when the CPI increases. Many public compensation schemes and private contracts adjust pay and/or benefits when the CPI increases. While numerous economists, statisticians, pundits, bloggers and other riff raff decry this or that about the CPI, no one has said it's secretly rigged. The Bureau of Labor Statistics is trusted to calculate and announce CPI figures.

Perhaps a group in the U.S. Commerce Department could be given the responsibility for determining Libor. (We should disregard America's special relationship with Britain and exclude the Brits from Libor calculations; they had their chance and blew it, big time.) The Commerce Department does not regulate any banks, nor does it have responsibility for monetary policy, nor does it finance the operations of the U.S. government. It has no vested interests, and could credibly determine Libor (preferably using actual market transactions, rather than the opinions of banks of the interest rate at which they could fund themselves, which is the formulation of Libor that has proven to be so problematic).

Having the U.S. government determine Libor would accomplish two important things. First, it would enhance the integrity and credibility of the announced rate. Since public confidence is, ultimately, the only thing that really matters in the financial markets, integrity and credibility are worthwhile. Second, a government determined rate wouldn't give rise to private liabilities the way that Libor has with each manipulated tick up and each manipulated tick down. The massive potential liabilities that major banks face, and the possible collapse of the financial system they could produce, would simply not arise. The cost of a handful of government statisticians putting out Libor might run a few million a year. The cost to taxpayers of bailing out the dodos at the big banks who have screwed up yet again could run billions and billions more and then billions more. At the risk of voicing a political heresy, there are some jobs government does better than the alternatives, and calculating Libor is one of them.

Stocks Are Not Cheap

Forget what the bulls have to say. The Federal Reserve Bank of New York just released a study showing that over 50% of the increase in the S&P 500 since 1994 is due to Federal Reserve actions. http://www.cnbc.com/id/48165921. Without central bank intervention, the market as measured by the S&P 500 would be around 600 instead of today's close at 1334.76. In other words, based on economic fundamentals, stocks are overpriced by more than 100%. That's a sell if there ever was one. It looks like all the retail investors who are abandoning the market aren't so dumb after all.

One may quibble with the Fed's methodology. Its staff looked at market activity in the 24 hours before the Fed announced Open Market Committee decisions, totaled and netted the market movements, and came up with the more than 50% figure. It's certainly possible that some portion of the market movements in the 24 hours before announcements of Open Market Committee decisions could be attributed to other causes. In fact, it would be surprising if the only discernible reason for these movements over an 18-year time span was anticipation of the Fed. But even if only 25% of the S&P's rise since 1994 is due to the Fed, stocks still remain seriously overpriced. They're a buy only if you have faith in the efficacy of central banks. And history does not vindicate such confidence.

Of course, the Fed isn't recommending that investors sell. It's certainly not about to undo all the accommodation and easing it's instituted over the past 18 years, not for quite a while. So the central bank put for stocks will remain in place for now. But ultimately, the government, including the almighty Fed, cannot prescribe stock prices (even though it's acting like it desperately wants to). If you choose to invest in stocks, expect volatility (especially if things in Europe continue their slide into the septic system) and a long wait before any big payoff arrives.

Target2: The EU's Little Surprise

Well, it seems that if the financially weaker members of the Euro zone were to go belly up, their Target2 liabilities alone might be enough to soak up the entire EU bailout bazooka. Isn't that something?

What are Target2 liabilities, you ask? The Euro zone operates a settlement and clearance system called Target2. Settlement and clearance systems have existed for centuries, serving to provide centralized places where checks and other funds transfers between banks can be netted out and paid. For example, most major European banks have claims on each other for payment of checks, wire transfers and numerous other types of funds transfers. These transactions can be done directly with each bank (highly inefficient), or presented to a centralized clearinghouse, which adds up all claims of and on each bank, nets them, and asks the bank at the end of each business day to make a single payment to (or receive a single payment from) the clearinghouse. The Federal Reserve System operates a humungous settlement and clearance system for American and foreign banks dealing in dollar denominated transactions. Without settlement and clearance systems, modern finance couldn't exist.

The prototypical settlement and clearance system doesn't extend overnight credit. Its job is to make sure there are no unpaid liabilities on the part of member banks and expects each member to completely pay all its obligations at the end of the business day.

But the EU's Target2 system evidently is different. It seems to have a little spigot for overnight credit. And, indeed a fount for some EU member nations. Greece reportedly has a 100 billion EU indebtedness at Target2 (see http://www.cnbc.com/id/48094098). The total unpaid Target2 liabilities of Greece, Spain, Italy and other troubled Euro zone member nations could be in the range of 700 billion plus Euros, equal to or greater than the 700 billion Euro bailout bazooka. And we haven't counted the formal sovereign debt of these nations, which totals in the trillions of Euros. Target2 requires collateral for intraday credit. But its collateral requirements, if any, for overnight credit are unclear. There may be none.

This is a funny way to run a settlement and clearance operation, with credit available on a continuing, overnight basis. It contravenes the basic purpose of settlement and clearance, which is to balance the books. By allowing member nations to participate on an unbalanced basis, Target2 seems to have bought itself a mission creep problem that it can't solve without blowing up the European Monetary Union. After all, how does Target2 collect from Greece or another nation with an unpaid overnight balance? If it boots that nation out of Target2, it effectively boots that nation out of the Euro zone. That, in turn, precipitates all the dire consequences that Europe's leaders profess to want to avoid.

If a Euro zone member nation--let's randomly pick Greece--is unable or refuses to pay its Target2 liabilities, the losses evidently would be allocated among the central banks in the Euro zone. Most likely, the central banks of the larger nations like Germany and France would bear more liability than, say, Finland's central bank. Hence, the incentive for the EU powerhouses to keep trying to muddle through the crisis even though Greece is trying mightily not to repay its debts and Germany is striving mightily not to pay Greece's debts, either.

How Target2 became a secret sugar daddy for the spendthrift Euro zone members remains unclear. Whatever the explanation, the sudden surfacing of these liabilities only darkens the clouds gathering over the European financial world. Target2 evidently has been quietly carrying these liabilities without forcing repayment. That doesn't promote confidence in its financial solidity. Wary member banks might be inclined to take defensive measures, and those, if extreme enough, could resemble a credit crunch. We just had a credit crunch in 2008 and it made for a lousy party. There's no easy way to reduce these Target2 liabilities since the debtor nations ain't got the moola to pay down the outstanding overnight balances. Which means they'll be barking up any nearby tree for yet another bailout.

But the EU's bailout bazooka appears overwhelmed once Target2 is added into the mix of indebtedness it's supposed to cover. High ranking EU officials will surely issue a comforting sounding press release or two to paper over the Target2 problem. But talk therapy, a favorite EU maneuver, hasn't done squat to resolve the crisis and it won't help much here, either.

The Supreme Court's Big Surprise

The Supreme Court held a surprise affirmation party for Obamacare today. Most pundits and experts had predicted the health insurance law would be overturned, and aren't enjoying the party very much. But the biggest surprise was the key vote in upholding the law, which came from Chief Justice John Roberts. Most observers of the court had perceived Roberts to be reliably conservative in the political sense. The Citizens United case (Citizens United v. FEC, 558 U.S. 50 (2010)) was regarded as a classic example of how Roberts and the four other conservative justices on the Supreme Court banded together to rule favorably for conservative interests, and unleash a torrent of business funding into the campaign process, most of which is going to Republican candidates.

In today's healthcare ruling, however, Roberts appeared to take a judicially conservative approach, finding a narrow ground to uphold the mandate for uninsured individuals to buy coverage and deferring to the policy judgments of the legislative branch, while explicitly avoiding any endorsement of them. Such displays of judicial restraint have seemingly fallen out of fashion at the Court. No doubt Roberts knows that public estimation of the Court has been falling as it has increasingly been seen as a political body. The perceived politicization of the Supreme Court has turned the judicial confirmation process for both Supreme Court justices and lower court judges into a hyper-paranoid brawl of an inquisition over every possible nuance of every statement, whether written or oral and without regard to remoteness in time, made by the nominee under any circumstances whatsoever. It's no wonder the judicial confirmation process is clogged, backlogged and bogged down. Nominees are no longer viewed as potential judges, but as potential tools to secure political gains.

Restoring the Supreme Court and the lower courts to their intended role as judicial forums would force politicians in Congress and the White House to take their jobs more seriously. They could no longer count on the courts to clean up messes they make. Possibly one reason why conservatives in Congress were so uncompromising about Obamacare is that they gambled the Court would smack it down if they couldn't. If they had understood the Court would show deference to the outcome of the political process, they might have engaged more seriously with the Democrats to fashion a compromise. Perhaps this is one message the Chief Justice meant to send. Certainly, if Obamacare had been struck down, some alternative more acceptable to conservatives would have been enacted to replace it, but then very possibly litigated by liberals and dumped back into the Supreme Court's lap. The Court might then have been placed in the position of fashioning America's health insurance policies. Roberts, as a judicial conservative, would surely not have wanted this.

The Supreme Court is the duck billed platypus of the democratic process, an oddly structured decisional body composed of unelected people with lifetime appointments who can make crucially important decisions based on whatever they individually believe to be right. While all of them purport to base their decisions on the Constitution, the flexibility of that document is copiously evidenced by the abundance of concurrences and dissents that blossom with each difficult decision. To maintain its legitimacy and effectiveness, the Court has to find and fulfill what each generation of citizens perceives as its proper judicial role. It must treat the Constitution as an organic organic (not a typo) document, with its meaning capable of changing and evolving as the needs and welfare of the nation require. For example, the meaning of the Commerce Clause, as interpreted in early New Deal cases, would not be conducive to today's federal economic regulatory structure, designed as it is to foster nationwide confidence in the regulated matters. Had that interpretation not changed with the times, we would probably be a poorer nation today.

Yet, the Court cannot reach so far that it appears to be stretching beyond the meaning of the words of the Constitution. Americans have a very high regard for the rule of law. This is not surprising, considering that the United States was not founded based on tribal or ethnic loyalties, or religious beliefs, or the imposition of sheer military power. It was founded by the voluntary congregation of former British colonies that depended greatly on the effective functioning of the Constitution to maintain their union and thus ensure their survival. Without the rule of law, the nation could fail (and almost did fail, twice). The Supreme Court has the task of constraining the other branches of the government, the states, and, indeed, itself to stay within their respective constitutional roles. Just as the Court has to stop Congress, the Executive Branch and the states from overreaching, it has to stop itself from overreaching.

Finding the right balance between judicial activism and judicial restraint is one of the most crucial challenges for every generation of justices, and especially every chief justice. The loudest sound you hear in the political blogosphere tonight is conservative teeth gnashing. But behind that, there is a faint of hum of legal scholars saying "hmmmmmmmmmm, maybe John Roberts will attain stature among the chief justices."

The Fed: Let's Twist Again

The Federal Reserve's message today was: Let's Twist Again, Like We Did Last Summer.

The market wanted more of a QE3 Shotgun approach. When the Fed announced its modest extension of the Twist, the market gyrated, doing the Locomotion, and ending slightly down. Perhaps the Fed thought the market would say I Thank You. But no such luck, not from Wall Street. If you took losses today, you can Cry If You Want To. You might feel better if you go Downtown.

But don't worry. The Fed said that it Heard Through the Grapevine that the economy might be slowing, and that the market should Hold On, I'm Coming, because it's prepared to launch QE3 if necessary.

The market has blithely ignored negative economic data over the past week and has rallied in the hope of Fed accommodation. Just as When A Man Loves A Woman, the market can't keep its mind on nothing else. Market players hung on every word of current and former members of the Fed Open Market Committee, even asking Please, Mr. Postman for news of impending government intervention. The market Ain't Too Proud To Beg for more money printing. The Fed knows this, and if the economic clouds darken, it will roll out QE3, hoping to spur Dancing in the Street and push market averages Higher and Higher.

But QE3, compared to earlier QE's, has less potential for effectiveness and greater possibility of negative side effects like inflation. If the Fed's accommodation goes haywire, we could have a Heat Wave and meltdown in the financial markets. Of course, with the EU crisis far from over (and perhaps getting worse), and the U.S. economy slowing, the Fed may have little choice but to take that risk. Today's financial markets have no tolerance for any downturns exceeding 2%, expecting instead to Rock Around the Clock. The markets are all government, all the time. So, it might not be a bad idea to Say A Little Prayer.

A Social Security Hint For Stay At Home Parents and Other Part-timers

If you're a stay at home parent, or have been laid off, or are otherwise not working full time, you can still do something to prepare for retirement. That would be to work part-time, because even a small amount of earnings from part-time work builds your Social Security record.

To be eligible for Social Security retirement benefits, you first need to accumulate 40 credits. You get a credit by earning a minimum amount ($1130 in 2012 for each credit, with this amount to be adjusted over time as wages increase). You can earn up to 4 credits per year. Thus, it takes at least ten working years to earn 40 credits. If you don't have 40 credits, even a small amount of earned income from part-time work can help you earn more credits.

Once you have 40 credits, your Social Security benefits will be calculated based on your highest 35 years of earnings. People who work a full career until their 60s will have 35 or more years with earnings. But stay at home parents and many other people who, for whatever reasons, don't work a full career, may have many years with zero earnings. Those zero years bring down the level of benefits to which you would be entitled. By working even a little during some of those years, you'd reduce the number of zero years, thereby boosting your benefits.

If you're not allergic to math, here's a more detailed explanation of what happens (in 2012 dollars; the amounts discussed below will increase over time as wages increase). Social Security calculates your total earnings for your top 35 years (with the earnings from earlier years adjusted to their equivalents in today's dollars). Then it divides the total by 35 and divides the result by 12, to get an average monthly earnings for your top 35 years. It then takes the first $767 of that average monthly figure and multiplies by 90%. You'll get that 90% in your benefits. Then Social Security takes the next $3857 in your average monthly earnings and multiplies by 32%. You'll get the 32% in your benefits. Any amount in your average monthly above the $3857 tier is multiplied by 15%. That 15% is added to your monthly benefit.

In brief, Social Security replaces 90% of the first $767 of your average monthly earnings, 32% of the next $3857 of your average monthly earnings, and 15% of anything above that. When you have a lot of zero years in your Social Security record, your average monthly earnings may fall below the $767 level, and any increase in that average will improve your Social Security benefits by 90% of the increase (until you surpass the $767 level). This is worth working for.

Maybe you plan to collect under your spouse's Social Security record. That can often be advantageous, assuming your spouse has a substantial record and you remain married to that spouse long enough. But life is unpredictable, and your own Social Security record can't be taken away from you. Building it up makes sense.

These days, incomes are stagnant, investment returns are volatile and often lousy, and homes are still dropping in value (on a national basis). Upticking your Social Security benefits by working part-time, even if just a little, is a way to improve your retirement. Ignore the cocktail party wisdom that Social Security won't be around for you. It will. Maybe not in its current form. But some kind of national retirement benefits program will be in place. With half of all Americans not saving at all for retirement, and many others not saving enough, we can't afford not to have a Social Security program. Make the most of it.

For more on Social Security, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement.html (how Social Security benefits are calculated), http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html (when to start collecting), and http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_03.html (who is eligible to collect).

The EU Fighting Market Forces

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

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

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

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

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

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

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

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.