Pragmatic Capitalism

Capital for Living a More Practical Life


The following is an excerpt from John Mauldin’s weekly letter:

In trying to decipher Europe it is hard to know where to start, but let’s begin with some assumptions:

For the euro to survive, one of two things must happen. Either the Germans (and the Dutch and Finns and French) decide to back the concept of some sort of eurobond financing of the balance sheets of the peripheral countries, OR there need to be massive write-downs of insolvent-country debt and the various countries need to backstop their banks, because bank losses will be massive.

The former needs buy-in from German voters. Polls show Germans are against the idea of eurobonds by something like 5-1 (75% against, 15% for). (More on Germany below.) The latter option assumes the peripheral countries will lose access to the private bond markets, thus forcing sudden and enormous austerity (read Depression levels or worse). Will they simply throw in the towel and leave the euro on their own, remaining in the free-trade zone but with their own currencies, much as Denmark, the Czech Republic, or Sweden are now? Or opt to suffer and remain in the euro?

Germany could decide not to back the peripheral country debt, and leave the Eurozone. But this would be painful for Germans. If you think the Swiss franc trade is crowded (and way overvalued) because people are looking for a safe haven, what would a new Deutschmark look like to investors? Switzerland is a country (and one of my favorite in the world, so no slight intended – I will be in Geneva for my birthday in October) of just over 7 million people, only somewhat larger than the population of the greater Dallas-Fort Worth, Texas area where I live (although with much better weather!).

Germany, on the other hand, is the world’s 4th largest country by GDP, with a population of over 82 million. It is well-run and respected. The new mark would climb to far higher levels against the remaining euro countries and other currencies, which for an export-driven nation would not be very helpful. Mercedes and BMWs cost a lot now (and don’t forget tool parts and other things Germany excels in making). Double the value of your currency in a short time? Watch your market share drop. Painful is perhaps an inadequate word.

So, what to make of the remarks this week by respected German leaders? Let’s fire up a few quotes here (

“German President Christian Wulff has accused the European Central Bank of violating its treaty mandate with the mass purchase of southern European bonds. In a cannon shot across Europe’s bows, he warned that Germany is reaching bailout exhaustion and cannot allow its own democracy to be undermined by EU mayhem.

“ ‘I regard the huge buy-up of bonds of individual states by the ECB as legally and politically questionable. Article 123 of the Treaty on the EU’s workings prohibits the ECB from directly purchasing debt instruments, in order to safeguard the central bank’s independence,’ he said. ‘This prohibition only makes sense if those responsible do not get around it by making substantial purchases on the secondary market,’ he said, speaking at a forum of half the world’s Nobel economists on Lake Constance to review the errors of the profession over recent years.

“Mr Wulff said the ECB had gone ‘way beyond the bounds of their mandate’ by purchasing €110bn (£96.6bn) of bonds, echoing widespread concerns in Germany that ECB intervention in the Italian and Spanish bond markets this month mark a dangerous escalation.’” (London Telegraph)

Who Will Rescue the Rescuers?

From the same article: “The blistering attack follows equally harsh words by the Bundesbank in its monthly report. The bank slammed the ECB’s bond purchases and also warned that the EU’s broader bail-out machinery violates EU treaties and lacks ‘democratic legitimacy’. The combined attacks come just two weeks before the German constitutional court rules on the legality of the various bailout policies. The verdict is expected on September 7.”

Yet “Nobel laureate Joe Stiglitz told the forum that the euro is likely to fall apart unless Germany accepts some form of fiscal union. ‘More austerity for Greece and Spain is not the answer. Medieval blood-letting will kill the patient, and democracies won’t put up with this kind of medicine.’ ”

His solution? Germany will either have massive banking losses (see below) or assume some debt. Why give up the dream of a united Europe over a few trillion and your credit rating? Yet (Ambrose Evans-Pritchard writing in the Telegraph):

“Marc Ostwald from Monument Securities said Germany is drifting towards a major constitutional crisis. ‘This has all the makings of the revolt that unseated Helmut Schmidt [in 1982], and indeed has political echoes of the inefficacy of the Weimar regime,’ he said.

“Mr. Wulff said Germany’s public debt has reached 83pc of GDP and asked who will ‘rescue the rescuers?’ as the dominoes keep falling. ‘We Germans mustn’t allow an inflated sense of the strength of the rescuers to take hold,’ he said.

“ ‘Solidarity is the core of the European Idea, but it is a misunderstanding to measure solidarity in terms of willingness to act as guarantor or to incur shared debts. With whom would you be willing to take out a joint loan, or stand as guarantor? For your own children? Hopefully yes. For more distant relations it gets a bit more difficult,’ he said.”

The final option is for the peripheral nations to eschew austerity and leave the Eurozone, launching their own currencies again. This would mean long and painful bank holidays and massive losses for European banks and local citizens, depending on how many countries left. And the lawsuits would last for decades – nothing short of a full-employment act for lawyers all over the world.

And Merkel was not helped by her own Labor Minister, Dr. Ursula von der Leyen. Rather than simply hand over further loans to Athens – money many Germans believe they will never see again – Dr. von der Leyen suggests Berlin should ask for collateral. Gold, preferably. From theIrish Times:

“One month after euro zone leaders agreed a bailout reform package, and a month before the package goes to vote before national parliaments, a senior German minister appeared to be calling for a renegotiation.

“On an aircraft back from Belgrade, a thin-lipped chancellor Angela Merkel reportedly told advisers: ‘I’m going to have to have a word with Ursula.’

“Even before she landed, German officials were in full damage limitation mode, working the phones and issuing statements denying the minister spoke for the government. ‘This is sub-optimal,’ groaned a senior government source. ‘No one is amused.’ ”

Some back-bench minister? Hardly. Dr. von der Leyen, a 52-year-old mother of seven, is one of Dr. Merkel’s most ambitious ministers and one of two names regularly mentioned as a possible successor.

But she only reflected a rather contentious Bundestag meeting this week, in which one after another representative voiced opposition, invariably noting that the voters disapproved.

Of course, none of this is helped by Finland negotiating a side collateral deal as part of their conditions for approving their portion of the next loan to Greece. And a chorus of countries have jumped on that wagon. How do you explain to YOUR voters that the Finns got actual in-the-bank collateral and you got nothing but Greek promises? But if everyone gets collateral, the whole deal will fall apart. What’s the point if you give back a large chunk of your loan? It just means you need even more!

The Problems of Debt in the Eurozone

Let’s look at some charts. This first one is the amount of principal debt in terms of GDP from July 2011 to July 2012 (plus budget deficits, in red) needed by ten European countries. Note that France and Italy are well over 20%! Source: Peterson Institute of International Economics (hat tip, Simon Hunt!)

From the same report this chart illustrates how Germany could become the banker for the Euro Zone. The question is will it? The question will be more clearly defined in September when Germany’s Constitutional Court will rule on the legal complaints against the Euro Zone rescue packages. If the comments being made by the Bundesbank and by the country’s President are a hint as to the outcome of the court then a negative ruling is a real risk. Who then will take the losses?” (Simon Hunt)

Note in the chart that Germany holds the largest percentage of net debt.

Claims of Euro Area members from netting of Euro System cross-border payments (in billions of Euros):

And then there are the interest-rate issues. Rates were rising rapidly in Spain and Italy until the ECB stepped in. Everyone knows Greece, Ireland, and Portugal are on life support and cannot get debt on their own. The ECB inserted an IV into Spain and Italy and started them on a slow drip. The real question of the moment is, can they get off that support and stand in the markets on their own? The answer a few weeks ago was starting to look like “No.”

And look at the massive growth in ECB lending to Italian banks, which are getting shut out of the “normal” market. It has literally more than doubled in a few months:

Credit spreads at French banks are blowing out. Review how much France has to borrow in the next 12 months, in the first chart. Then look at their deficit-to-GDP (above 10%, according to Charles Gave) and realize that there is no reason why S&P should not downgrade them as well. How do they cut spending? Taxes are already at 50% of GDP. Wealthy French have voted with their feet by moving away.

The list of country woes is long in Europe. Massive unemployment in Spain and Portugal. Deficits everywhere. Voting populations in both creditor and debtor nations are upset.

It is only a matter of time until Europe has a true crisis, which will happen faster – BANG! – than any of us can now imagine. Think Lehman on steroids. The US gave Europe our subprime woes. Europe gets to repay the favor with an even more severe banking crisis that, given that the US is at best at stall speed, will tip us into a long and serious recession. Stay tuned.

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