ECONOMIC & MARKET COMMENTARY, November 2011

What is the future of the euro?  All eyes are on Europe, except for those few who were briefly averted due to the futile deliberations of the super committee.  The lengthy process of bailing out Greece from its debt burdens by giving them more debt is now coming to a climax.  Let’s be clear: the Greek bailout was really a bailout of the large northern European banks and their bond holders.  There were fears that a Greek default would trigger credit default swap contracts with unknown consequences to the European banking system.  The recent proposal for a “voluntary” discount of 50% is an attempt to avoid setting off that trigger (the Greeks are negotiating for a lot more).  When Greece toyed with the idea of a referendum to approve austerity measures, France and Germany quietly threatened that Greece would be deciding if it wanted to remain in the euro-zone.  Merely mentioning the possibility that Greece may not remain in the euro-zone opened the barn door and has put the future integrity of the euro-zone in doubt.

George Friedman, the founder of Stratfor – the highly respected private intelligence service, has articulated that the European Union (EU) and, more recently, the euro were part of a project born after World War II as an alternative to nationalism and centuries of war.  The vision of a single continent brought together in common enterprise ensured Europe its rightful place at the heart of the international political system.  In addition to peace, this grand bargain promised prosperity.  For the present generation of leadership, the European project has been an ideological given.  Economic stresses are now broadening well beyond Greece and are being felt across Europe.  If the price of keeping the union together is a massive decline in the standard of living, then the project’s legitimacy will be undermined.  Friedman anticipates an emerging struggle between Europe’s “elite” and a new, growing political class of nationalists who do not share the same level of commitment to the European project.  Much will depend upon who will pay the cost of maintaining the union.  It is now evident that the debtors are not able to bear the burden alone.  Nor are the banks strong enough to absorb the losses, either.  The cost will fall to the public, both in the north as well as the south.

For those with a conspiratorial bent (okay, include us), it can be said that the Germans have managed to exert the power and influence through the EU that they only dreamed about in the pre-war years.  Germany, more than any other country, has benefited from having access to the European market with broad currency stability.  In response to the current problems, behind what appeared to be a mindless “kicking the can down the road” approach to resolving Greece’s debt problem, there seems to be a German plan.  German Chancellor Angela Merkel has proposed submitting revisions to the treaty to national parliaments by the spring of 2012.  The idea is to create a stronger fiscal union.  Part of that plan involves changing the European Central Bank (ECB) voting structure to favor the larger states and putting in policing structures to intervene in fiscal processes of struggling European countries.  Whether the Germans can pull this off in time remains to be seen.

Many pundits expect Germany and the ECB to capitulate and come to the rescue of Greece, Italy…  Those expectations should be tempered by the limited capabilities of each one.  Evan Lorenz of Grant’s Interest Rate Observer makes an interesting comparison between Deutsche Bank, Germany’s largest bank, and JPMorgan Chase.  Each shows a ratio of capital to risk based assets of 15.3%.  After peeling back the onion, Lorenz discloses, “Without regard to risk weightings Deutsche is leveraged 43:1, JPMorgan Chase 12.6:1.  ….with tangible capital equaling 1.7% (at Deutsche) and 5.8% (at JPMorgan).”  He also points out stable sources of funding for Deutsche Bank amount to 36% of total liabilities, while they amount to 71% for Morgan.  With regard to the ECB, Article 123 of the Treaty on the Functioning of the European Union prohibits the ECB from providing any type of credit facility to central governments or through third parties, such as the European Financial Stability Fund (EFSF).  Although the ECB has bought some Italian bonds, that should not be interpreted as a signal that it will embark on a printing spree in violation of EU rules.  And changing those rules would be very difficult – and impossible as long as Germany and Finland remain opposed.

Whether Greece stays in the euro-zone is of little consequence (except to the Greeks, of course).  It is likely that most of the European banks will ultimately be nationalized, with the public picking up the cost of recapitalizing and deleveraging them.  As the costs rise and economic stresses mount, expect to see further political tensions.  Despite the best intentions of the political classes, the challenges to keeping the euro intact are enormous.

Equity markets around the world have been very volatile, alternating between risk on and risk off.  At North Star, we remain cautious.