EuroZone Woes

There’s been a number of interesting things coming out of Europe this weekend that will undoubtedly impact US Financial Markets and probably the economy since they are a significant trading partner as well as investor in US businesses.  The adoption of the Euro and the expansion of the trade zone area has generally been shown to be a huge boon to the European Economy.  It’s really hard for me to imagine the collapse of the Euro since it has been so successful that a variety of countries through out the world are in the process of adopting their own versions.  There have been a lot of people against the arrangement primarily because they’re still in nationalist mode and dislike the idea of any kind of cooperation that looks like ‘collectivism’.  The astounding economic results have been difficult to rebut however.

There are two items that generally are considered problematic for some countries that join a monetary union.  The first is the loss of independent monetary policy including the ability to debase your currency as a means to stimulating your economy.  The offset to that is that if you’re a country like Greece that has had incredible issues with inflation stemming from politicized monetary policy, you pick up credibility when you outsource that function to a shared central bank.  That’s especially the case when you share your central bank with the Germans who have been inflation wary since the Weimar Republic. The Japanese central bank and the German central bank are well known for controlling inflation over just about any other economic priority.  The second problem is the potential need for cross country fiscal policy.  That has never been much of an issue in the EU until now.  That is why there is talk of an IMF rescue of countries like Greece.  Also, there’s some talk of hurrying fiscal integration or giving some entity the ability to float “eurobonds” specifically for countries that are in trouble right now like Italy.  The problem right now is that many of the weaker EU countries were allowed to borrow substantially and with a credit crisis and banking troubles that led to recession, the bonds from those countries (sovereign debt) have no lost their value.

There are some that think the Eurozone will fall apart.  I find that hard to accept given the substantial boost that the zone has been to many economies in the form of trade and direct financial investment.  This benefit has gone to all countries and is called the “Rose Effect”. I’ve spent the last three years of my life studying all of this in great detail.  I am as vested in any one in the outcome. Here’s a few items that have been going on as we watch Eurozone brinkmanship play out. Reuters reports that Germany and France are forming a “Stability Pact” and hoping to get the European Central Bank leaders will act more like Bernanke’s Fed.

Echoing a Reuters report on Friday from Brussels, the Sunday newspaper said the French and German leaders were prepared to back a deal with other euro countries that might induce the ECB to intervene more forcefully to calm the euro debt crisis.

The newspaper report quoted German government sources as saying that the crisis fighting plan could possibly be announced by German Chancellor Angela Merkel and French President Nicolas Sarkozy in the coming week.

In an advance release before publication, Welt am Sonntag said that because it would take too long to change existing European Union treaties, euro zone countries should just agree among themselves on a new Stability Pact to enforce budget discipline – possibly implemented at the start of 2012.

It could be similar to the Schengen Agreement which applies to EU countries that choose to take part and enables their citizens to enjoy uninhibited cross border travel. Among the countries in the Stability Pact, there would be a treaty spelling out strict deficit rules and control rights for national budgets.

Reports from AFP show that the IMF may be planning a 600 billion Euro rescue plan for Italy. Italy is the world’s 8th largest economy.  It’s the 4th largest in Europe.  Needless to say, this is highly irregular.

The IMF could bail out Italy with up to 600 billion euros ($794 billion), an Italian newspaper reported on Sunday, as Prime Minister Mario Monti came under pressure to speed up anti-crisis measures.

The money would give Monti a window of 12 to 18 months to implement urgent budget cuts and growth-boosting reforms “by removing the necessity of having to refinance the debt,” La Stampa reported, citing IMF officials in Washington.

The IMF would guarantee rates of 4.0 percent or 5.0 percent on the loan — far better than the borrowing costs on commercial debt markets, where the rate on two-year and five-year Italian government bonds has risen above 7.0 percent.

The size of the loan would make it difficult for the IMF to use its current resources so different options are being explored, including possible joint action with the European Central Bank in which the IMF would be guarantor.

“This scenario is because resistance from Berlin to a greater role for the ECB in helping states in difficulty — starting with Italy — could be overcome if the funds are given out under strict IMF surveillance,” the report said.

The European Union and the ECB have sent auditors to check Italy’s public accounts this month and the IMF is set to send experts soon under a special surveillance mechanism agreed at the G20 summit in France earlier this month.

The WSJ reports that a number of countries are pressuring ECB for concessions.  The worry is that these same economies that have always had weaker economies and lax fiscal constraint will continue on that path.  (These countries include Portugal, Spain, Greece, Italy and Ireland which have been sarcastically  given the acronym PIIGS.)

While the ECB has so far said that it won’t beef up its limited bond buying, a growing number of governments are lobbying it to change its stance. A green light from Berlin for a bigger ECB role is seen by many euro-zone policy makers as a political necessity if the ECB is to act. Although the bank is politically independent, it has also paid close attention to the debate in Germany, where the government has so far rejected a bigger role for the central bank.

A new, binding fiscal regime would not be enough to justify the creation of collective euro-zone bonds, German officials say. But it might be enough to justify ECB action to stabilize bond markets that policy makers view as increasingly dysfunctional, some in Berlin say.

Other German officials remain skeptical about a greater ECB role—including Bundesbank President Jens Weidmann, who sits on the ECB’s governing council. Germany’s central bankers have been outvoted by the ECB majority before, however, including this August, when Mr. Weidmann opposed the decision to make limited purchases of Italian and Spanish bonds.

German Chancellor Angela Merkel said last week that she wants EU treaty changes to make the bloc’s fiscal rules legally enforceable by European authorities, in the same way that EU antitrust rules are.

European Council President is going to meet with Treasury Secretary Geithner on Monday at the US Treasury. Both Germany and Italy have had bond auction failures within the last week. This is causing the situation to look more dire. FT’s Wolfgang Munchau says the Eurozone has about 10 days before it collapses. His analysis borders on the sanguine.

Last week, the crisis reached a new qualitative stage. With the spectacular flop of the German bond auction and the alarming rise in short-term rates in Spain and Italy, the government bond market across the eurozone has ceased to function.

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The banking sector, too, is broken. Important parts of the eurozone economy are cut off from credit. The eurozone is now subject to a run by global investors, and a quiet bank run among its citizens.

This massive erosion of trust has also destroyed the main plank of the rescue strategy. The European Financial Stability Facility derives its firepower from the guarantees of its shareholders. As the crisis has spread to France, Belgium, the Netherlands and Austria, the EFSF itself is affected by the contagious spread of the disease. Unless something very drastic happens, the eurozone could break up very soon.

Technically, one can solve the problem even now, but the options are becoming more limited. The eurozone needs to take three decisions very shortly, with very little potential for the usual fudges.

All eyes and much money is on the European Central Bank right now. Watch the equity markets. They will probably represent the collective guess on the end of the world as we know it.