ARE WE STILL TALKING ABOUT EUROPE?

The sovereign debt crisis in Europe seems like the movie Groundhog Day, where Bill Murray wakes up to the same thing day after day after day. We have been discussing the problems in Europe for almost 2 years now, and it appears we are still a long way from a solution to the problems. What has happened since our last discussion on this a little over a month ago?

On November 30, many of the world’s central banks, led by Ben Bernanke and the U.S. embarked on a coordinated move to inject much needed liquidity into the world’s credit markets. Reports were that a major European bank was on the verge of failure, and this action to inject liquidity into the system would stave off the impending train wreck that was about to occur had nothing been done. The stock market enjoyed a furious rally, but this action by no means solved the debt crisis in Europe, it was just another finger in the dike.

So what exactly did the coordinated move by the world’s central banks entail?

First of all, the swap lines merely provide banks with access to dollar funding. This is nothing new so the fact that the program was touted as something new is very odd. The program has been in place since 2007 so the announcement is just an alternative form of something that was already in place. What they announced here was a reduction in the cost of the loans. The swaps were also extended to several other currencies though the USD is the primary focus. The goal is to keep short-term lending markets from seizing up like they did in 2008 after Lehman Bros went bankrupt. There had been signs in recent weeks of money market troubles and short-term loan troubles so this program should help to some degree. The Fed elaborates on the purpose of the swaps –Cullen Roche, Pragmatic Capitalism blog

“These swap lines are being implemented as a contingency measure, so that central banks can offer liquidity in foreign currencies if market conditions warrant such actions. These lines provide the Federal Reserve with the same ability to provide foreign currency, should the need arise, as foreign central banks currently have through the existing dollar swap lines with the Federal Reserve to provide dollar liquidity in their jurisdictions.”

So the move has increased liquidity which was a problem in the 2008 crisis, but it is only treating the symptoms of the problem, and not the disease itself. It buys more time and gives a bit of confidence to the markets that the central banks are willing to take a proactive role in this ordeal.

Next, the big European Union (EU) summit came and went last week and the European’s have come up with a plan to solve the crisis in Europe once and for all, right? Certainly, now we can get back to just concentrating on the economy and issues here in the U.S. Ok, let’s not kid ourselves. In the grand scheme of things, not a whole lot was accomplished last week in Europe, even though the stock market temporarily thought so. What really came out of the EU summit last week?

All in all, it appears to be a lot more of the same things they have been doing, but with an increased emphasis on more austerity. Unfortunately, austerity when the region is teetering on a recession will likely make things that much worse as curtailing spending going into a recession is a recipe for a depression. It is akin to starving yourself to lose weight. True, your calorie intake decreases, but, because of the way your body is designed, it actually increases its fat storage and instead of burning it will devour muscle tissue before using stored fat. It still appears that they are hesitant to force anyone to take write-downs, and instead want to solve the situation by increased austerity measures, which have already demonstrated their ineffectiveness.

Germany is driving the hard line on austerity measures for the weaker members of the Eurozone. They, as a fiscally stronger nation than many of their southern neighbors, will be able to tolerate spending cuts, because their economy is relatively vibrant. But how are the people in the weaker nations that have already been rioting against austerity programs that their own governments have proposed going to react when these measures are imposed from Germany?

Yes, it is true that many of the countries in Europe (and the U.S. for that matter) need to live within their means. But it does not seem that austerity alone is going to be enough to stem the crisis in Europe. Many were hoping that Euro bonds backed by the full faith and credit of the EU would be issued, or that there would be a step towards greater fiscal unity. These steps would qualify as the “bazooka” that most think Europe needs to bring to the battle rather than the “peashooter” solutions that keep getting brought to the table.

What actually came out of the summit that concluded December 9th were several things that have been discussed for weeks:

1. The creation of a fiscal compact that will include the European Commission (EC) as an oversight of EU budgets and a Court to enforce the provisions. The EC is the executive body of the European Union and is responsible for proposing legislation and upholding the EU’s treaties. This could be argued as a first step towards fiscal union in Europe, but much remains to be seen as to when it will require balanced budgets among the EU members and what kind of penalties will be slapped on countries that do not comply. The EU has a history of not following through on threats for noncompliance.
2. The European Stability Mechanism (ESM) fully in place by July 2012 that will stand alongside the European Financial Stability Facility (EFSF) instead of replacing it. First a couple of definitions. The ESM is a permanent rescue fund for the EU designed to replace the temporary bailout fund (EFSF) which is set to expire in 2013 and was only designed as a short term solution. The ESM would be launched once Member states representing 90% of the capital commitments of the fund have ratified it. The ESM is funded by the member countries of the EU with the largest contributions coming from Germany & France. The fund, together with assistance from the International Monetary Fund (IMF) would be utilized to bailout countries in the Eurozone that are facing a financial crisis and hopefully prevent the crisis from spreading to other countries. There are problems with this. First, will the markets wait until next July for the ESM to be fully functional? Second, there is a fair amount of dissension from people in Germany and France who are footing a large part of this fund. Will the populace want to go along with this new deal?
3. Eurozone states’ budgets need to be balanced or in a surplus.
4. Member states must report national debt issuance plans in advance.
5. If members violate deficit ceilings there will be automatic consequences which could include sanctions, unless a qualified majority of Eurozone member states oppose.
6. EU leaders agreed to lend up to 200 billion Euros to the IMF to help aid countries that are struggling in the Eurozone.

In regards to #3, 4 and 5, it remains to be seen what kind of “enforcement” and “penalties” will actually be carried out by the EC for noncompliance. The history of the EU has shown that it can be somewhat lax on following through on their threats.

There is also still a lot of uncertainty with the results of the summit because many of the above decisions still need to be approved in the capitals of the member countries. This has proven to be tough in the past and will likely be a challenge again when leaders bring these proposals home for ratification.

Another cloud that hangs on the horizon is the possibility that the ratings agencies may downgrade the credit ratings of several states in the Eurozone because of the additional funding needed to support the EFSF and ESM, which could affect the credit worthiness of these bailout mechanisms.

Oddly enough, the U.K. chose not to be part of the new treaty, as getting that referendum passed by its populace would likely prove daunting. This does not mean that they are leaving the EU, but rather, they are choosing not to play by the new rules proposed by the latest treaty. This looks to have created some resentment from other countries in the EU, primarily France and Germany. As a result, many people in the UK are worried that Britain is travelling down a path of isolationism.

So, as we seem to always end these missives, they have appeared to “kick the can” down the road a little more for the time being. It just appears that unless a closer fiscal union is forged, and nations are willing to give up some of their sovereignty, the situation is going to continue to fester. Will the markets allow this to continue, or will they force the issue? It is likely that we will continue to operate in an environment of heightened volatility and the proverbial roller coaster ride until there are some more concrete solutions or things unravel for good. The markets still appear on edge and the yields on Italian bonds are still very high which is a sign of continued stress. And since Italy has a large amount of bonds that are up for refinancing in the first quarter of 2012, there will likely be continued pressure on Italian yields that will prompt further action by the EU.

It is too bad that we have to constantly address the news out of Europe, because the data here in the U.S. has shown some modest improvement over the last several weeks. Retail sales have been decent, auto sales have been strong, the job market seems to be slowly recovering and corporate earnings remain robust. Can this continue with all the stress in Europe will remain to be seen? For now, as investors, it still seems prudent to play things close to the vest, until there is a little more clarity out of Europe. Other than that, Happy Holidays to all!