Investors are growing increasingly concerned as each successive proposal in Europe has fallen flat. While the deals have bought time, they have failed to make substantive improvements. Ominously, each failed attempt engenders ever more skepticism that Europe has the political will and economic savvy to fix the problem. This has left clear-eyed investors with one burning question: What is a real end game to all this posturing?
At this point, it looks like European leaders, led by Merkel and Sarkozy, will gravitate towards one of the following three remedies, or perhaps a combination of all three:
European leaders will approve a massive new financial package (on top of all the previously created facilities) to cover the debt and deficit financing needs of the PIIGS.More moves will be made to enact greater fiscal and political integration within the European Union. These changes will allow the more solvent countries (read: Germany) to exert great fiscal control of the prodigal countries.
The European Central Bank (ECB) will follow the lead of the Federal Reserve and come to the rescue as a lender of last resort, effectively guaranteeing the debt of the troubled nations or creating credit lines in their behalf.
But each of these "solutions" has major roadblocks, and we don't see any meaningful changes until Germany and France have devised, launched, and ultimately lamented more doomed half measures. This process may well stretch into 2012-3.
A new financial bailout would likely require funds in the order of 1 trillion euros, a quantity of cash we believe is much higher than could be drawn from some mixture of the IMF's 290 billion euro forward commitment capacity, the E.U.'s 250 billion euro Financial Stability Facility (EFSF), and various other smaller sources. We don't know where that cash could come from. Although the extension of German political control may be enticing to the German ruling class, it will be significantly less popular among the rank and file, especially if it involves the commitment of more bailout funds to profligate neighbors. In addition, the legally complex and time-consuming measure of greater integration would likely take many months, if not years, and would probably face staunch opposition from key countries, such as the U.K. and Ireland. The third option, which would turn the ECB into a lender of last resort, runs afoul of E.U. treaties and would likely be politically untenable in Germany.
Our bottom line: We see an unavoidable resolution likely coming about via a voluntary default on sovereign debt by overly indebted counties and their possible exit from the Eurozone. Those countries that remain will likely have much better finances and will likely be more closely aligned with German economic policies. This could result in a more stable and powerful economic bloc of fiscally responsible central and northern European countries, most notably Germany, that would share monetary and fiscal ties. Lastly, in order for any restructuring to have long term viability, we must see significant structural changes in France, which up until now has somehow avoided the budgetary limelight (see article in this newsletter by Andrew Schiff).
Contrary to what many analysts project, we see the further deterioration of the European experiment as likely a positive development for the Euro in the medium- to long-term. Germany's determination to avoid devaluing its currency as a means of escaping its current predicament stands in sharp contrast to the behavior of the United States and other OECD nations. Furthermore, removing the fiscally reckless countries like the so-called Club Med from the Eurozone may help move the Euro higher, as the economic appeal of the new group may better draw assets into the region and investors develop greater confidence in its budgetary position.
While many non Eurozone countries, most notably the United States, are struggling in the wake of the financial crisis, Eurozone members face the unique dilemma of being unable to reduce their debt load through currency devaluation. Greece, Spain, and Italy struggled with debt even before the crisis, and are now doubly wounded by the high yields they have been forced to offer. In the not-so-distant past, Americans might have smugly wondered why countries with such obvious debt issues would so blatantly refuse to swallow the bitter pill of fiscal reform. But the last few months of ineffectual Supercommittees and political paralysis in Washington have shown unmistakably that politicians on this side of the Atlantic are no more capable of putting their country on sound budgetary footing than their Old World peers.
However, we take pains to note that the European crisis is essentially a political struggle rather than an intractable financial quagmire. Sooner or later the continental powers will get on the same page and fashion a solution that will provide clarity and a legitimate path forward. Unfortunately no such solutions are currently even imagined here in the United States.
But each of these "solutions" has major roadblocks, and we don't see any meaningful changes until Germany and France have devised, launched, and ultimately lamented more doomed half measures. This process may well stretch into 2012-3.
A new financial bailout would likely require funds in the order of 1 trillion euros, a quantity of cash we believe is much higher than could be drawn from some mixture of the IMF's 290 billion euro forward commitment capacity, the E.U.'s 250 billion euro Financial Stability Facility (EFSF), and various other smaller sources. We don't know where that cash could come from. Although the extension of German political control may be enticing to the German ruling class, it will be significantly less popular among the rank and file, especially if it involves the commitment of more bailout funds to profligate neighbors. In addition, the legally complex and time-consuming measure of greater integration would likely take many months, if not years, and would probably face staunch opposition from key countries, such as the U.K. and Ireland. The third option, which would turn the ECB into a lender of last resort, runs afoul of E.U. treaties and would likely be politically untenable in Germany.
Our bottom line: We see an unavoidable resolution likely coming about via a voluntary default on sovereign debt by overly indebted counties and their possible exit from the Eurozone. Those countries that remain will likely have much better finances and will likely be more closely aligned with German economic policies. This could result in a more stable and powerful economic bloc of fiscally responsible central and northern European countries, most notably Germany, that would share monetary and fiscal ties. Lastly, in order for any restructuring to have long term viability, we must see significant structural changes in France, which up until now has somehow avoided the budgetary limelight (see article in this newsletter by Andrew Schiff).
Contrary to what many analysts project, we see the further deterioration of the European experiment as likely a positive development for the Euro in the medium- to long-term. Germany's determination to avoid devaluing its currency as a means of escaping its current predicament stands in sharp contrast to the behavior of the United States and other OECD nations. Furthermore, removing the fiscally reckless countries like the so-called Club Med from the Eurozone may help move the Euro higher, as the economic appeal of the new group may better draw assets into the region and investors develop greater confidence in its budgetary position.
While many non Eurozone countries, most notably the United States, are struggling in the wake of the financial crisis, Eurozone members face the unique dilemma of being unable to reduce their debt load through currency devaluation. Greece, Spain, and Italy struggled with debt even before the crisis, and are now doubly wounded by the high yields they have been forced to offer. In the not-so-distant past, Americans might have smugly wondered why countries with such obvious debt issues would so blatantly refuse to swallow the bitter pill of fiscal reform. But the last few months of ineffectual Supercommittees and political paralysis in Washington have shown unmistakably that politicians on this side of the Atlantic are no more capable of putting their country on sound budgetary footing than their Old World peers.
However, we take pains to note that the European crisis is essentially a political struggle rather than an intractable financial quagmire. Sooner or later the continental powers will get on the same page and fashion a solution that will provide clarity and a legitimate path forward. Unfortunately no such solutions are currently even imagined here in the United States.
Peter Schiff
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