The Inevitable Franco-German Discord

Here we are in the fourth quarter 2012, and the Wall Street Journal is writing about growing Franco-German discord after yet another European summit.  Going back to mid-2011, we wrote,

"Turning to the ECB, it has relatively few options that will provide meaningful support to a dismal outlook in Europe. The Wall Street Journal naively suggests that the Germans, French and stronger European countries will withdraw from the European currency union and create their own "strong euro."


This is extremely unrealistic and would not solve the fundamental problem of economic imbalances within the European Union. Germany is really in the driver's seat, but it too will be reluctant to detonate the charge that destroys the empire of the Brussels bureaucrats, of which many senior ones are French. A slow, economically inefficient unwinding is probably what's in store."

Looking at the original photo ops with former French President Sarkozy and Chancellor Merkel, it was evident to us from the start that the fundamental interests of France and Germany could never align.  Now, with a new French President with his own limitations and political agenda, the situation is worse than before.  At least former President Sarkozy and Chancellor Merkel had a cordial relationship; President Hollande, despite his having been trained at the Ėcole nationale d'administration, seems determined to establish a prickly relationship with Chancellor Merkel. 

President Hollande's attempt to be a broker between Germany and the European periphery is a recognition that the French hand is weak.  It is yet another path to painting German Chancellor Merkel as the reason for rioting in the streets in Greece and Spain.  This subterfuge won't work, because as we said in 2011, Germany is ultimately in the driver's seat.

Nicolas Veron of the Bruegel think tank agrees with us, as the Journal quotes him as saying, "Germany is pivotal in Europe, France is not." 

The edge has been taken off the crisis because the ECB has chloroformed the markets with it promises of a "bazooka" of liquidity.  The markets will eventually awaken again.

A German Sovereign Wealth Fund Redux

I used to read the Economist when I was in graduate school, but I gave it up because it is currently as stimulating as reading Time magazine.  Someone sent me a link to an online article from the Economist, and this quote caught my eye:

"Lastly, if the euro is to survive, creditor countries need to give more aid to deficit countries. They could do this directly, or the ECB could provide liquidity to banks or buy up government bonds before they fall too far."

Thinking about the direct comment, that would be the course taken by using the instrument of a German sovereign wealth fund, which we have posted about before.  Such a fund would be looking for returns, and potential investees would have to present their cases just as private entities would have to do.  Ideas with good economics would earn the capital investment. The interests of the German state in continuing the euro experiment would advanced through their own oversight and control.  There would be no intellectual policy fog or dead weight cost leakage from the ECB, IMF, or other bureaucracies.

The equity markets are looking a bit queasy as the European policy machine continues to founder. 

Chancellor Merkel In a Lose-Lose Position

                Johannes Eisele/Agence France-Presse - Getty Images

The New York Times this morning carried a front page puff piece about the "friendship" between German Chancellor Angela Merkel and IMF Managing Director Christine Largarde.  It is full of references to synchronized swimming , and to  high end Fragonard French candles being given  as gifts to Merkel as symbols of "hope." Constrasts are drawn to  the differences between the analytical physicist Merkel and the smooth talking lawyer Lagarde, who was an intern on the U.S. Capitol Hill.  Well, as you can see from the picture, Chancellor Merkel has probably realized that she has been hoodwinked into a lose-lose position by an IMF Managing Director who couldn't have been appointed to that position without German support.

What's the big deal?  France is in the throes of Presidential elections, and there isn't any doubt that the timing of Lagarde's very public volte-face about European policies handling the EU crisis is intended to help incumbent President Sarkozy and to hamstring German influence on future multinational political decisions.  In financial crises past, the IMF has uniformly taken the position of "tough love" and taking the bitter medicine of austerity.  Now, the IMF is all about growth and stimulus, putting Chancellor Merkel's position about profligate EU members having to put their houses in order first, in danger of seeming backward looking and intransigent.

If Chancellor Merkel sticks to her guns, which would be absolutely appropriate, she opens the doors to her own internal opposition and to resentment against austerity morphing into a broader, anti-German sentiment.  If she were to throw in the towel and throw her support to the a gigantic bailout fund under the control of the IMF and Eurocrats then the future of the German economy would be be impaired and her own political career finished. 
Recent U.S. trade statistics show a dramatic drop in exports to Germany, reflecting the already marked slowdown in German economic growth, which makes Chancellor Merkel's position even more difficult.  Let's hope that German politicians of all parties can rally around the broader European and German self-interest, which is not served by the burgeoning bailout funds. 

Euro Sovereign Bond Investors Get a Raw Deal

IMF Managing Director Christine Lagarde, speaking in Berlin, said, "It (stepping up to a bigger bailout fund) is about avoiding a 1930s moment, in which inaction, insularity, and rigid ideology combine to cause a collapse in global demand."

These profound insights are said by the Wall Street Journal to constitute a "dire" warning.  We've been talking "dire" since last summer.  I must say that before watching the behavior of sovereign bond investors, I had always thought of bond investors as being more the "green eye shade" types than manic-depressive equity investors.  Now, I'm not sure at all. 

European sovereign bond investors, particularly Greek bond investors, include many European banks.  They are apparently willing to accept interest rates on new Greek bonds of 3% max, with a fifty percent haircut on the principal value of their old bonds, plus some unspecified higher rates in future years if the Greek economy does better than a baseline number.  The IMF and the ECB have drawn a Maginot Line at 3%.

My question is the following: why on earth would any rational investor take a 20-30 year risk for 3% from a country that will not realistically ever be able to repay? The investors must not have any realistic mechanism for pursuing a default, but it's probably more rational to bite the bullet now, take the write downs, file perfunctory lawsuits, and wait and see what the ECB would do. The banks would be short regulatory capital, but it's hard to see the IMF, ECB and other alphabet soup regulators pushing the banks over the edge; that would be bad for everybody.  Someone has to lend Greece money, but surely a 3% rate is irrational.  Who's going to win this game of chicken?

The longstanding low interest rate environment which central banks have institutionalized globally has completely distorted capital prices, forcing investors to take more and more risk in search of returns.  For example, stories abound about hedge funds that leveraged their Japanese sovereign bond purchases at three-to-one yielding them an annual return of 12.5% per year; the lenders who gave the money to the hedge funds didn't earn very much for taking this risk. 

C. Fred Bergsten, formerly of the Brooking Institution and late of the Peterson Institute for International Economics ("PIIE")  predicts that European leaders will dither until the last minute, pull a rabbit out of the hat, end the euro/Greek/European periphery crisis and Europe will emerge from the crisis "much stronger."  I've followed his work since I was a graduate student, and he has thirty years of professional and emotional investment in the euro currency experiment.  If the bondholders are irrational and give in, nothing fundamental will have changed: the weak players in Europe will still be weak, will be further eroded by ongoing recession and debilitated by internal political crises. 

When MD Lagarde talks about rigid ideology and a collapse in global demand, that is very disingenuous.  The growth in demand was driven by artificially low rates and the ability of EU periphery countries to borrow with impunity while running fiscal deficits in violation of their treaties.  Now, the absurd suggestion is put forward that Germany should run fiscal deficits in order to purchase goods and services from Spain, Ireland and Greece.  Not agreeing to do so would be "rigid ideology," according to the IMF. 

PIIE authors Boone and Johnson take a more normal economic approach to the crisis, suggesting that it has to deepen unless ongoing fiscal issues and bank insolvencies are addressed.

If the bondholders are irrational enough to go along with this charade, then I might just go and rip up all my teaching materials about the Capital Asset Pricing Model and Efficient Market Theory.  This stage is not filled with economic actors, for sure.

Euro Dithering Continues

From: Wall Street Journal Online Edition.  Credit to Zuma Press. 

What do these two EU leaders have in common, and why are they smiling?  Answers are : "Very little," and "Mandatory Photo Op." 

After a year of meetings in hotels, beach resorts, chateaux and medieval castles, nothing of substance has changed.  Ostensibly, the German and French leaders are trying to (1) restore European competitiveness and create job growth; (2) implement last year's 130 bn euro Greek bailout, as the Greek government tepidly tries to impose austerity and negotiate with private bondholders; (3) keep the European Union from crumbling, while simultaneously, (4) creating a regime of sanctions for profligate members who run persistent budget deficits. 

What countries would want to be  members of this kind of union?  The former Eastern European nations are on the sidelines wondering, as is Sweden. The Wall Street Journal points out,  "Mr. Sarkozy, who faces a tough election in May, was also pushing ahead of the meeting (Tuesday with the IMF) to stress the need for promoting economic growth and jobs, rather than belt-tightening and austerity."  Solving the euro crisis under the current framework is all about fiscal pain; it's not about competitiveness and jobs with available policy instruments. 

 Economist Robert Barro of Harvard writes today in the Journal, "I suggest that it would be better to reverse course and eliminate the euro. ...The euro is a noble experiment, but it has failed."  A European Union running fiscal policy for its member states out of Brussels was never in the cards--that could not have been a noble experiment.