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Boeckh Investment Letter

Investment and economic commentary by J.Anthony Boeckh and Robert Boeckh

Second Chance for the Euro? Still not clear

Europe—Brinkmanship Continues

World financial markets breathed a sigh of relief earlier last week as it looked as though the combination of a Merkel-Sarkozy deal along with potential support from Draghi at the ECB and Monti’s new Italian budget would create the pre-conditions for the long awaited grand bargain needed to pull Europe back from the brink of disaster. Once again the politicians snatched defeat from the jaws of victory.

It has been obvious for some time that Europe can only obtain political movement on the ongoing financial saga by scaring politicians and the public with a close look into the abyss. This is high stakes brinkmanship and it has been stagemanaged by Angela Merkel with consummate skill and sang-froid to get the Germans what they want: fiscal union, closer political integration, fiscal austerity and sustained and enforceable budget discipline. The Germans have the only balance sheet left to lever off of and that is why they call the shots. They have consistently been prepared to risk the confidence of financial markets by blocking big bailouts, so as to achieve an end to the moral hazard risk that accompanies such funding. The consequence is that the vicious downward spiral of euro banks and sovereign debt has not been ended.

When trading the deutschemark for the euro, the Germans made the naive mistake of thinking that everyone else would play by the rules they created. Now, smarter and more cynical, the Germans have been holding the feet of others to the fire to obtain the changes they want. Using the Scylla/Charybdis analogy, the Germans did not want to be too early nor too late in future bailouts, nor did they want the amounts too large. That is why the new agreed bailout funding is only €200 billion and will be done through the IMF in order to diminish the divisive politics that go with tough lending conditions.

Markets are not rules-based or logical at crucial times and the risk is that the package of measures agreed is too late, too vague, too small and too uncertain as to actual adoption. Markets swing from naive and complacent when profits are fat, to fear when confidence is snapped and losses start mounting. Confidence is not easily regained when the upside is dwarfed by the potential downside. That is why the shortlived confidence that appeared early last week snapped so quickly. Who really needs to own any European sovereign or bank debt or keep their deposits in a European bank? What Greek in his right mind would keep his money in Greece? That is why there has been a persistent and continuing run out of European paper, starting with the most egregious of the troubled debtors. It has rapidly moved to Germany, the financial heart of Europe. 

The failed German bond auction two weeks ago and the spike in the 10-year rate is surely a warning shot as the German balance sheet suddenly doesn’t look so solid.
A comprehensive and significant euro-deal is not beyond reach, but the agreements at the summit don’t achieve it. The hoped for grand bargain would be a trade-off: meaningful Spanish and Italian fiscal austerity and growth-oriented reforms in exchange for a broader fiscal union, i.e. centralized German control and enforcement of member budgets in the future. The quid pro quo for this fiscal compact is the hope that the ECB will become a central bank like others with potentially unlimited, lender of last resort powers. The agreement also includes a commitment not to force bondholders to take losses on future eurozone bailouts, to establish the new European Stability Mechanism in 2012 and an enlargement of funding for potential bailouts in the future.