The Phony War

by Dechert LLP

photo of Rick JonesIt’s been a while since we’ve visited Europe in this column, but events, or non-events, cry out for a fly-by. I am reminded of those months of September 1939 to April 1940 when the conflagration that was to be WWII was looming over the western world, yet, on the western front, no shots were fired. Last we wrote, we wondered how long the European community could avoid acknowledging the ultimate denouncement that its economic model of the past half century had failed and simply had to change radically. With sovereign debt continuing to grow and default threatened in Greece and, perhaps, elsewhere, a broad recession, many states with breathtaking levels of unemployment, broken banks, and growing civil unrest, where was the path to normalcy? How could that path not ultimately lead through the breakup of the common currency “as we know it” and to the restoration of national control over monetary policy? But over the past several months, a grand illusion of normalcy has been diligently constructed and nurtured across Europe. If things have not gone terribly well, please, don’t stare. And whatever you do, just don’t tell the European politicians.

The Euro has strengthened against the dollar, sovereign spreads have come in materially, and banks, having refused to budge on selling assets, seem pretty comfy with a zombie-like existence reminiscent of the last decade in Japan. Some have even been able, very recently, to raise private money in the bond market (who’s buying that paper?). Mr. Draghi announced that he is entitled under the ECB’s enabling legislation to buy bonds and monetize sovereign debt in order to “fix the transmission mechanism” (such a delightfully content free sounding phrase). In a Clint Eastwood-ish moment, he stared down the debt crisis: “Are you feeling lucky, punk?” and boasted that he still had all the bullets he needed. That boldface assertion alone has driven down periphery bond rates without Mr. Draghi having ever fired a shot. The political class seems happy to meet every Thursday for yet another summit and hold a conference call announcing confidence. In many countries, both investor and consumer confidence has risen.

Except for a bunch of crabby Greeks and a handful of Spanish citizens who, quite legitimately, feel ripped off by their banking sector (I mean, come on, who sells Ma and Pa Kettle subordinate preferred securities in their own bank?), pouty German legislators and some small momentum for a variety of fringe political groups across the continent, it all seems like the debt crisis was yesterday’s news. French socialists are partying like it’s 2007, and equity markets across Europe and around the world seem blithely indifferent to any bad news.  

While it’s often said it’s darkest just before the dawn, it sometimes is actually darkest just before it gets entirely pitch black. The past four months seem like an elaborate, self-delusional piece of political economic theater, another “Phony War”, in which, if enough people simply refuse to look at the underlying reality, they can continue to pretend it doesn’t exist.

So what are those underlying realities?  

• There is a growing and broadening, severe recession spreading across Europe. Hard to see what fiscal or monetary tools are left in governmental tool boxes across Europe and it’s not obvious the U.S., China or the rest of the world will pull Europe out.

• Mr. Draghi’s vaunted bond buying program, the OMT, hasn’t bought a single bond and can’t until Spain, and whoever else might need it, asks for the money and “conditions are imposed.” No one is quite clear on what those conditions might be. In fact, no one is quite sure who will get a say in setting them. If Germany gets what amounts to a veto, there may be no OMT. As Mr. Draghi’s willingness to buy an unlimited amount of short terms bonds is the foundation of the phony war’s temporary peace; if it wobbles, the deluge follows.

• Broad, real support of the silver bullet of a banking union, which was going to underlie a comprehensive bank repair program, is nowhere in sight. The French government ludicrously predicted a banking union in place in 2013. Implementation is now slated for 2014 at the very best and, frankly, there is no agreement on the fundamental structure of this banking union and, it seems to me, almost no chance for it to be achieved. The French, mon dieu, have been pretty clear on this point! That means the Big Bazooka to break the conjoined twins of banks and broken sovereigns (and remember, the major banks are vastly larger than the countries in which they reside) won’t happen.

• Spain and Belgium are at the edge of some sort of Velvet Revolution as regions in each country are seriously considering independence (and don’t forget Scotland and Wales). Won’t that simplify things!

• The UK grows increasingly euro-skeptical and even getting an EU budget for 2013-2014 is going to be difficult. This further de-legitimizes the EU at just the time it needs the gravitas to speak for the continent and drive a consensus on economic repair.

• Fixing a debt problem with liquidity (and, let’s face it, while “providing liquidity” sounds better than more debt, it really is just more debt) won’t, in itself, work, whether you’re a Keynesian, a monetarist or a witch doctor. Perhaps it buys time to fix what is broke, but if that time is squandered, liquidity is just more debt. And there is little fundamental fixing happening, or even contemplated, across the EU’s member economies. Moreover, countries like Spain and, to a lesser extent, Italy, Greece, Portugal and the like have economies that are so badly damaged by past profligacy that no level of monetary loosening or liquidity infusion can possibly give them enough runway to fix the problem. Could Germany tolerate a 2% or 3% inflation rate as its contribution to the European-wide fix? Sure. Unfortunately, many of the most damaged economies need a 30% devaluation. That is not happening within a common currency union.

• France continues to pursue a left-wing populist agenda and to tax the economy to death in order to re-distribute the goodies with the hubris only truly committed European socialists can command. Are they aspiring to join the PIIGS? If France begins to wobble, the French-German center cannot hold, and without that, it is hard to see a path forward for the European community.

• EU politicians are still having fun beating up bankers (and, frankly that’s certainly true here in the states as well). This has, and will, drive capital formation out of Europe. If the British PM has got the courage of his convictions, he may protect the Square Mile. Otherwise, capital is heading for Hong Kong, Singapore and New York.

• It costs “Joe Small Business Owner” vastly more to borrow in France, Italy or Spain than in Germany. Kinda flys in the face of all that cheery common market talk, doesn’t it?

• Europe’s version of austerity; more taxes coupled with a refusal to shrink government spending, squeezes out the private sector, whose growth is really the only hope for a recovery. This tax and spend austerity will not work, period.

• Most European states are beginning to chip away at the fundamental underpinnings of the common market, most notably on labor mobility issues. Credit controls are not far away.

• The European banks, sated on sovereign debt and bad loans, will remain unwilling to confront the consequences of right-sizing and will be completely unable to meet the capital needs of even a recessed European economy. Maybe North American and Asian banks can fill the gap, but that can’t be good for Europe.

We need to remember the reality of gloom, if not doom, in Europe as we face our fiscal cliff. We see opportunity in Europe for U.S. institutions, both banking and non-bank, resulting from this never ending crisis. But fundamentally what’s happening in Europe is not good for the world economy; it’s not good for the U.S. economy. This sort of self-inflicted defenestration is hard to watch. 


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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