The Fiscal Mess in Europe Will Continue, Thanks to German Ideology

The European conference in Brussels late last week produced what European leaders called the necessary steps to avoid a collapse of the Euro currency and to assure that the sovereign debt crisis will not expand beyond Italy, Greece, Ireland and Portugal.

In hope that Europe would finally get its act together, most stock and bond markets and currency rates were favorable to the Euro on Friday.

This weekend, all was smiles on the continent, with President Sarkozy’s and Chancellor Merkel’s people offering self-congratulatory comments about what had been accomplished. They also took what seemed to be a great deal of satisfaction in bashing Great Britain and its Prime Minister David Cameron for not going along with their plans.

So, it probably came as a surprise on Monday to find that the Euro sank to its lowest against the Dollar in more than 2 months, ending the day at 1.316 Euros to the Dollar. More troublesome, the fall in the Euro took commodities with it, with gold down more than 3%, although some analysts say this is a temporary move down.

Stock markets all over the world also reacted negatively to last week’s disappointing European program by falling as much as 1 to 2%. Predictions are for this up-and-down market instability to continue at least for the rest of the year, negating the traditional Wall Street “Santa” rally.

Interest rates required for the sale of European bonds were also on the rise again on Monday, in Italy pushing some bond interest rates to near the 7% unsustainable level just weeks after the European Central Bank (ECB) and others stabilized Italy’s debt situation with inflows of financial support in the form of buying Italian bonds that nobody else wanted. In part, this was caused by the continuing refusal of Germany to agree to allowing the ECB to buy large enough blocks of bonds from indebted Eurozone countries to make a real difference in the outcome.

At the bottom of the European Union and Eurozone mess is the almost evangelical belief in Germany that austerity is all that is required to solve the sovereign debt problem. If only debtor countries (Greece, Ireland, Portugal, Italy, Spain) would cut back public spending on social services, eliminate their budget deficits and increase retirement ages, as Germany keeps saying, then all would work out and Europe would get back on the road to prosperity.

The devil in this argument is that it is not true. Cutting back so severely on government spending and forcing austerity to such a level that it creates massive unemployment and forces people on to the streets just to ask for enough money to feed and house themselves is not efficient or workable in the short term. It will create an extended period of recession and high unemployment in Europe that will mean that governments will not collect the tax money they need to pay off their old and new debts. The circle will spin forever - no jobs, no taxes paid and no taxes paid, no money for the government to use to balance its budget by paying off its debts.

That Germany cannot see this is mind-boggling. Is Germany so traumatized by its memories of the hyper-inflation between WWI and WWII that it will risk creating a deflationary disaster rather than find the will to be flexible?

In his NetNet blog today, John Carney said, “What Anglo-Saxon economists need to understand is that the Germans and the ECB really, really don’t share our worldview; they really do believe that austerity is all you need. And all indications are that they will cling to that belief, even as the euro falls apart — an event they will insist was caused by the fecklessness of the debtors….Given a choice between saving Europe and remaining righteous, they’ll choose the latter.”

And this is what the rest of the world has trouble believing. The world does not understand that ideology can be so entrenched that it will lead Europe and the Euro down the path to destruction. The world keeps investing in Europe because they believe that one morning, Chancellor Merkel, who is very intelligent, will wake up and say, “Today I have to try the other path.” She will never do this - because intelligence and ideology are two separate universes. It may be that Angela Merkel will remain irrationally ideological longer than Europe can stay solvent without the aid she refuses to agree to.

And, as long as Merkel is firm, Sarkozy will not desert her because without Germany as a partner, France has neither the financial resources nor the political will to save Europe. Already today in the political arena, for example, French Socialist presidential candidate François Hollande said that if he is elected he will re-negotiate all that was decided last week in order to better protect the interests of France.

The bond markets have realized this and the high interest rates being demanded of the European debtor nations to buy their bonds reflects it.

The currency markets may be in the process of understanding this. Monday, the Euro took a beating, big time, falling more than 1.5%, an enormous one-day drop in the currency markets. Some analysts believe that if the US actually agrees to a continuation of the payroll tax reduction by year’s end, then US markets will stabilize and rise and the Dollar’s strength will continue to push the Euro lower.

World stock markets are beginning to see the problem, too. The fall in world stock markets Monday is seen as a direct response to Europe’s non-helpful decisions of last week.  

And, as if on call, the ratings agencies, which have been publicly on Europe’s case for a month, are today saying that all European sovereign debt (public bonds) will be re-evaluated in the first quarter of 2012.  

Moody’s said in a report,  "The absence of measures to stabilize credit markets over the short term means that the euro area, and the wider EU, remain prone to further shocks and the cohesion of the euro area under continued threat."

The chief economist of Standard and Poor's in Europe said there would need to be more summits and that time was short. "Time is running out and action is needed on both sides of the equation, on the fiscal and monetary side."  S&P added that it thinks only a real market shock to a major German bank will change Germany’s and Merkel’s position, and he added that this may be coming soon. It also has warned that it is preparing to downgrade 15 European countries.

Fitch said on Monday that it sees no comprehensive solution to the European crisis and it expects it to continue at varying levels of intensity beyond 2012. It also forecast a significant economic downturn across the euro zone in the near term.

The fat lady is far from warming up to sing in Europe.