Endgame Approaching, by Tim Duy: Wall Street is again taking Europe seriously, at least for the moment. Today was unpleasant. The most important news of the day is that Germany and France are planning for a new Europe. From Reuters:
Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait. "That will mean more Europe, not less Europe," she told a conference in Berlin.
She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.
"It is time for a breakthrough to a new Europe," Merkel said. "A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can't survive."
For the Eurozone to work, there needs to be greater fiscal integration. But Germany and France do not see a place for Greece and likely Italy, possibly Spain and Portugal as well, in such a fiscal union. And, in all honesty, it is hard to find fault with such a conclusion. The clearly dysfunctional behavior of the Italian and Greek governments has made it all but impossible to erect a firewall around the crisis at this point. The credibility of the Eurozone decision making process, allready severly weakened by the endless inconclusive summits, is now completely non-existent.
Interestingly, the IMF appears to be holding out hope that a firewall is still possible:
Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade."
"If we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand."...
..Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.
How viable is the idea of leveraging up the EFSF now that Sarkozy and Merkel have openly breached the topic of a breaking of the Euro? Do the Europeans really take the Chinese for such fools that they will save the Euro when the economic backbone of the Continent no longer believes it is worth saving?
A wild card in this disaster is the European Central Bank. The calls for action are deafening, yet they apparently fall on deaf ears. I think we all agree that the ECB can at least put a floor under Italy, and arguably should be doing that to prevent what appears to be largely a liquidity crisis from becoming a solvency crisis. They would also send a strong signal that the Eurozone does in fact have a lender of last resort. Make no mistake, they can't stop the blinding painful recession that is about to descend upon Europe. That is already backed into the cake, and the ECB would put the icing on the top by calling for harsh austerity in any nation receiving its backstop. But they could prevent a depression. And everyone believes they will step up to the plate eventually.
But what if they don't? What if Germany and France absolutely forbid it? If Germany and France are already planning for a new Europe, they certainly don't want it to begin with a central bank holding a massive piece of the debt from those nations they intend to eject from the Euro. As it is, they probably already fear that a Greek default is inevitable in the next few months, and the ECB will be left holding the bag on their Greek debt holdings. Why add further to those potential/likely losses?
Now where is the Fed in all of this? Quiet, very quiet. To be sure, they will stand ready to provide dollar liquidity via swap agreements with their foreign counterparts. And will likely expand the balance sheet in the event of sharp deceleration in US economic acivity. But such a deceleration is not likely to be revealed in the near term data. And, interestingly, note that despite all the turmoil, the implied inflation rate via the TIPS market is 1.88 and 1.99 at the 5 and 10 year horizons, respectively. I believe the Fed would like to see clearer deflationary pressures before they engaged in another round of QE.
Brad DeLong pleads with the Fed to get in front of the curve:
The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.
Here too it is probably already too late. The time to move was this summer.
At a minimum, the Fed could be preparing a credit facility to take European sovereign debt as collateral. Beyond that, I find it hard to imagine the Fed making large scale European debt purchases. After all, what will they define as an American financial instituion? Deutsche Bank has a US financial holding company - would a Fed commitment include all of Deutsche Bank's European bond portfolio? I don't think the Fed is ready to make such distinctions, especially after the public relations beating they took for lending to foreign banks during the US financial crisis.
In my opinion, they did not have a choice - the foreign banks are part of the US banking system and thus needed to be part of the emergency lending facilities. And, of course, the interconnectiveness of the European and US financial sectors argues for exactly what Brad proposes, even it if meant taking European debt off the hands of European banks. But isn't that the ECB's job? I find it hard to see the Fed eager to take on the role of global lender of last resort. Just as I find it difficult to see the US supporting an expansion of the IMF to aid Europe. Europe has both the capital and the lender of last resort to deal with this crisis themselves. They don't need external financing, they need internal rebalancing. Ultimately, the Europeans will need to find the political willpower to solve the crisis. I just don't see much US involvement in the process, either fiscal or monetary. And if such involvement did occur, it would not happen until conditions became much, much worse.
Bottom Line: The tide turned from optimism to pessimism today. Perhaps the opposite happens tomorrow. But ultimately, I believe pessimism will rule the day. The point of no return was reached when Germany and France openly discussed a smaller Eurozone. To be sure, the ECB could still offer upside surprise by serving as the lender of last resort, which would ease the downside pain. I don't anticipate the Fed will take on this role. The Fed is probably still mulling over what they perceive to be the limited US exposure to Europe, just as they did with the US subprime debt. And the relatively painless demise of MF Global probably reinforces that sense of complacency. The Fed will react eventually, but US conditions will need to deteriorate markedly before they do so.