The Gang That Couldn’t See Straight

07/19/2011 11:13 am EST

Focus: GLOBAL

Igor Greenwald

Chief Investment Strategist, MLP Profits

Europe’s economic policies are an unsustainable mess, but at least there’s lots of room for improvement, writes MoneyShow.com senior editor Igor Greenwald.

Let’s not beat about the bush like Europe does: the Old World’s daft, and not in an endearing way, either.

Its economic policy and debt crisis response are in the hands of…well, no one in particular, really.

While European stock and bond markets were choking on debt fears last week, the continent’s single most powerful decision maker, German Chancellor Angela Merkel, was touring close allies like Kenya, Angola, and Nigeria.

Meanwhile, European Central Bank President Jean-Claude Trichet said once again the other day that everything will be fine, as long as Europe shows “will and determination.”

By this, he means that national governments should figure out a way of bailing out all the heavily indebted sovereigns…and maybe also the overleveraged balance sheet of the ECB.

Otherwise, many of the European banks will soon need copious amounts of new capital. And ECB’s contribution to that problem will have been to make that capital more costly, and bank profit more meager, by repeatedly raising interest rates just as growth was petering out.

As for the rest of European officialdom, on Friday results of a second round of bank stress tests were announced, and proved as unconvincing as the first. Just eight of the 90 banks tested failed, and their combined capital shortfall was a mere $3.6 billion.

Investors might have taken the whole exercise more seriously if the tests had factored in the threat of sovereign default stalking bank stocks. Of course that would have exposed scores of banks as insolvent, making an undesirable point.

Instead, that point was left to the motivated sellers who discounted a regional banking index another 3.2% on Monday. That gauge is down 11% since July 1, and 26% over the last five months.

Shares of the top Italian banks are down some 20% for July. The value of Germany’s Commerzbank (OTC: CRZBY) has been cut in half since March.

Europe’s cure for this advanced case of financial gangrene is to hold another summit this week on a second rescue package for Greece and unspecified confidence measures that might still save Italy and Spain, if not Portugal and Ireland.

European policymakers are belatedly acknowledging that Greece has been led into a dead end and will not grow again without some debt forgiveness and stimulus that might drag its economy out of depression. But other countries are still pursuing austerity that’s likely to further sap growth—the one outcome countries like Italy can’t afford.

Italian bonds hit new lows after the country’s lawmakers passed a tough new budget aiming to eliminate the deficit within three years, pushing the ten-year yield to 6%. That’s a rate that’s likely to choke off the negligible Italian growth on its own, without any help from the latest budget cuts.

The market is trying to help Merkel and Trichet understand that their policy prescriptions are unworkable. Protecting existing bondholders with austerity leaves little reason for new investors to come on board, since growth is what enables borrowers to pay off new debts.

In the absence of a credible economic policy, Europe is suffering the worst of both worlds. Banks are under the gun, given the likelihood of sovereign defaults, and growth is sputtering as governments try to dodge that outcome.

The good news is that this can’t go on for much longer. Either default will end the austerity charade, or Europe will pay up (again) to bail out its zombie banks.

It’s fine to say that there’s too much debt around, but that knowledge has been in the markets for years now. The European debt crisis is more than a year old, allowing many banks to shift their sovereign exposure, at a loss, to hedge funds and other vultures.

Ultimately, one way or another, the debt loads will be cut. In this process, creditors’ losses will be borrowers’ gains, and vice versa.

Right now, everyone is suffering. That will change. Zero-sum games require some winners, even when governments leave everyone at a loss.

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