Bring On the Bazooka

12/06/2011 10:59 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

With credit ratings across Europe under the gun, the markets won’t wait on Germany for much longer, writes senior editor Igor Greenwald.

So six days ago, Europe was on the verge of a catastrophe. But then the Federal Reserve and the European Central Bank promised the continent’s wobbly banks easier access to dollars, and for a while everything looked better.

Italy’s appointed government pushed through another austerity program, Germany and France hurried to forge a closer fiscal union, and the bond yields demanded of Italy and Spain dropped from prohibitive to merely expensive.

But then Standard & Poor’s repeated what Moody’s said last week, which is that no one—not even Germany—is going to come out of this mess smelling like roses. And it’s apparent, once again, that nothing has really been solved, heaping unrealistic expectations on Friday’s European summit.

S&P, for one, isn’t inclined to wait, warning that its continent-wide downgrade threat will be resolved “as soon as possible following the EU summit.” France, which faces a two-rung rating drop, can probably kiss its cherished AAA au revoir.

Germany is likely to hang on to that distinction. But if it ends up sharing it only with Finland and Netherlands, its conservatism is going to prove unaffordable.

The looming credit downgrades threaten to turn the Eurozone’s EFSF bond-insurance scheme into a non-starter. And that leaves the European Central Bank as the only potential rescuer with the necessary resources to get the job done.

Hence feverish speculation about the likelihood of the ECB deploying its “Big Bazooka.” As anti-tank weapons, the original bazookas proved most lethal to the infantry using them, so perhaps it’s time to find a happier analogy, say, the Daisycutter.

It was then-Treasury Secretary Hank Paulson who told Congress in July 2008 that it was better to confront the markets with a bazooka rather than a peashooter, that a bazooka was likely to do the job without ever being fired. As it turned out, Paulson would shoot early and often, requiring several reloads.

Fannie Mae and Freddie Mac ended up in federal receivership two months after The Bazooka That Need Never Be Fired was deployed. Lehman, AIG, and TARP were still to come.

This is Merkel’s nightmare—that the ECB would be forced to keep reloading as well, debasing the euro to underwrite profligacy abroad. She ought to be more worried about getting her way, and dealing with a continent-wide slump and credit crunch that are only going to get worse.

Italy’s latest austerity package trims, on a net basis, the equivalent of 0.5% of GDP in each of the next three years. But the previous cuts already amount to a headwind equivalent to 2.7% of GDP next year, according to Deutsche Bank. It expects Italy’s economy to shrink by 1.1% next year before recovering somewhat in 2013. The Italian government is assuming a 0.5% contraction in 2012 and no bounce the following year.

Austerity isn’t even Italy’s main concern. That would be an economy that mostly can’t compete against northern Europe, and can’t improve its odds by devaluing the currency. But since austerity will only make the problem worse, the banks and insurers holding Italian bonds have been getting out.

The thing about Paulson’s bazooka, and the ECB’s, is that they’re a lot like Anton Chekhov’s gun—spectators see one hanging on the wall and expect it to fire by the end of the production.

And the longer Germany resists, the less bang it will get for its euros.

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