Europe's Fix Is No Solution

12/12/2011 10:43 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Counting on overleveraged banks to buy more sovereign bonds with borrowed money won’t fix the fatally flawed currency union, writes senior editor Igor Greenwald.

The weekend after the latest do-or-die European summit, it’s clear that Europe is still dying the death of a thousand cuts, even as its rulers claim they’ve stopped the bleeding.

Italian ten-year bond yields are up to 6.64% today, from 6.36% late last week. Germany’s DAX index has slumped 2%, and the euro’s descent has also picked up speed. So much for the big bazooka.

The “solutions” Germany insisted on instead looked more like mustard gas: foggy, toxic, and liable to harm the issuer as soon as the wind changed. Europe’s war chest of funds that could be used to buy Italian and Spanish bonds isn’t significantly larger than it was last month, and will only shrink in its potential scope once the credit agencies follow through with the inevitable downgrades.

Instead of increasing its commitment to buy sovereign bonds, the European Central Bank went out of its way to signal the opposite, setting a €20 billion cap on weekly purchases. Of course, the ECB is perfectly willing to lend Eurozone banks an infinite amount of euros for three years at just 1% annually, in the hope that they in turn will buy the sovereign bonds it doesn’t have room for.

At least that’s the thinking of the governor of the Bank of France, and it’s a notion so dumb it warrants a downgrade all by itself. Eurozone banks are already sitting on too much sovereign debt, and while for regulatory purposes it remains risk-free, in real life the risks and losses are all too real.

Why buy something that will only drop in value once S&P and Moody’s confirm the obvious? And why buy something now when it figures to be on sale in huge volume next year?

The kicker is that the deficit curbs secured by Germany simply lock in the austerity failing so spectacularly in Europe’s bailed-out nations.

Europe is in the throes of a severe credit contraction and, almost certainly, a budding recession. And the German response is to make it harder for everyone to spur growth.

A true fiscal union would imply huge transfer payments from the taxpayers of prosperous northern Europe to the clients of the states on the continent’s uncompetitive southern and western fringe. That’s what happens in the US when wealthy taxpayers in New York subsidize unemployment benefits and food stamps in Detroit.

In Europe, subsidies from the prosperous countries are being used to deflate the overleveraged economies with little regard for their welfare. And the more the economies deflate, the more tax revenue falls short, necessitating further cuts.

This is a policy that’s deflating global demand and posing particular risk to Asian countries that are coping with the queasy aftermath of strong domestic booms. And as warnings by Texas Instruments (TXN) last week and by Intel (INTC) this morning show, corporate earnings are likely to suffer as a result.

That’s not likely to be the case for McDonald’s (MCD), which saw consistent growth everywhere throughout the Great Recession, and has recently been raising prices even as its food costs have declined. No wonder the stock is grazing near a record high not far off $100 a share.

But it’s worth noting that even as its sales held up in 2008, the stock dropped 25% from that summer’s peak to the bear-market trough the next March.

Maybe the herd won’t make the same mistake again. But there ought to be better times to grab a bite.

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