Monday, July 18, 2011

Time is Running Out on the EU

Nouriel Roubini offers a detailed solution for the continually worsening Eurozone problems. Roubini is one of the smartest minds today regarding credit related issues and his ideas here should be taken seriously. One of the most notable facets of his plan involves extending maturities on Greek debt without forcing banks to write down losses. Despite the laughable stringency of the recent EU bank stress tests, the need for significant additional capital was readily apparent. Considering the large sell off in bank stocks currently taking place, imposing realized losses could make obtaining further capital nearly impossible.

Another major part of his plan involves the ECB reversing recent interest rate hikes, supporting a devaluation of the Euro. While the periphery nations would become more competitive globally, some significant headwinds face this option. Unlike the Federal Reserve, the ECB’s only mandate is to maintain price stability, effectively through low inflation. Inflation has been picking up in Europe recently with Germany in particular feelings the effects. Reversing recent policy actions would likely generate a temporary jump in inflation and appear in direct contradiction of the mandate. Germany also maintains significant power over the ECB and may not be able politically to accept the short-term pain.

Separately, any attempt at Euro devaluation would likely come largely at the dollar’s expense. Misunderstanding of QE has allowed the Fed and Treasury to support a weak dollar policy without increasing the monetary base beyond historical trends. These efforts have been focused at reducing the large US current account deficit and provided the added benefit of propping up US stock markets. If the ECB/EU were successful, a stronger dollar might undermine recent export growth, corporate profits and equity prices. It’s unclear what, if any, response US policy would take against a weak-Euro policy.
The EU/ECB are faced with choosing from several less than ideal options. While I think Roubini's plan is among the best, implementation and support remain concerning factors. Ultimately Roubini comes to the same conclusion as many others, either the EU becomes more fiscally cohesive or allows defections and defaults. With Spanish and Italian bond yields spiking in the last week, potential solutions are dwindling. One way or another the EU crisis may be resolved far sooner than many expect.

From Project Syndicate

The Eurozone’s Last Stand by Nouriel Roubini

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