John P. Hussman - The Reality of the Situation

Euro Hopium

Two main hopes have kept investors relatively complacent about the growing risks in Europe: the hope for Eurobonds, and the hope for large-scale ECB purchases of distressed sovereign debt (essentially money-printing).

With respect to Eurobonds, investors should understand that what is really being proposed is a system where all European countries share the collective credit risk of European member countries, allowing each country to issue debt on that collective credit standing, but leaving the more fiscally responsible ones - Germany and a handful of other European states - actually obligated to make good on the debt.

This is like 9 broke guys walking up to Warren Buffett and proposing that they all get together so each of them can issue "Warrenbonds." About 90% of the group would agree on the wisdom of that idea, and Warren would be criticized as a "holdout" to the success of the plan. You'd have 9 guys issuing press releases on their "general agreement" about the concept, and in his weaker moments, Buffett might even offer to "study" the proposal. But Buffett would never agree unless he could impose spending austerity and nearly complete authority over the budgets of those 9 guys. None of them would be willing to give up that much sovereignty, so the idea would never get off the ground. Without major steps toward fiscal union involving a substantial loss of national sovereignty, the same is true for Eurobonds.

Over the weekend, Jean Claude Trichet, the former ECB head, proposed a system to save the Euro, whereby European politicians could declare a sovereign country bankrupt and take over its fiscal policy. He also proposed a system whereby the Eurozone could produce its own domestic energy by placing a giant hamster on a wheel the size of the Eiffel Tower.

Moving to the European Central Bank, large scale ECB purchases of sovereign debt would simply be the money-printing version of Eurobond issuance. When the ECB purchases the bonds of a given country, and creates Euros for them, it has essentially printed money until the point in time that the bond is paid off. If that day never comes, as is the concern with distressed European debt, then the ECB has essentially printed permanent Euros in order to finance the spending of the country whose bonds it purchased. In order to guard against this sort of backdoor fiscal policy, the ECB only buys bonds after ensuring that it has a senior position to other bondholders. So if the ECB was to purchase distressed European debt on a grand scale, the result would be that theremaining bonds would be subordinated, making the prospective losses on those bonds evenhigher than they were previously.

Ultimately, what investors really want is for the debt of various countries to be wiped away by the ECB simply printing money to retire that debt, or by having Germany and stronger Euro-area members to make endless transfers to peripheral European countries. The whole system rides on this willingness to transfer fiscal resources, or to allow money printing (with no revenue to stronger members from that money printing) in order to finance heavily indebted members. The reason the recent elections in Greece and France matter is that they send a signal from the public to European governments: the people are unwilling to make any more "austerity bargains" that put the public behind bank and government bondholders. So Germany is now being asked to continue its transfers without any end in sight.

We can't rule out the chance that Europe will cobble together enough temporary liquidity for Greece and troubled banks to kick the can down the road another time or two, but these kicks will become increasingly weak and short-lived in the context of a new recession. Even in the event of various liquidity injections, there is virtually no chance of addressing the solvency of Europe - the ability of each government (much less the banking system) to sustainably pay their debts - within the constraints of the Euro. As long as the Euro exists as a single currency, individual countries can't inflate away the real value of their debt, or restore their trade competitiveness through exchange rate depreciation against other countries.

Under these strains, I expect that the Euro will fracture well beyond a Greek exit. Ultimately, the result might be a "strong Euro" that reflects the union of Europe's most fiscally responsible countries, or we might instead see a "weak Euro" that follows the departure of Germany from the currency union and leaves peripheral members free to inflate. So it's not clear which direction the value of any surviving Euro may take until it is clear which member countries will remain. In any event, however, what we are unlikely to see is a single Euro that combines fiscally responsible and fiscally irresponsible countries, and requires endless one-way transfers of sovereign public resources in order to hold the system together.

Read it at Hussman Funds
The Reality of the Situation
By John P. Hussman, Ph.D.