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Europe: Too Little, Too Late   December 5th, 2011
New agreements won't change the math       

 
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Reports today indicate that Germany and France will propose modifying EU treaties to try to prevent a future economic crisis.

In what is seen as a concession by Sarkozy, the pact includes automatic sanctions for member states that violate an existing rule to keep budget deficits under 3% of gross domestic product...

"The crisis requires an extra commitment towards unity and a Europe that will not repeat the mistakes of the past," said Sarkozy, speaking alongside Merkel, at a press conference...

It would also require governments to enshrine a "golden rule" in national constitutions that would likely require committing to balanced budgets.


Simultaneously, markets seemed to breathe a sigh of relief as Italy's bond yields dropped:

Italian bond yields backed further away from the danger zone Monday, as Italy's new prime minister prepared to present a budget proposal that includes 30 billion in new taxes and spending cuts over two years.


The obvious take-away from this is that Europe is trying to get a handle on its problems by taking a stab at fiscal conservatism: The German/French proposal appears to emphasize reducing deficits and, perhaps, efforts at balanced budgets in member countries. Similarly, Italy's bond yields have dropped as a result of an expected proposal to reduce spending and deficits.

Yet there is every reason to be skeptical of these solutions.

First, in Italy, it's too little too late. While reducing spending and deficits are the right medicine, experience with Greece, Ireland, and Portugal have all demonstrated that once a crisis is unfolding, even valiant efforts at reducing spending and deficits are insufficient to stop the crisis. As such, it's unlikely that the proposed cuts in Italy are sufficient to stop their bond crisis. After a pause, Italian bond yields--like Portugal's yields before it--will resume their upward trajectory.

In addition, Italy's proposed cuts are entirely insufficient. Italy's budget is approximately $1.053 trillion (about half of its GDP) with a deficit of about $100 billion/year. A reduction of 30 billion over two years is about a 2% decrease in its budget and will still leave Italy with a deficit that exceeds the EU 3% limit.

And, of course, it remains to be seen whether Italy's proposal will be passed by its parliament--and actually implemented even if it is.

As for the German-French proposal, the problem isn't so much what it proposes as what it doesn't. While strict limits on deficit spending--and maybe even a requirement of balanced budgets--would be great to avoid future problems, it does nothing to address the current problem.

The proposal calls "for accelerated implementation of a permanent mechanism to replace the European Financial Stability Facility." It doesn't seem to explain what that "permanent mechanism" will be. It also expressly rejects the ECB printing Euros to buy the bad debt of member countries and rejects joint Eurobonds.

The rejection of Eurobonds--while the right thing to do--is not what the markets will ultimately want to hear. Additionally, reaffirming the ECB's status as not being a lender of last resort means that--at least publicly--Europe is not expecting the ECB to print Euros to buy the bad debt of member nations. Again, this is the right thing to do but it's not what the markets will want to hear. What markets want is for Europe to jointly assume responsibility for the debt of member nations by way of some kind of Eurobonds, and/or for the ECB to start printing money to buy bad debt so banks and investors can unload that bad debt.

It's certainly possible that Europe is saying these things with a wink and a nod to generate general confidence so that the ECB will, without prodding, start buying the bad debt on the secondary markets with the pretext of price stability.

But, in the most general terms, the current trial balloon being floated by Germany and France does not resolve the current debt crisis, it doesn't accept joint European liability for existing European debt, it doesn't propose Eurobonds, and it doesn't propose that the ECB buy bad European debt.

In fact, the only thing it really does is put some teeth behind the 3% deficit limit which has actually always existed in the EU treaties and which Germany and France started ignoring over a decade ago. Given that this "grand proposal" is little more than an effort to enforce limits that already existed and which were violated by the countries that are now re-proposing the limits, it doesn't seem like this will do much to save the Euro.

As always, the solution is to cut spending now. Not over two years. Not just a little bit. Not just promises to avoid large deficits in the future. The solution to solving the current crisis is to demonstrate that Europe is serious now by instituting large and immediate spending cuts in real-time. This would be action that would give the markets a reason to believe, mathematically, that the problem can actually be solved.

But since it's unlikely that that will happen, We are once again faced with the probability of a do-nothing European summit where leaders will just talk for awhile, sign an agreement, and give the markets a momentary adrenaline rush.

But if the agreement is essentially the proposal that's currently being floated, it will be a rush that will last only a few weeks. Maybe even just a few days.

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