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Getting Chippy In The EU

Things are getting a little chippy in the EU, and I don’t mean on the soccer pitch. While in the U.S., the economic data continues weak (with Consumer Confidence and core Durable Goods the latest numbers to fall short of expectations, although not terribly so), the important drama is still on the continent.

Temperatures are rising, at the EU summit meeting and outside of it. George Soros has started the Countdown to Disaster; the three days he declared Europe had left to act to avoid a “fiasco” ends tomorrow (generously, let’s give him until the end of the week). But years from now, we may look back on the behind-closed-doors, but widely-reported, declaration by German Chancellor Angela Merkel that Eurobonds and other forms of pan-European debt sharing would not happen “as long as I live” as being the moment of clarity. If it were just Merkel saying this, it would mean little. But Merkel’s position has not been softening with time, but hardening; she is, in short, moving to a position more in tune with her electorate. Germany is not going to agree to Eurobonds. Europe better hope that the EFSF and ESM are enough, because that seems to be about the extent of what it is willing (or able) to give.

Some observers think this is just a hard bargaining line, and that Germany will agree to union as long as it’s a German-dominated union. I don’t think it is a bargaining line, but for a minute let’s suppose it is and let’s ignore the touchy question about whether the other creditworthy Eurozone entities – Finland springs to mind – will blithely hand the checkbook over to Germany. If such a fiscal and political union actually happened, it might defer the Euro crash for years or even a decade or two. But European union will not work in the long run if one country is put in the driver’s seat. Because what happens when Germany’s time to be ascendant is over? Can you imagine if the EU was led today by Italy? Well, between 300BC and 300AD, Rome was the unquestioned seat of European power. Spain was also a world power once, as was Portugal, and of course France during Napoleon’s time. The only way that a confederacy works, such as the one that includes such different populations as Texas and California, is if none of them is in charge.

In other words, the best chance that Germany has to remain the unquestioned leader of continental Europe is for it to remain independent, not for it to accept vassal states. To me, it looks like that nation is gradually figuring out that its interests are not in fact shared sufficiently with its neighbors to continue down an irrevocable path. I suspect Greece is as well, for the opposite reason.

Meanwhile, although U.S. growth indicators have been surprising on the downside (the Citi Economic Surprise Index for the U.S. is at -60.9, but it was as low as -117.2 one year ago), European indicators are significantly worse. The Citi Economic Surprise Index for Europe is at -90.5, just about as bad as in the months following the Japanese disaster last year and otherwise the worst levels it has seen since 2009 (see Chart, source Bloomberg).

The chart doesn’t illustrate the level of economic activity, but rather the severity and frequency and degree of the miss of the actual data relative to expectations. A big negative number means things are getting worse faster than economists predicted (or it could mean, in a different context, that they’re not getting better as fast as they had predicted). In that context, consider the next story, which ran on Bloomberg today: “Draghi May Enter Twilight Zone Where Bernanke Fears to Tread.”  The article suggests the ECB is considering cutting interest rates to zero in fairly short order, and might even make ECB deposit rates negative as a spur to get banks to take money out of the ECB vaults and lend it. Gee, what a fine idea – I wonder where I’ve heard that before?

The Fed doesn’t want to lower the overnight deposit rate below 0.25% because they are afraid of damaging the money market industry irreparably. The lack of confidence that the Fed has in capitalism to figure out a way that the money market can survive and/or regenerate once rates rise again is appalling. Sure, I know that the government is doing everything it can to destroy the finance industry so that it can never regenerate, but I think Fidelity would figure something out if money market interest rates were negative. For example, it could design a money market fund that wasn’t guaranteed at a buck. See? That wasn’t hard.

Yes, doing this would hurt the credit quality of the European banks. Golly, that was hard to even write with a straight face. Look, the sovereigns will end up bailing out many or most of the banks anyway. So what if they make some negative-expectation loans? Isn’t that whole point of forcing negative real rates anyway?


I have some comments on oil and TIPS but I will save them for tomorrow. I want to make sure I say congratulations and welcome to a professor (and good friend) of mine who recently posted his first on-line article here.  Dr. Huston is an outstanding economist, a very creative thinker, a fine nurturer of student minds, and an enthusiastic lecturer. His article points out the current status of the “Fed model,” and illustrates the point that stocks are quite cheap relative to bonds on that model (although it’s a bad model for trading decisions!). I agree that stocks will probably outperform nominal bonds over the next ten years, although neither return series will be very exciting and inflation-linked bonds stand a chance of beating both of them depending on how much margins compress and multiples fall when inflation first rises. Congratulations on your first post, John. (By the way, he and co-author Roger Spencer – both of Trinity University – wrote an outstanding quantitative history of the Federal Reserve called “The Federal Reserve And the Bull Markets: From Benjamin Strong to Alan Greenspan.” At $110 I can’t recommend you buy it, but persuade your local library to buy it so that you can check it out! Or better yet buy it, donate it to the library when you’re done, and get a tax benefit.)

  1. BLSHC
    June 28, 2012 at 2:23 am

    Excellent article about the political situation in Europe. Brings the problem of the situation (‘Germany has to be in the driver seat in this long journey to the unknown’) to the point. Thanks and have a nice day !

  2. Jim H.
    June 28, 2012 at 8:51 am

    From John Huston: ‘Does [the Fed model] imply that stocks are currently undervalued? The short answer is yes – statistically speaking this is a stationary series suggesting that the ratio’s value should rise back to more familiar levels in the long run.’

    As one commenter noted, with the Fed running Operation Twist with the explicit intention of depressing long rates, long Treasuries are a contaminated yield reference.

    Future stock returns can be projected fairly accurately over periods of a decade or more, using earnings yields, dividend yields and the like. Currently such methods project about a 5% nominal return on stocks through 2022. I would vigorously thump the table in asserting that such a puny projected nominal return — which probably ranks in the bottom decile or two over the past century — reflects OVERVALUATION of stocks, not undervaluation.

    It’s not entirely facetious to claim that any model endorsed by ‘Magoo’ Greenspan is useless, as Greenspan is the only known example of a vertebrate biped who is infallibly wrong (not to mention being the subject of a book by our esteemed blogger).

    One wonders whether TIPs would serve as a better yield reference than nominal bonds for the Fed model. Have to take a look at that, using a simulated TIPs historical time series.

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