There is a phrase in baseball that is rather infamous. It is “a player to be named later.” This refers to when a team decides to trade Player A for Player B but Player A is, at least on paper and in the mind of the fans, clearly superior to Player B. It does not matter what the reason for the trade is. Player A could be a troublemaker, or the team could have developed a new and better (or cheaper) player for that position, or they think they see a problem getting ready to happen. But if it was just a straight-up trade, the fans would get angry. So, to get the deal done and keep the fans happy, the owners of Player B agree to give the other team “a player to be named later.” Management tells the fans, we are going to get full value at some later date. Just trust us.
All too often, the player they eventually get is someone the other team wanted to get rid of anyway, or a young player deep in the minor leagues with – that most dicey of terms – “potential”; but sometimes it works out for both sides. Not often, but often enough that it does provide a minimal rationale for the team trading away Player A. Fans are ever hopeful that management knows what they are doing, even after years of being shown that they are clueless.
Not unlike the markets, which salivate over each new announcement from Europe that tells us that all will be well. Trust us, and buy more tickets, or bonds, or stocks. Whichever.
This week’s meetings gave us some rather important decisions. But what they did not do was give us a real solution. What we got was “a player to be named later.”
The important decisions? The first was that Germany finally got France to go along with its view of how the future of Europe should look. There would be no more bailouts of any type without serious reforms. Sarkozy is in a bind. French banks are essentially so bankrupt that they are too big for France to backstop all alone and maintain its AAA rating. Plus, France’s deficits are nontrivial and its ability to raise taxes with any real effect is rapidly dwindling. France needs help. Merkel simply held her ground. In the end, Sarkozy had to agree. To not do so would doom the European experiment and any French hopes for future relevance (more later).
The meetings between Sarkozy and Merkel and “announcement” give Sarkozy the political points he needs to demonstrate that he did not actually cave in. I am sure he in fact did get a few points in, here and there. But not the key points and certainly not what he was asking for this past summer. But he has elections coming up in five months. He can’t appear to be weak when negotiating with the Germans.
Germany would have liked to have all 27 EU members agree to a major treaty change, essentially giving up some sovereignty to a new European entity (or the current one with more teeth) that could enforce budgetary controls on individual members. Britain could and would not agree. So, since we don’t want to kick anyone out, Germany simply goes around the Maginot Line of the present treaty and says it will get an agreement from each individual country. They will each write into their national constitutions or laws binding rules that commit them to fiscal controls and austerity. If you want to be in the club you have to play be the rules. If you don’t agree, you cannot be part of the eurozone and get access to the central bank and larger agreements on aid.
Each member has to take steps to help themselves before they can apply to the EU for help. If you want the ECB to buy your bonds and support your markets, then you need to get control of your fiscal situation. The carrot and the stick. The carrot is 1% financing for your banks, which can then buy your bonds at 4-5-6% (depending on the country). That makes it easier for your banks to get whole.
Remember, it is not just French banks. Almost without exception, every European bank has bought massive amounts of various European government bonds. Leverage of 30 to 1 is common. (This has the rather bizarre effect of making large US banks look conservative.)
And why not? The regulators actually encouraged the banks to buy government bonds. Since everyone knows that sovereign nations, within Europe at least, cannot default, then that debt is pristine. Why reserve capital against possible losses when there was no possibility of loss? Just a quick and easy spread.
So even if you are a country with a reasonable fiscal balance sheet, your national balance sheet can get a huge hole blown in its side if you have to bail out or nationalize your banks. And what if you are Italy?
Your debt-to-GDP is already 120% and rising. The market has weighed you in the balance and found you wanting. Without ECB intervention your interest rates would already be north of 7-8%. My friend Nouriel Roubini (who grew up in and studied in Italy) makes a long and detailed case that Italy needs to go ahead and write down at least 20% of its debt today. But if rates went up, then the write-down might need to be even greater. But who owns the lion’s share of Italian debt? You got it, Italian banks. And in order to keep them afloat you would have to raise capital to borrow money to bail out your banks, so they could write down your debt. That is the problem with debt spirals; they can spin out of control rather quickly. Just ask Greece. Or Ireland.
And if you can’t print your own currency? You are in double jeopardy. You can’t simply use the old-fashioned, tried and true method of devaluing your way out of your problems, the way Italy used to do with such regularity.