Posts Tagged ‘European Integration’
Tuesday, August 7th, 2012
August 7, 2012
Investors have not woken up to it, but last week may have been a game changer. European Central Bank (ECB) President Draghi took tail risks out of the Eurozone, while at the same time forcing closer fiscal integration. He did it all while keeping the ECB out of some political minefields. It’s pure genius. The initial market reaction suggested he might have lost a battle, not realizing that he is winning the war.
Dismayed by a dysfunctional process caused by a lack of leadership and the increasing risk of some of the worst case scenarios playing out, we have been staying away from the euro in our hard currency strategy. As of late last week, those dynamics changed: we are giving the euro another chance, not only because of substantial short covering potential, but also because Draghi’s “whatever it takes” approach might bring about seismic changes in how European integration, fiscal and monetary policy move forward.
In essence, Draghi told the world that the ECB will act like a central bank of a United States of Europe if the integration of European fiscal policy accelerates. The “integration” process hasn’t worked particularly well. In the early years of the Eurozone, peripheral Eurozone countries used cheap access to financing to live beyond their means. Now, the markets have serious doubts about the sustainability of the finances of weaker Eurozone countries. To regain the markets’ trust, governments have nibbled with austerity measures. While the respective governments will take offense to us using the term ‘nibble’ at their hard fought progress, governments have not been able to reduce their debt loads. Politicians blame the high cost of borrowing and speculators. Unfortunately, as long as debt is merely shuffled around, no matter how big any aid package may be, it is unlikely to bring long lasting relief. In an effort to regain the trust of the markets, governments must engage in credible structural reform. Ireland has successfully gone down this path, but politicians have so far been unable to do the same in Spain, Italy and Greece. In Spain, Prime Minister Rajoy enjoys an absolute parliamentary majority and has no excuse. Italy is run by a technocrat; as such, the market is rightfully suspicious. Greece, well, is in a category of her own.
To break the debt spiral of these weaker countries, the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) have been put in place. Accessing these facilities comes with a hefty price tag: giving up sovereign control over one’s budget. However, that’s exactly what a United States of Europe needs: tight fiscal integration. While access to the bailout facilities reduces the immediate cost of borrowing, it may also shut the door to selling bonds in the markets at palatable cost.
That raises the question of what is a palatable cost of borrowing? In the 1990’s, paying 6% for 10-year debt was just normal for some countries. Yet, because so much more debt has piled up, paying 6% is now considered unsustainable – at least unless such draconian budget cuts are introduced to balance budgets even with such high interest burden. And just in case anyone is wondering, the U.S. would be in just as dire a situation, if not worse, if it had to pay 6% on its long-term debt. We are currently concerned about the “fiscal cliff” in the U.S. – but even if the draconian cuts and increased taxes introduced by the fiscal cliff were implemented, the U.S. budget deficit would still be above 3% of GDP (the level that Eurozone nations are intended to stay below). The difference between the U.S. and peripheral Eurozone countries is foremost that the bond market lets the U.S. get away with its deficit spending.
We have long argued that the market provides the best incentive to stop governments from overspending. Spain, Italy, Ireland, Portugal, Greece – all these countries have engaged in astounding reforms, all with the “encouragement” of the bond market. Politicians, however, are most creative in avoiding making tough choices. So how does one square the circle, how does one live with political realities while at the same time provide a path to fiscal sustainability? Politicians have called for the ECB to step in, to buy bonds of weaker Eurozone countries, thus lowering their cost of borrowing. But when the ECB has done that in the past through the Securities Markets Program (SMP), policy makers have lost their motivation to pursue structural reform. Policy makers choose between the cost of acting and the cost of not acting: the moment there is relief in the market, commitment to reform fades. It also puts the ECB into the uncomfortable position of playing judge of whose reform plans are worthy of support and whose are not.
The argument for market intervention is that the “monetary transmission mechanism” is broken. That may be correct, but becoming a political hot potato is no attractive alternative for a central bank.
So ECB President Draghi announced a new philosophical framework last week: the judge of whether sufficient austerity is implemented to warrant ECB support is the conditionality of EFSF/ESM, i.e. the types of rules the International Monetary Fund (IMF) introduces on countries. It’s the best one can hope for if policy makers don’t accept the market’s judgment. In our view, accepting the market pressure would be preferred, but this is the best course of action given the realities presented. Indeed, we consider Draghi’s action nothing short of pure genius.
Draghi’s action is pure genius because it dramatically accelerates fiscal integration in Europe. Already Spain and Italy are contemplating joining the bailout regime, if in turn Draghi will help lower their cost of borrowing. There will certainly be a lot of horse-trading; we also don’t expect all austerity measures to necessarily be fully implemented. But that’s not the point. The point is that weak countries subject themselves to a political body (not a central bank) that negotiates and sets terms. It is the United States of Europe we have been waiting for. With the framework set, the ECB can engage in market operations targeting securities that are part of the program. Draghi already indicated that the focus will be on the short-end of the yield curve (shorter dated Treasury securities); this is akin to what other central banks, like the Federal Reserve (Fed) do; well, the Fed has since moved out the yield curve (longer dated Treasury securities). Longer dated debt will be affected, although significant risk premia over German bonds may continue for some time.
Based on other comments we have seen, odds are that not many others, if any, will agree that Draghi’s actions were “pure genius.” After all, he did not provide the immediate relief all those stimulus addicted market participants have gotten used to. But Draghi understands that the best short-term policy may be a good long-term policy. The short-term policies advocated by many pundits, an aggressive purchase program of peripheral bonds would only achieve that holders of such debt can dump their bonds; buyers would be guaranteed to buy such securities at inflated prices, setting them up for almost certain disappointment (and thus scaring them away from future bond auctions).
Instead, Draghi achieved a great deal: as fiscal integration in the Eurozone may be dramatically accelerated. Importantly, a political process has been put in place. Ironically, it took a monetary policy maker to put a fiscal process in place; yet, Draghi allowed the ECB to be used merely as a catalyst, not as a political pawn.
Draghi also correctly shifts the focus going forward on the increased “fragmentation” in the Eurozone where market participants increasingly focus on domestic rather than intra-European activities. While more needs to be done, other central bank activities under consideration would have amplified rather than reduced fragmentation, would have made the demise of the euro more likely. To address fragmentation issues, work on many fronts needs to take place. Market participants are doing their part by rewriting contracts to clearly state what law they are subject to in case a member country were to leave the Euro.
As such, we started buying the Euro again in our hard currency strategy. Make no mistake about it: we are only putting our foot in the water; we are not yet wholeheartedly embracing the Euro. But we are giving this new framework a chance, as we judge it to be the greatest progress in the Eurozone debt crisis we have seen to date. The coming months will show whether this is to be written off as a trading opportunity or whether it is the new strategic direction that it has the potential of being. Greece may still drop out of the Euro, but such an exit is much less of a threat to Eurozone and global financial stability than it was as recently as a week ago.
Given that currencies trade against one another, this analysis would not be complete without looking at the U.S. dollar. In the U.S., too, many pundits have been disappointed at the lack of action by the Fed. Indeed, we also think the Fed under Bernanke’s leadership is likely to provide more stimulus. But just as Draghi has presented a new philosophical framework for future action, Bernanke may feel he is obliged to provide a new framework for “QE3”. That’s because many have rightfully pointed out that any new action might have limited impact, yet risk ever more unintended consequences. The obvious opportunity that presents itself will be in Jackson Hole, where he will be speaking later this month. The Fed is focused on different issues, notably a sustained recovery after the housing bust. As such, the Fed – and we are putting words into Bernanke’s mouth here – may need to err on the side of inflation. No responsible central banker – never mind closet central banker and chief Keynesian cheerleader Paul Krugman – would ever openly advocate inflation. Let’s just say that Bernanke’s upcoming Jackson Hole speech should be interesting to watch.
For now, with the prospect of ECB action – even if with delays and no guarantee – a number of tail risks have been taken out of the Eurozone. In our assessment, that alone warrants a significantly stronger Euro versus the U.S. dollar. As we discussed, we believe there’s a new wind blowing in the Eurozone. That wind may well take the tailwind of recent months out of the U.S. dollar.
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President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds
This report was prepared by Merk Investments LLC, and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice.
Tags: August 7, Austerity Measures, Cost Of Borrowing, Debt Loads, Doubts, Ecb President, European Integration, Eurozone Countries, Fiscal And Monetary Policy, Fiscal Policy, Genius, Hard Currency, Initial Market, Minefields, Nibble, Seismic Changes, Speculators, United States Of Europe, Winning The War, Worst Case Scenarios
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Friday, February 3rd, 2012
What will happen if the euro collapses? For many people, the answer is unmitigated disaster. But this column argues that to identify the euro, the EU, and Europe as one, as many politicians like to do, is totally misleading. A possible demise of the euro and the EU can be seen as a chance for the evolution of a better future Europe.
Politicians devoted to the European cause are fond of proclaiming: “If the euro falls, the EU falls, and then falls Europe”. The German Chancellor Angela Merkel keeps repeating this statement. This is an example of what Carmassi and Micossi (2010) call “careless statements”.
The major problem is that people do not see any alternative to the presently enacted European unification. The Europe-minded politicians even insist that, if the euro and the EU collapse, complete chaos will break out. The European continent will go back to the situation before World War II. The various nations will isolate themselves economically, and they will even start to fight each other. A war within the core of Europe, in particular between France and Germany, is taken to be a real possibility lurking in the background.
This view disregards the fact that the European unification process was made possible only because Germany and France stopped considering each other as enemies. They then saw themselves as the ‘motor’ of the European integration process, which started with the establishment of an economic union and then expanded to the political sphere. It is certainly wrong to think that the only thing that was needed to bring peace to Europe was a formal international treaty.
The claim that the downfall of the euro and the EU would produce chaos and war may be interpreted to be just a strategy necessary to get support for helping the highly indebted nations such as Greece, Portugal, Spain, or Italy with ever more financial support. However, conversations I have had with persons from various European countries suggest that many people really believe that Europe will disintegrate and that wars are looming if the EU dissolves. I hold this view to be seriously mistaken.
The euro, the EU, and Europe are far from being identical. Some important countries are members of the EU but kept their own currency (such as the UK, Sweden, or Denmark). In contrast, there are some non-EU countries (such as Switzerland) that are nevertheless members of certain European accords – in particular the Schengen Agreement and the various treaties in the area of scientific research. With respect to culture, science, sports and – above all – the economy, countries like Norway or Switzerland are without any doubt an integral part of Europe. To identify the euro, the EU, and Europe as one, as many politicians like to do, is totally misleading.
Even more important is the fear that a destruction of the euro and the EU would lead to a catastrophe pushing all European nations into an abyss. However, no chaos leading to an economic and political collapse of Europe is to be expected. Such a view is far too pessimistic.
The individual countries in Europe will quickly form new treaties among themselves. Collaboration will be maintained in all those areas where it has worked well. Some countries will remain in a newly formed and smaller Eurozone, for which the appropriate treaties will be designed. A similar reconstitution will take place with respect to Schengen, which will then encompass different members. Only those countries that find it advantageous will join a new convention on the free movement of persons. In contrast, those nations that do not find such new treaties attractive, or that are not admitted to them by the other members, will not join.
The result will be a net of overlapping contracts between countries, which the various nations will join at will. These contracts will not be based on a vague notion of what ‘’Europe’ may mean, but rather on functional efficiency. Crucially, the individual treaties will be stable because they will be in the interest of each member.
This concept has been called FOCJ, following the initials of its constitutive characteristics: Functional, Overlapping, Competing Jurisdictions (Frey and Eichenberger 1999). The term ‘functional’ is to be interpreted in a broad, non-technocratic way. The functions should be designed so as to strengthen the citizens’ involvement and commitment to specific public activities. Thus, for example, citizens’ intrinsic motivation to protect the natural environment should be reflected in jurisdictions catering for these preferences. Similarly, FOCJ should be designed to fulfil citizens’ conceptions of fairness.
A new formation of European cooperation may well happen along these lines, in particular because the EU is already partly organized in functional units. It is most likely that all the present members of the EU will participate in a free trade area since this has proved to be very productive. On the other hand, the democratic deficit of the EU, which is epitomised by the Commission, will be counteracted. Similarly, the ever-growing bureaucratic apparatus in Brussels is likely to be substituted by more flexible institutions and more democratic decision-making mechanisms.
Some might consider such a flexible net of contracts and jurisdictions to be too complicated and cumbersome, and therefore undesirable. But this is only at first sight. The essence of ‘Europe’ is variety and diversity rather than étatisme and bureaucracy. A net of contracts of which each one serves a particular functional purpose is open to all countries at the border of Europe and beyond. Thus, for example, Turkey could participate in contracts with an economic orientation and would in that role certainly be welcomed by the other European nations. At the same time, it might be excluded from political contracts if the other European members feel that Turkey does not (yet) fulfil the necessary requirements with respect to human rights. This allows for blurred distinctions: Turkey would be part of Europe in some respects, but not in others. This exactly mirrors reality, the only distinction being that the existing EU does not include Turkey but is entangled in what one might call a stalemate.
An association of European states using flexible and overlapping contracts based on functions can be considered desirable as the existing problems would be efficiently addressed while the essence of Europe would be strengthened. A possible demise of the euro and the EU can be seen as a chance for the evolution of a better future Europe.
Tags: Angela Merkel, Bruno S Frey, Chancellor Angela Merkel, Collapse, Demise, Downfall, Economic Union, Economics University, Enemies, European Continent, European Integration, Frey Professor, German Chancellor Angela Merkel, Indebted Nations, Minded Politicians, Political Sphere, Portugal Spain, Unification, University Of Zurich, World War Ii
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Tuesday, December 6th, 2011
December 5, 2011
A Sharp Rally for Stocks
After two weeks of disappointing economic and policy news that drove stock prices sharply lower, stocks witnessed a strong reversal last week. The main catalyst for the rally was a global coordinated central bank policy action designed to help banking liquidity, but markets also benefited from some improved economic data. For the week, the Dow Jones Industrial Average jumped 7.0% to 12,019, the S&P 500 Index rose 7.4% to 1,244 and the Nasdaq Composite advanced 7.6% to 2,626.
Central Bank Action a Positive, but More Is Still Needed
Last week’s market action centered on the US Federal Reserve’s and other central banks’ announcement that they would provide coordinated action to boost the liquidity of the financial system by reducing dollar borrowing costs from foreign central banks by between 50 and 100 basis points. The central bank actions are clearly a positive in terms of investor sentiment and will be helpful from a practical basis regarding expanding liquidity. Importantly, the move does underscore the willingness of the Fed and other central banks to support the global banking system.
The moves by the central banks, however, do not address the root causes of the European debt crisis. On that point, Germany’s chancellor Angela Merkel and French president Nicolas Sarkozy have been pushing hard for increased European integration and more effective fiscal discipline. Should these efforts succeed, they would provide some reassurance to the policymakers at the European Central Bank (ECB) that the politicians are serious about establishing the fiscal measures the ECB believes are necessary, which could pave the way for additional ECB intervention in the market. Whether any of this comes about is, of course, still an open question since any proposed plan would need the backing of countries other than Germany and France, but it does appear that the parties are moving in the right direction.
Also on the global policy front, China announced last week that it would lower its bank reserve requirements. This likely represents the first in a round of reductions and should be stimulative for Chinese growth, helping reduce the probability of a hard landing.
US Economic Improvements Continue
In the United States, economic data continues to point to an acceleration in growth. November’s labor market report was a solid one, showing that jobs growth came in at 120,000 (with private payrolls increasing by 140,000). The data also showed some solid upward revisions to October and September jobs growth. At the same time, unemployment fell noticeably in November, although it remains uncomfortably high at 8.6%. In addition to the labor market data, consumer confidence measures moved higher for November, which is a reflection of improved economic activity on a number of fronts.
In addition to the solid economic data, there have also been some signs of progress on the political front. It is still much too early to say for sure, but signs are emerging that politicians may be able to come together to enact an extension of the payroll tax cut (and possibly unemployment benefits) that are set to expire on December 31. Should these extensions not occur, they would cause a fiscal headwind in the first part of 2012.
Outlook Still Mixed, but Slowly Improving
Although last week’s news was positive (and investors were certainly cheered by recent events) it is too early to declare any sort of victory and it is important to remember that the market gains that occurred last week did not match the losses of the previous two weeks. In any case, however, it does appear that conditions are continuing to improve. The coordinated rate action and continued easy availability of money should ease some of the world’s debt burdens. On the economic front, we are expecting gross domestic product growth in the United States to increase to at least 3% in the fourth quarter, which should provide further evidence that the macro backdrop is getting better. The main risk remains a potential Eurozone failure or breakup, but the odds of that occurring have been at least slightly reduced.
About Bob Doll
Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock’s Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.
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Tags: Angela Merkel, Central Banks, Chancellor Angela Merkel, Debt Crisis, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, European Integration, Fiscal Discipline, Fiscal Measures, French President Nicolas, French President Nicolas Sarkozy, Global Banking, Investor Sentiment, Nasdaq Composite, Nicolas Sarkozy, Open Question, President Nicolas Sarkozy, S Market
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