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The Eurozone crisis: not insoluble

The Eurozone crisis is a political mess that can only be solved by a political solution, which you don’t need a degree in politics to see is not proving easy, given the variety of interested parties involved – 17 eurozone member countries, 10 other EU member states and the governments of every other major economy on the planet also feeling the need to have their say. Much to the chargrin of some Eurozone leaders, voters too have to be consulted.

Given how many warnings there have been of the risk of a depression and financial meltdown if the Eurozone is not saved, the wonder is that financial markets have not been more affected than they have been by the failure so far to arrive at an agreed solution. The equity markets in particular have been surprisingly resilient. How can that be explained?

This is how one sensible wealth management firm, Saunderson House, is addressing the issue in its client comunications. Implicit in this view is that there will be an endgame in which the Eurozone survives, at least for now, without triggering an economic crisis, which must mean Germany eventually sanctioning some action by the European Central Bank once the various peripheral countries with the worst debt problems (Greece, italy, Spain) have their new governments in place.

My own view is that is still the most likely short term outcome, with further fragmentation to come in the longer haul. Were this to be way that things do play out, with so much bad news already in the price, there could be s strong equity market rally of the kind that often happens when the outlook appears impossibly bad. A lot of European equities do look cheap on a non-doomsday scenario.

Solutions exist, but they are not straightforward and not without cost. Hence, what we are witnessing is a process whereby economic reality is slowly dragging indebted nations and their would-be rescuers towards a solution. Politicians have to make unpopular choices and convince self-interested electorates that the chosen path really is the best one available. A quotation from American essayist H. L Mencken comes to mind, ‘For every complex problem there is an answer that is clear, simple and wrong’.

The ‘answer’ to the eurozone debt crisis is not simple. It will be arrived at when creditor nations, and the institutions involved (the EU, ECB and IMF), have extracted sufficient concessions from the debtor nations to enable them to justify the release of additional financing to their electorates, shareholders and stakeholders. Struggling peripheral nations will be forced to concede these concessions to the point at which they are just achievable and receive the (grudging) support of their electorates. Electorates on both sides will be put in no doubt of the dire financial consequences of not accepting the required concessions and that the deal ground out by the political process is the best, or least worst, available.

Evidence to support this view includes the following:

At the prospect of a referendum, which if lost would have resulted in a Greek exit from the eurozone, the Conservative opposition in Greece supported incumbent socialist prime minister Papandreou and passed the required austerity package. Greece has now installed a technocratic government under Lucas Papedemos to oversee implementation of the austerity package.

Faced with spiralling bond yields, the Italian parliament quickly passed emergency austerity measures by 156 votes to 12 to try to convince bond investors and European institutions that they can bring their public finances under control. Italian bond yields subsequently retreated. Prime Minister Berlusconi has since resigned to be replaced by Mario Monti, the ex-EU competition commissioner, who will head a government with cross party support in order to enact legislation to address Italy’s public sector finances.

France, at risk of being sucked into the vortex of rising sovereign bond yields and with its banks more exposed to the periphery than other eurozone members, announced additional budget cuts of €7bn for 2012, on top of the €12bn announced in August, in an attempt to bolster confidence in its public finances.

With regard to the would-be rescuers, German chancellor Angela Merkel gave a clear message about German commitment to the European project in a speech to her party conference on Monday. Standing in front of a banner that read, ‘For Europe, For Germany’ she said, “The task of our generation is to complete economic and monetary union and build political union in Europe… This does not mean less Europe, it means more Europe”.

With 60% of its exports going to other European nations, the impact on the German economy of a euro break-up and resulting currency revaluation is crystal clear to German politicians. It would lead not only to bank failures and financial turmoil, but the failure of many German exporters with the resultant impact on employment and prosperity. The task of German politicians is to ensure that their voters understand this too.

We conclude that it is in the interest of all parties for a solution to be found. Despite German reticence, such a solution is likely to include jointly guaranteed eurozone government bonds and an ECB with wider powers, including the ability to fully underwrite member government bond markets, if necessary. The solution may also include the Chinese, who look likely to offer financial assistance if a satisfactory structure to a further enlarged bailout fund can be found.

Thus the seemingly endless round of summits, rescue packages, adverse market reactions and subsequent recoveries are not evidence that a solution is impossible – simply that it is complex and must be achieved through a painful and repetitive political process. We are heartened that, despite the continued volatility, equity markets, supported by attractive valuations, are showing resilience through this process. We recommend that current allocations are maintained.

Written by Jonathan Davis

November 21, 2011 at 1:45 PM