Evercore Pan Asset

I would like to write about something else, but once again we face a week-end dominated by news of hectic EU negotiations to try to fix the Euro.

So far I have been pessimistic. I have advised avoiding investment in Europe, and holding cash instead. Germany and France disagree about how to proceed. The sums of money that could have fixed Ireland, Greece and Portugal are nowhere near big enough to support Italy and Spain, should need arise. The July package of a solid €440 billion was not big enough then. It is now thought to be way too small even by the defenders of the Euro. That failure to agree is over how to stretch the €440 billion to the €2-3 trillion that we have regularly read from unofficial briefings they now think they need.

Why do they need so much? The main reason is Euroland governments spending far more than they can afford. They need to borrow large sums to cover their current bills, or in the case of Italy need to refinance large amounts of debt from past high spending. If they had faster growth they would raise more in tax revenues, which would help cut the debt requirement. Unfortunately, the Euro scheme does not allow them to devalue or to print more of their own money, and limits their ability to grow more quickly. Countries like Italy, Greece and Portugal cannot afford to pay high interest rates for their new borrowing. If they did the debt interest component of their spending would get out of control, making the deficits even worse. As a result Greece and Portugal now have subsidised loans from the IMF and EU. The European Central Bank is buying in large quantities of Italian debt to try to keep the interest rate down and the price of the bonds up, so the Italian state can continue to borrow more cheaply.

The second reason they need so much money is the state of the banks. Many EU banks have lent large sums to governments. Now there is open talk that Greece may default on her loans, paying back less than she borrowed. There is panic in markets about how much banks could lose. If the habit of default passed from Greece to other larger countries, the banks could lose very large sums indeed. The EU remedy for this part of the crisis is more capital for the banks. Whilst Germany expects the banks to raise this on the private market, or failing that to get it from their own governments, France thinks the EU should help bail out the banks from its funds.

Most now understand the precarious balance between weak banks and weak sovereigns. If the banks lose too much they need more money from governments that are already borrowing too much and cannot afford to help. If governments borrow too much from weak banks, and then threaten not to repay in full, they undermine the banks. The EU seems resolved on bank recapitalisation. This could have the perverse side effect of making more banks reluctant to lend more money. One way to improve a bank’s loans to capital ratio is to lend less. This would be far from helpful in trying to sustain and promote economic recovery.

There is talk today that there will need to be yet another summit next Wednesday, to sort out what has not been sorted out this week-end. We are due sometime another rally based on the hope that whatever the EU is promising might make some difference. It is difficult to see, however, how they can come up with a fix for all the problems. As they meet the interbank markets are badly damaged, banks are very reluctant to lend, and the yield on ten year Italian state bonds has almost reached 6% when the ECB has been trying to keep it down to near 5%. The underlying sovereign debt problem can only be solved by less spending or more revenue, not by more lending. That seems to produce riots on the streets and unhappy politicians. The underlying bank issues can only be solved by active support from the European Central Bank in the short term with longer term reform and capital raising. Little of this is in prospect.

The disagreements between France and Germany come down to a simple and big divide. France wants the EU to behave like a single country and to print, devalue and borrow as the US and UK do. Germany has no wish to underwrite the extra spending of certain members of the Eurozone and has a fear of inflation. She is not happy about the idea of a laxer monetary policy, with devaluation and more money printing. It is best to avoid European investments.