Wednesday, November 23, 2011

The EU Sovereign Debt Crisis: Skipping a Few Dominos

A hooded figure of Death appeared at the Euro's door today, scythe in hand, beckoning insistently. Germany held an auction of 6 billion Euros worth of 10-year bonds (called "bunds") and sold only 60% of it. The German central bank, the Bundesbank, bought the rest. But that's like your right hand buying from your left hand. The German auction was catastrophically bad. And, who knows, the Federal Reserve may have contributed to the shortfall, by subtly putting pressure on U.S. banks to trim their Euro-denominated exposure (see

By contrast, the U.S. Treasury Department today sold $29 billion of 7-year Treasury notes, receiving three times as much in bids as it was offering (or close to $100 billion in bids). Even though the U.S. may be approaching another credit rating downgrade, the greenback remains a sturdy oak in a forest of blighted trees.

That the German bund auction went so badly means the European sovereign debt crisis is fastfowarding more rapidly than anyone anticipated. Next to topple were supposed to be Italy, Spain, France, Belgium, and Austria. Then, the Netherlands, Finland and Luxembourg would be at risk. But Germany was seen as the last bastion of stability, the wealthy uncle who could save the family if disaster struck. Indeed, the latest concept being proposed for salvation, the Eurobond that was to be backed on the entire EU, would be feasible only if Germany's creditworthiness was beyond question. That's no longer true. If Germany can sell only 60% of a bund auction, how could the EU as a whole sell a Eurobond auction?

The sovereign debt crisis has skipped the intermediate dominos and smashed directly into Germany. The German government continues its opposition to Eurobonds. At this point, that may be irrelevant because the viability of the Eurobond has been called into question. One naturally asks what else might be on the table. That's the really scary part. There is no Plan B. Germany has always been the fallback, the backup, and the backup to the backup. After Germany there's no one, not the IMF, not America, not China, not Russia and not Brazil.

The EU sovereign debt crisis is now proceeding at warp speed. That doesn't mean collapse is imminent. Experience teaches that the financial markets hear what they want to hear and need only one or two rosy press releases from prominent government officials to stage a relief rally. Time and time again, that's the way the EU has kicked the can down the road and avoided the moment of truth. But the EU's principal tactic has been to substitute new debt for old debt, offering promises to replace the promises that this member nation or that couldn't keep. Actual transfers of wealth to reduce debt doesn't seem to be on the agenda. But this paper-for-paper game keeps expanding the amounts of debt outstanding, and investors will eventually tire of playing (as they did with the German bund auction today). When that happens, the Grim Reaper will be waiting to collect his due.

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