Sunday, May 6, 2012

A Farewell to European Union

The stock market's penchant for taking the short term view has never been so evident as tonight, with Japanese stocks down over 2% and U.S. stock futures down around 1% following anti-austerity elections in France and Greece. These election results are hardly a surprise; they've been predicted for weeks. Yet, the market is acting like it is shocked--shocked--that electorates would put their personal well-being ahead of the bond market's interests.

The market, as it so often does, allowed itself to be lulled into complacency by the EU's bailouts, which were just kicks of the can down the road with maximum PR effort. Press release politics, it was, and the market took the press releases at face value.

But the problem with the EU sovereign debt crisis is that debt must ultimately be repaid. It can be repaid by debtor remittances to bond holders. Or it can be repaid by forcing bondholders to take partial losses, with debtors kicking in a few pennies for the sake of principle (or principal, if you will). And most typically for the EU, it can be repaid by rolling the debt over, with the help of bailouts from wealthier nations. The last was the EU's first choice, although Teutonic imposition of austerity policies was the EU's way of trying to make debtor nations share some of the burden.

Austerity by itself is likely to produce only economic deceleration. It reduces spending and therefore economic stimulus. The workable form of austerity--austerity along with currency devaluation--can work. It was a formula for recovery by various Asian nations following the 1997 financial crisis there, albeit with substantial short term pain. But Greece's and France's citizens aren't willing to bear the pain of austerity, and the ECB and Germany aren't willing to devalue the Euro. So the EU's brand of austerity isn't destined for success.

The absence of true political union within the EU made it too easy for member nations to ask, not what they could do for the EU, but what the EU could do for them. Europe's political leaders bear much responsibility, presenting the EU as an great opportunity, while downplaying the risks. If the EU were selling securities in the U.S., the SEC would have serious questions about the completeness of its disclosures.

A true currency union can't realistically be a goal by itself. It must be accompanied by true political union. Witness America's Civil War, which not only unified the United States. It also made the U.S. dollar America's sole currency, when federal legislation in 1863 taxing state issued currencies--and federal victory over the Confederacy two years later--effectively eliminated all competing legal tender.

But Europe is too diverse for true political union. Unity requires a willingness to share burdens, to pay an economic price so that political unity can be maintained. Europeans don't have enough in common to contemplate such generosity with any degree of equanimity. So the EU as it now exists cannot survive. Some nations will exit. Those sufficiently similar in outlook and economic strength may stay together in a smaller currency union. But the recent collapse of the Dutch government, due to the growing strength of the right in the Netherlands, raises doubts about the potential for even a smaller currency union.

In one sense, the Euro was part of Europe's effort to prevent another world war. Both world wars of the 20th Century imposed almost unimaginable costs on Europeans. Postwar leaders sought economic union in order to diminish national differences that had fostered the hostilities. But Europeans remain tribal, something that economic interests and market forces have not overcome. And European tribalism will take its toll on the financial markets.

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