Nein, nein, nein

Next time Henry Kissinger asks whom to call if he wants to speak to Europe, the answer will be obvious:
Henry, just call Angela.

The Greeks can be forgiven for not having seen the memo.
Germany had been very restrained until now.
But, with the sovereign crisis, all that is rapidly changing.
The tide is retreating and those who were swimming naked are exposed.
Germany will make sure everyone wears the proper uniform from now on.
Or else, they’ll have to find another beach.

Yet, who can blame the Germans?
Their intentions were always clear.
Neither should they be blamed for Europe’s seemingly slow response to the crisis. A quick fix is not the goal here.
Angela Merkel wants to methodically address a fundamental problem.

At first, she used Germany’s deep pockets to calm the markets and stop the panic. A domino effect had to be prevented.
Next, she insisted on draconian reforms from the profligate countries as a condition for help. In the process she made it clear that monetizing the debt was off the table. Finally, appalled by the US bailouts, she made sure to address the moral hazard. This time, those who fed the beast were going to pay for their greed.

Greece – and Italy – tried to soften their austerity packages.
France tried to monetize the debt through a new bailout bank.
Some countries wanted to create a European bond market guaranteed by all members.
Banks tried to avoid or limit a haircut on their exposure to Greek sovereign debt.
All to no avail.
Germany would have none of it.

Germans do not do quick fixes.
They make long-term decisions and then stick to the new orthodoxy.
Ten years ago, for example, they decided on a number of reforms that resulted in lowering unit labor cost by 25% over the ensuing decade.
Economic growth suffered, but they kept at it.
Greece and the other Club Med countries, in the meantime, were enjoying the good years. So, while Germany worked hard at becoming more competitive, unit labor cost kept going up in southern Europe. Over ten years, it increased 60% in Greece, 25% in Italy and 20% in Spain.
It stayed flat in France.

The message is clear.
Germany is forcing everyone else in the monetary union to reform.
Austerity is here to stay until major adjustments are made.
So what if it pushes Europe into a recession?
Short term pain is needed for long term gain.

Unfortunately, Europe’s imposed fiscal discipline comes at a bad time.
Already, all signs are pointing to a recession on the Old Continent.
The new measures make it now a near certainty.
The question for investors is no longer whether, but for how long and how deep will the down cycle be?

It could be short and brutal.
The Baltic countries, for example, took a bitter pill, experienced a double-digit GDP shrinkage and then came back with a vengeance.
In Ireland, unit labor cost has also been drastically cut by 35% from its 1999 level.
But the recession could also be long and shallow.
It is difficult to imagine Southern European politicians taking the same kind of drastic measures.
Japan could be a more appropriate model here.

Anyway, austerity in Euroland has only just begun.
Fiscal tightening hurts socialist economies disproportionally because of the preeminence of the public sector.
The forced recapitalization of the banks means that less money will find its way into the economy.

Germany is winning the tug-of-war.
Angela Merkel will get reelected.
And France will harmonize its fiscal policies (a euphemism for tax hikes) with their Teutonic friends.

From a German point of view, the only negative note comes from the CDS market.
By destroying their values through “voluntary” haircuts, Europe may have bailed out the issuers of these instruments of mass destruction.
Could it be that Goldman Sachs got bailed out by the politicians again?
Time will tell.

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