I am afraid the worst case path for the EZ crisis, in terms of possible pathways I considered and outlines last September, is occuring.
1. The EZ is entering into a general slump, at least as most describe it – a “recession” but what is most ominous is the recent German factory orders announced Friday the 6th:
“[German] Industrial orders dropped 4.8 percent month-on-month, reversing October's 5 percent growth, figures published by the Federal Ministry of Economy and Technology showed on Friday. The decline far exceeded the 1.8 percent fall forecast by economists…”
This is most serious considering that highly engineered exports are the heart of the German economy. What is strange is that most pundits are using descriptors like “soft patch” or “slowdown” , though I suspect this is the beginning of a calamity.
Germany is the cause of the EZ debt crisis as their intra-EZ anticompetitive policy (wage pact and subsidized industry in zaibatsu like structures) has established a significant intra-EZ trade imbalance in Germany’s favor which is mercantilist in characteristics. Germany has made the PIIGS their effective economic colonies. Imbalances imposed, especially to the weaker and smaller PIIGS, are not able (nay, allowed) to be corrected but for severe unemployment adjustments and austerity. Being basically a mercantilist construct, these imbalance adjustments in the end eliminates the export markets required by the German economic model. Therefore in lock step with the grief being felt by the PIIGS, as priced in sovereign debt and rising unemployment levels, the German economy is imploding.
Therefore the words “slowdown” and “soft patch” are optimistic and pan gloss as the common sense of trade accounting identities will show, the problems in the PIIGS will be visited upon the Germans. In short Germans are likely to enter a depression if austerity and unemployment is felt to be the only remedy available for the EZ – as Merkel, and to a lesser degree, Sarkozy are insisting upon.
If the “grand strategy” objective of the EU and EZ is to provide repair and then stability for the European economy post WW II and to subsume Germany to a greater sovereign egalitarian Europe – the risk of that “grand strategy” failing spectacularly is now high.
The EZ debt crisis remains endemic and chronic to where the point I made earlier about the frog’s willingness to stay in a pan of water over the stove burner as long as the water is only incrementally increased could not be more apt. The EZ frog’s water is about to hit boiling.
2. Yet the USA has decoupled from the EZ crisis so that tactically there is little if any risk of contagion from the EZ crisis or outcome to the USA economy. The Federal Reserve has done a magnificent job in providing this defense through a massive link of central bank cooperation, principally through reinstating and then activating the foreign exchange and foreign central bank swap lines as were utilized in the 2009 crisis. This time the swap lines are now aligned with significant resources from all non-EZ area central banks such as Japan, Canada and Switzerland. Private sector US financials have fairly well made themselves immune to EZ contagion from reduced exposure if not total elimination of any EZ area assets in money market funds to lending and securities and derivative holdings with EZ explicit or implicit exposure. Total immunization is not possible, of course, but given the Federal Reserve actions taken above there should be minimal impact from any EZ problems. I do not think there is systemic financial risk for the USA from Europe.
Furthermore the USA is entering a robust resumption of trend economic growth that is likely now exceeding potential. Unemployment has been showing this turn since early summer 2010 in the household survey data which leads establishment survey data at this point in the US economic cycle. The administration is righteously stating 1.9 MM jobs were created in 2010, which was not noticed by most Street folks and professional economists as it was masked in the headline number with returning job seekers to the labor pool – this is why the headline number stands at “only” 8.5% while the 1.9 MM is about 1 ½% improvement on a gross basis (meaning the unemployment rate if the labor pool stayed unchanged would have a 7% handle now). I didn’t realize we were in a full recovery until October. This likely assures the Obama re-election. Various financial markets in the US are starting to leave their obsession with the EZ crisis and as the markets come to understand the US recovery and economic vigor and the bulwark of defense, they are starting and will price in a general recovery and then trend growth. Nominal pricing of USA risk free bonds will take a tumble but “real” pricing will likely maintain stability given the actions taken by the Federal Reserve and equity markets should have large returns for 2011. This may cause problems in the hedge fund and risks taking financial communities as most are positioned for the opposite outcome. I do not think even the more astute hedge funds and risk managers understand the scaling and size of the USA in relationship to the rest of the world and they do not understand the efficacy of the Federal Reserve.
The above is becoming a very bullish environment for the USA current political and financial markets and returning the USA to a normalized economy without subsidizing or expending political capital on the EZ crisis. But I am afraid that the current more positive USA economy and environment is actually allowing a dangerous “America First” like mentality, a dangerous withdrawal from the European political sphere at a critical time.
It seems support for the technocratic “muddle through” approach to the EZ crisis is the adopted US policy and given the above results in the USA – it would seem to be the right approach, especially for your Client. And with only a one horizon to the election that may in fact be the optimal approach in terms of political expediency. But I suspect it will be in the end leading to a disaster and possibly a costly error, not in terms of financial markets or the economy but in terms of providing cost efficient security for the US.
3. The recently announced RIF, approaching 500 billion reduction, is a most serious “new” factor for the above points. The market has not even begun to appreciate the positive impact of the RIF. The last time we had a strategic RIF, the period from post Desert Storm 1992 to 2001, the US went from a chronic deficit posture to where we had a surpluses and even were then discussing the dangers of not having enough US Treasury debt. The US “long bond” was eliminated (since reinstated of course) and real yields were at record lows. There was a lot of flash and hype on the internet but the stock markets and basically all financial markets enjoyed a strong bull market from 1994 to 2001. The internet “bubble” was an overextension of this bull market, but the very presence of Google and the likes today show it was not a bubble in reality. To my view the main change post 2001 was reversing the RIF and going to a war footing post 9/11, not the internet bubble crash. Now we are returning to RIF and as it was in the beginning of the Bosnia conflict (remember Rebecca West’s “Black Lamb and Grey Falcon” fears on how Yugoslavia tied down 40 German divisions in WW II?) there is skepticism that the USA can still present security and implement a RIF. Of course I do not have to recite why I think the USA can implement RIF to you, but there is one difference that does challenge the ability of the USA to implement a RIF versus the 1990s.
4. Since the USA is avoiding any persuasion to the EZ but for current efforts and that the USA indicates it will not take actions beyond supporting “muddle through”, and given that the EZ leadership are showing a complete inability to leave parochial politics and provide a suitable remedy to the crisis for all EZ people, then the EZ will likely crash. It seems the administration is gambling that the EZ crashes after the election and not before.
5. When the EZ crashes it will enter a long and bitter reconstruction phase which will mean the sole available remedy, a federation of the EZ sovereign states to one sovereign entity, will be a long time in the coming post-crash. In this eventuality, the US will find it impossible to implement the planned RIF if any reasonable security is expected.
Only a federal EZ can ever provide either a suitable hard power ally of the USA or that would allow a setting for US hard power projection. The “pity” is that hindsight will likely conclude that the long torturous route post-crash to reach the necessary federal Europe could be achieved in principle in one weekend now if the USA would expend political capital and insist upon this outcome.
6. The EZ crisis was always, given the history of the EZ and the motive for its creation sponsored and encouraged and even “permissioned” by the USA, about security. The EZ was always about security for Europeans and security for the USA. Therefore it is the security of the USA at stake in the EZ crisis, not financial or economic considerations. The only way to approach the EZ crisis and reach prescience and also to design a robust solution that is in accord with US values is to approach the EZ crisis as a constitutional crisis.
“We are led, by events and common sense, to one conclusion: The survival of liberty in our land increasingly depends on the success of liberty in other lands. The best hope for peace in our world is the expansion of freedom in all the world. “
While most are using the “Bush Doctrine” in reference to the current event s in the Arab world and North Africa, I think the most important implications of those words in terms of security for the USA is now to be found in Europe, specifically the current tolerance the USA shows for the undemocratic authoritarian technocratic “muddle through” policy now being applied to Europe is not aligned with US values. While the USA pursuing of a “Bush Doctrine” for Europe may not be feasible at this point from any short term consideration for political reality, plans should be made now for a most intense diplomatic and even covert campaign to prompt the EZ to form a democratic federal union and not permit the current technocratic confederation or the authoritarian plutocracy Europe seems headed towards. There are excellent chances that the EZ crashes before November 2012, but with some luck it does not and then after the election the USA can then turn and prompt the EZ towards federal Union – it will not happen any other way. It is clear to me that only the USA can evoke a democratic federal EZ being formed. Be best if it were now, but it seems that is not to be.
With luck the EZ will not blow prior to the election. But I think it is very likely that the first two quarters 2012 will be dramatically fast paced as US withdrawal from the EZ becomes understood and Europeans will take defensive actions, civil disobedience will rise, likely exponentially, and extreme financial stress that would take a weekend now to remedy will take decades to mend. As is now it is difficult for the US to implement the RIF and to look to Europe as a reasonable partner in international security. Where EZ is headed and if it enters a catastrophe the US will find it impossible to implement a RIF and in fact will likely have to greatly increase security expenditure in Europe.
It should be noted the situation in Hungary and the Ukraine and the inability for the EU to provide suasion or an answer or apply leverage. They are powerless. To my mind both the situation in Hungary and that in the Ukraine are like developments from the press of the 1920s.
I wonder if the USA has made Europe aware of what form the EZ should be in that would be most welcome to the USA. Has that been unambiguously relayed to the Europeans? Is there a form the EZ should take that is agreed to be optimal by US policy makers? To date all I have read is the USA mentioning rather technical details about TARP like financing and the EZ crisis should be solved and so on and so forth – basically trivialities and details - but without the USA giving any mention as to what form or shape the EZ might change towards or should seek. Is the USA comfortable with the unelected technical rule of Italy? Or the technical rule for Greece? Why is Sec Geithner leading this dialogue and not Sec Clinton if the EZ is in fact a national security issue? To my mind and given the above points, if valid, this use of Treasury versus State and your Agency might indicate the administration does not understand the nature of the problem. If the EZ crashes before the election, more will start to ask this question as the consequences for US security become clear and as the US shows it is basically free from financial contagion. “Where was Sec Clinton prior to the crash?”, will be asked. “Why did the US allow this?” , will be asked.
Everything I read and observe leads me to believe the current time is very similar to that prior to WW I – a most dangerous era indeed. Europe is returning to dominate our security concerns, I am afraid.
The two most dangerous errors that I see being made now by our government and also by the majority of the world leadership and intelligentsia are first with the declinism thesis applied to the USA and second the belief that general war and the general deployment of “great power” hard power in symmetrical conflict is something that will never occur again. (Of course the belief that hard power is no longer a factor suits nicely the US declinism thesis.)
And the reality is that no time in the last century has ever been more like the time immediately prior to WW I – it is not identical of course but it resonates with many rhymes. This is why Europe counts and should take center stage, until the EZ crisis is ended, for USA national security strategic formulation.