Europe’s deteriorating demographic and pension situation alone means that Europe’s governments do need to contemplate serious pension reform. Or, failing that, to open their borders to workers from all horizons in order to keep expanding the tax-paying, pension- contributing workforce. Needless to say, neither of these options is very enticing politically. As such, rather than convince millions of pensioners to cut their benefits, or work longer, Europe’s politicians may be tempted to try and convince a small minority of central bankers sitting in Frankfurt to massively ease monetary policy and print a bunch of money to help the governments meet their liabilities.

In essence, the scenario we are painting is a simple one: the credit crunch which has thus far mostly only engulfed the US is starting to make its way into Europe. And soon enough, Europe’s banks will likely be reporting losses and write-downs, and investors will flee to the safety of the highest government bond paper. Unfortunately for Italy, Greece, Belgium or Portugal, their paper does not qualify as “high quality”.

Now as we highlighted earlier in this book, a credit crunch typically invites a “three-step” plan policy response. First, one collapses the currency (to make one’s assets and goods more attractive to foreign capital and invite inward capital flows). Secondly, one needs to see the banks recapitalized (if the market can not do it, then the banks need to be nationalized). Thirdly, one puts in place a very steep yield curve in order to force the banks to start lending again and the private sector to take risk.

It is obvious today that this course of action is very much the preferred path of, for example, President Sarkozy. Hardly a day goes by without the French President taking the ECB to task for doing so little to help Europe’s liquidity crunch. But each time he does, his comments are increasingly met by responses from Angela Merkel, the German Chancellor, for whom the independence of the ECB is sacrosanct.

The possibility of a massive easing from the ECB is nonetheless an interesting one and raises the question of how the market will respond to a more activist ECB. Would an ECB that did the bidding of politicians be seen as less of a Bundesbank and more of a Bank of Italy/Banque de France? And if so, would long bond yields across Europe be below 4% and the Euro at 1.55/US$? Would the foreign central banks that have been piling into European government paper remain keen to finance Europe’s welfare states?

Another question, of course, is what would happen in the event of a bank bankruptcy in Europe? Would the ECB bail out the failing bank? Would the government of a failing bank be allowed to bend the EU’s competition rules and nationalize the troubled financial institution? These are all questions with answers that remain unclear.

Of course, there is another way to go about dealing with a credit crunch: bitter infighting. This is what Japan did throughout the 1990s when the MoF would tell the BoJ that massive monetary easing was needed, only for the BoJ to turn around and say that the MoF needed to stop financing the construction of bridges that went from nowhere to nowhere. And as the infighting ensued, the Japanese banking system wrote off its entire capital base not once, but twice, over the course of the decade. Meanwhile investors shied away from all asset classes save the highest quality government bonds.

Could the same thing unfold in Europe? In Japan, there were only three sets of players (the BoJ, the MoF and the LDP) and over fifteen years, they could not seem to get the three-step plan (currency devaluation, bank recap, steep yield curve) right. In that regards, when considering the numbers of players involved in Europe, one may fear that the same policy paralysis could easily grip Europe. And, in this case, the recent break-out in the spreads that has now started will prove to have marked the start of a revolutionary trend for our financial markets: the end of the convergence trades and the start of the divergence trades.

A few years before his death, Professor Milton Friedman declared: “It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart.” Today, one should question whether the “real bump” is being hit and whether Milton Friedman will end up being proven right. But regardless of where one falls on the answers to these questions, one thing is sure: selling the bonds of Europe’s weakest signatures and buying protection on Europe’s weaker banks continues to make sense. It is some of the cheapest protection available against what remains a massive “fat- tail” risk to our financial systems. That’s why we love this trade so much: the potential rewards are huge and the upfront costs still marginal. More importantly, it is a very good hedge against what would be a nightmare scenario for many financial institutions.

A Final Thought

In the next chapter of A Roadmap for Troubled Times, Louis goes into detail into how Italy might be the country to push the European Central Bank to take steps it might not otherwise want to take. Again, I strongly suggest you get the book. It is very thought-provoking and one of the better reads that I have had this year.

Source: The Change In Policy…The Divergence in European Spreads - Why Now?

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