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Sunday, November 6, 2011

Europe at Crossroads: Part I

King Abdullah bin Abdul-Aziz Al Saud first gets tautological and then philosophical about women's right to drive (Oct 2005).

Barbara Walters: "Would you support allowing women to drive?"

His Excellency King Abdullah: "I believe strongly in the rights of women.  My mother is a woman.  My sister is a woman.  My daughter is a woman.  My wife is a woman.  I believe the day will come when women will drive.  In fact if you look at the areas of Saudi Arabia, the desert, and in the rural areas, you will find that women do drive.  The issue will require patience.  In time I believe that it will be possible.  I believe that patience is a virtue."

Yours, thinking about the European experiment analyst,


Fig. 1: Night Map of the European Peninsula

The last time when Europe was at crossroads it was the late 19th century.  At that time Europe was grappling with unstable power balances in South-Central Europe and the Balkan Peninsula brought about by the simultaneous decline of the Sick Man of Europe and the overflow of creative energies, ethno-linguistic political aspirations and military capabilities of the German speaking peoples under the leadership of Prussia.  It took Europe three wars (the Balkan War and the two world wars) before it could finally decide which turn it must take.

In my view Europe is at crossroads again.  Much has changed since the 19th century.  However just as it was back then, Germany continues to remain too small to allow for the complete expression of capital and creative surpluses of the German speaking peoples.  The European debt crisis is right in the fore.  But lurking behind the façade of a debt crisis are the same 150 year old risks to the natural and complete expression of the surpluses of the German speaking peoples – potential loss of cost effective and free access to raw materials, and to markets in Europe.  I will skirt the Q of war as a means of dispute resolution mechanism and instead focus on financial and geoeconomic solutions to the debt crisis.  The good thing about the crisis is that it is solvable.  By solvable I mean it is within Europe's ability to solve the problem on its own.  There are five principal, non-mutually exclusive solutions to the problem, some European, some that rely on external help:

1. ECB Bond Purchase: ECB significantly expands the purchase of bonds of troubled sovereigns and systematically important European FIs.
2. Austerity and Deflation in the Periphery: In the short-run, strong austerity measures, public sector pay cut and sharp reduction in capital spending in the short run.  In the medium-run, facilitating ECB oversight of the budgetary process, denationalization or Europeanization of national assets, significant improvement in tax collections and linking of public sector wage hikes and credit availability to productivity gain as determined by some central institution.
3. The Indian Way: Since 1947 India worked towards achieving a political union.  The goal was achieved at a significant economic cost.  The center instituted mechanisms for perpetual transfer of wealth from productive regions and productive peoples to those that were perennially inefficient.  Europe over a similar period instead walked the road of economic integration while leaving significant political differenced unresolved.  The Indian way is European core permanently subsidizing the periphery.
4. An IMF-led bailout
5. A China-led bailout

In this five-part note we look at each of these options, understand their implications, and examine the difficulties in their being exercised.  Here is the first part.  In Part II we look at austerity and deflation in the periphery.

Option 1: ECB Bond Purchase (aka, ECB provides liquidity)

a. Who does it cheer in the short run?  The equity markets, CDS purchasers, private bond holders, Belgium, Portugal, Italy, Greece, Spain, France, the UK and the US
b. Who does it offend?  Ireland, the Nordic countries and Germany

c. Who are neutral?  China, Russia, India

d. Likelihood of exercise in a meaningful quantum: nearly 0.

e. Why is the exercise of ‘Option 1’ unlikely? – Because Germany wouldn't have it that way.  The reason for that lies in why Germany started the EU project in the first place.  Germany brought the EU project to the forefront, again, after the Berlin Wall was brought down [1].  To the Germans, this made perfect sense.  If Germany were to succeed (i) trade barriers would fall allowing her cost efficient and secure access to raw materials [2]; (ii) barrier-free access to a large market would make Germany’s continual investment in high technology affordable, allowing her to continue to maintain its high-tech edge; (iii) Germany would deploy its surplus capital in productive endeavors in nation states in the geographic and cultural vicinity as opposed to, say, in China, India or South America; (iv) nationalism in Europe  would wane with the rise of the notion of a common economic destiny (in the late 19th and early 20th centuries raucous expressions of the idea of nationalism caused internecine wars that culminated into the demise of European colonialism); (v) with the wane of nationalism, Germany could take a serious stab at reconstructing the European states from their current religio-linguistic basis into a law-based society – a change as transformational as the metamorphosis of a caterpillar into a butterfly.

f. What happens if ECB significantly expands its bond purchase program?
Ø  inflation in the EMU

Ø  moral hazard – the ones with  irresponsible credit behavior are left off hook and those that behaved responsibly are left to pick the tab 

Ø  Having barrier-free access to a large market benefits Germany only if such a market becomes self-sustaining.  No one wants to have access to a large market which one must also fund in perpetuity.

Ø  German nationalism is stoked. 

Ø  The fire of German nationalism will reduce the goal of German elites’ to transform Europe into a law-based society to cinders.

Ø  It will beget nationalistic feelings elsewhere in Europe, leading to resurrection of unions inspired by nationalism causing a reversal of intra-European free trade.

[1] The European dream is the manifestation of release of latent energies of the Germanic peoples following the collapse of the Holy Roman Empire in the early 19th century.
[2] secure from the vagaries of nationalistic jostling of the various European national states