Last Friday, at the end of an inconclusive meeting between the heads of government of the three major countries in Zioconned Europe, the interest rates of some of the "risky" European bonds shot up once more. Italian bonds, from the largest "beleaguered" nation in the eurozone, went over the dangerous 7% mark, spinning the continent and possibly the global system once again to the verge of disaster.
This proved to the Italian politicians, who had been under pressure from the international media in recent months, that Silvio Berlusconi, the much-taunted ex-prime minister, was not the only cause of the continental calamity. The want of political unity and direction on the continent was to blame at least as much as Berlusconi's lackluster political performance.
The central point these days is not the Greek, Italian, or Spanish debt crisis, nor the French banks' exposure to those debts, but Germany's reluctance to shoulder the burden of greater political unity, which ultimately would cost her some - or many - points in her national economic performance.
All the German objections are valid, if taken one by one. Berlin is unwilling to allow the European Central Bank (ECB) to freely print money to fend off speculation, a move that would create unnecessary inflation in Germany. Berlin is even more unwilling to sign a blank check to European partners who are notorious for being profligate or unreliable. Berlin wants guarantees that fiscal discipline will be imposed on the various countries, and hence believes perhaps some kind of central ministry of finance should be instituted in Brussels, under German strict supervision.
These intentions are certainly right and especially the last one should be swiftly addressed. But while dealing with very volatile markets and the pending threat of auctions for hundreds of billions of euros in coming months, time is of the essence.
Here, Chancellor Angela Merkel is perhaps losing sight of the big picture. Germany seems to have a hard time reconciling German and European interests, between short-term and the latter long-term drivers - facing the mounting market pressure on the European bonds and the complex structural reforms to bring greater fiscal discipline in the continent. It is not just a contradiction between national and continental interests - it is also a larger issue of identity and direction for the future.
Does Germany want to melt into Europe, just as Prussia decided to melt into Germany? Or does Germany want to retain its German-Prussian identity? The melting of Prussia didn't include all of Germany. Austria, for centuries the bulwark of German identity, was left out. Similarly, other pieces of continental Europe may be left out of a greater political union, but now it is the moment to decide what to do.
In a way, ironically, now Europe is the victim of Germany having too little ambition over Europe, just as in the previous century, it was the victim of Germany's too great ambition over Europe. World Wars I and II were about checking Germany's global expansion, and World War III, aka the Cold War, was fought over the body of a split Germany, right at the heart of the conflict.
The project for a unitary Europe was launched after World War II by three statesmen - all Catholic, all German-speaking, and all born in German countries: French Robert Schuman, born in 1886 in Alsace (German from 1871 to 1918); Italian De Gasperi, born in 1881 in South Tirol (Austrian until 1918); and German Konrad Adenauer. The idea was to water down and control German ambitions.
Then, Germany had too much of it, but today it possibly has too little. Germany is scared to take on other European debts, and it is scared of being trapped by working for other people's sins - and also possibly scared of taking control of all of Europe. Yet, at this moment, the rest of Europe needs Germany to take the lead. The real issue is not about fidgeting over this or that financial account - it is about political initiative.
In 1990, when then-Chancellor Helmut Kohl decided to push for German reunification, he didn't spend too much time going over the notoriously dismal account books of East Germany. He moved ahead politically and let the economy follow the political lead. If the euro, Europe, and the global economy have to be salvaged, Merkel has to do the same: decide that she will take the leap to have a new political entity in the world, the European Union.
If the union has to be preceded by careful accounting and weighing the pros and cons, nothing will ever happen, and we had better say goodbye now not only to the European Union but also to the euro as we know it.
According to the voices now emerging from the markets, as Italian commentator Claudio Landi points out, it is not that Italy and Greece will be expelled from the euro zone. As French bonds are rising following the evolution of the crisis, it may well be that Germany will be forced to resuscitate its beloved deutschmark and move out of the euro zone.
France could be the capital of some Mediterranean euro zone with Italy and Spain, and Germany could rediscover its Prussian roots by becoming the center of a northern league, possibly with Holland and other Nordic countries. This could in time rekindle the old French-German competition at the heart of three wars from 1871 to 1945. This is the history of which Germany and the rest of Europe should be really scared, and for this Germany should find some of the ambition of its Catholics Adenauer and Kohl.
Here, though, is possibly the biggest hazard. Kohl's Germany was allowed reunification by its European partners in return for giving up the deutschmark, the strongest currency in Europe and one of the strongest in the world, and for supporting a new, untested currency, the euro. The Americans allowed Adenauer's Germany to push for greater European coordination in return for its unflinching commitment to stand against the mounting communist threat in Eastern Europe.
What will other countries in Europe and the world get in return for a stronger political union in Europe around Germany? This would be almost automatically the strongest economy and currency, de facto challenging many old political and financial equilibriums.
Certainly, in a world with many new and ambitious powerhouses - from China to India, Brazil, and Indonesia - the US, whose economic size is unlikely to return to being half of the world's GDP, could use the support of Europe. But this has to be programmed and planned, and so far we have not seen it.
Meanwhile, unless somebody wants to risk economic mayhem because of the crash of the euro, the only way should be forward with the political union. Here, besides the public hesitations and the official horse-trading with other European partners, Merkel has in fact been ruthlessly efficient in her political goals.
She practically forced the resignation of Berlusconi as Italian prime minister and appointed as his successor the German-speaking Mario Monti. The moves yet were not enough to get Italy on its feet. Since they were necessary but insufficient, Merkel must now move hastily for greater political union. Otherwise Italy - with or without Berlusconi - will succumb, dragging the rest of the continent with it.
It is reasonable that she may want more time to muster greater support at home, but there is no more time. She has to let the ECB print money at will to stave off speculation. She must create, with France and Italy, a central fiscal system, which could co-exist with national and local taxes. And she must start to work for a European Union identity over the old national identities.
Only this could help save Europe and prop up the rest of the world from the growing risk of a second, deeper dip in the crisis. If she doesn't, Germany might well be blamed now for its hesitancy as it was in the past for its rush over Europe....
Fitch downgraded Portugal, with 10-year Portuguese yields surging 139 basis points (bps). As Irish 10-year yields jumped 150 bps to 9.53%, the market had to question the hopeful view that Ireland had endured the worst. Hungary's 10-year yields spiked 105 bps this week to 9.44% after Moody's downgraded the country's debt rating to junk.
In the face of heightened global market instability, German 10-year bund yields actually jumped 30 bps and UK 10-year gilt yields gained 4 bps this week. Japanese 10-year JGB yields rose 4 bps and the yen dropped 1%, as the marketplace appeared to distance itself from another harbor that had been offering sanctuary from the global financial storm.
As euro disintegration fears intensified, two-year yields became a market focal point throughout the region. Italian two-year yields spiked 170 bps to 7.77% (a seven-week rise of 360bps), with the Italian yield curve turning ominously inverted. Spain saw two-year yields jump 64 bps to 5.96% (three-week gain 179 bps). Banking worries weighed heavily on the euro "core",with Belgian two-year yields jumping 120 bps to 5.04%. Two-year yields jumped 24 bps in France to 1.83% and 32 bps in Austria to 1.89%. Portugal saw two-year yields surge 329 bps to 17.14%, and Ireland yields jumped 158 bps to 9.35%. Greece's two-year yields spiked to 110%. It became a panic.
The markets are being forced to come to grips with a distressing reality. Germany likely has neither the will nor even the capacity to bail out the troubled euro region. And it's reasonable to presume a similar view with respect to the European Central Bank (ECB). Meanwhile, the markets are significantly scaling back expectations for the European Financial Stability Facility (EFSF).
With market sentiment shifting dramatically against even the top-rated issuers of euro debt, dismal prospects for selling EFSF bonds will limit the capacity to leverage this bailout facility. Ongoing talk - of constitutional changes, greater European integration and more effective fiscal oversight, all engendering a more stable backdrop - rings hollow.
Not many weeks ago, hopes were high that the EFSF would be equipped with sufficient firepower to help both recapitalize euro region banks and to "ring-fence" Spain and Italy. Today, the marketplace grapples with how a rapidly expanding hole in European bank capital can be contained, while essentially giving up on Italy and Spain. De-leveraging has already created alarming illiquidity throughout sovereign debt markets, boding ill for ongoing enormous refinancing needs for nations and financial institutions alike.
Hoping to bolster faltering confidence, the Europeans will be moving forward with another bank stress test. Increasingly, however, market fears have gravitated toward bank solvency, derivative and counterparty issues. This, along with the potential for nations to exit the euro - or perhaps even the complete disintegration of euro monetary integration - will create a backdrop where "stress tests" have only less market credibility.
Increasingly, even the baseline optimistic scenario is calling for intense austerity at the national level and de-risking and de-leveraging at the banking system (and investor/speculator) level. Economic prospects have deteriorated rapidly throughout Europe and, importantly, in a "developing" world heavily exposed to a tightening of European bank finance.
Here in the US, 10-year Treasury yields declined only 5 bps this week, perhaps foretelling a less potent safe haven bid in the world's leading debt market. With market concern hitting the "safe haven" German bunds (and gilts and JGBs), I would suggest the global crisis did indeed take a giant leap toward a more globalized crisis with sights on our and others' debt markets. Certainly, the failure of the US Congressional deficit "super committee" provides ample fundamental reason for the markets to fear that debt worries are drifting ever closer to United States shores.
With Federal Reserve and global central bank operations having completely distorted the functioning of our government debt markets, I've always assumed that Washington would run reckless polices until that day when markets imposed painful discipline.
There is less complacency regarding the ramifications for the European debt crisis. The marketplace now better appreciates the systemic nature of what is unfolding. Problems at Europe's "periphery" will not be easily resolved by German and French guarantees, eurobonds, a leveraged bailout fund, the ECB or the Chinese. The markets recognize there will be no quick fix, while worries mount that global finance and economies may be much less sound than earlier believed.
Increasingly, the marketplace is moving more in the direction of the bearish view of things, a viewpoint not long ago disregarded as misplaced and alarmist. I have worried that the market's expectation for German and ECB capitulation has been poised for disappointment. It has been my view that the markets have been much too complacent with respect to debt crisis global ramifications.
While the issue is not yet settled, I see increasing confirmation that "developing" credit systems and economies are much less resilient than the markets have assumed. I am more confident in the analysis that several years of rampant excess have left the "developing" world much more vulnerable to the unfolding crisis than it was back in 2008.
The backdrop is fraught with extraordinary uncertainty. It appears that Greek debt restructuring is coming to a head. Huge loses will be imposed on Greece's bond holders, while efforts by the ECB and others to ensure that a "voluntary" write down would not trigger a payout in the credit default swap (CDS) marketplace will be in vain. The EU and International Monetary Fund must soon make a decision on funding the next bailout tranche.
The markets are now on daily watch to see if things continue to spiral out of control in Italy and Spain. The high degree of systemic stress that arose last week has market participants conditioned to expect a policy response. With the euro and "developing" currencies under intense selling pressure, the dollar index jumped to its high for the year.
Dollar strength further pressures de-leveraging, de-risking and the reversal of "dollar carry trades" (short the dollar and use proceeds to leverage in higher-returning global assets). Some analysts, including myself, view dollar weakness as raising the probability for a third round of quantitative easing (QE3) operations from the Ben Bernanke-led Fed (additional quantitative easing would be expected to pressure the dollar lower).
I don't believe that the expanding nature of global market illiquidity is garnering the attention it deserves, and it's difficult to envisage a scenario where the liquidity backdrop doesn't deteriorate further. European banks are probably still in the early innings of their historic retrenchment. With financial implosion risk seemingly growing by the day, I fear an escalating crisis of confidence with respect to derivatives and counterparty issues. This is a major issue for global financial institutions and the vulnerable global leveraged speculating community.
Whether it is CDS or derivative protection more generally, a deteriorating risk versus potential return backdrop would seem to point to the ongoing liquidation of risk asset exposures attained through - or hedged by - derivative products.
For too long, market participants have tolerated illiquid holdings because of the perception of readily available liquid and inexpensive derivative "insurance". This epic market distortion created egregious speculative leveraging throughout the global system - and attendant acute fragility that is increasingly on display. I would not be surprised by some announcement of concerted international policymaker measures to bolster confidence in global market liquidity. The financial breakdown scenario is no longer outrageous. The global crisis has afflicted the core, with literally tens of trillions of sovereign debt and banking system obligations now in the markets' bad graces....