A True Test Of The European Vision

This weekend saw perhaps a pivotal moment in the development of the EU and Europe as a whole. As the economic crisis shifts from the US to Europe and especially Eastern Europe true stress testing of the larger European vision is happening for the first time.

With regards to Eastern Europe, these countries face ongoing pressure on their currencies and issues in their economies that may require substantial support. Within the core of the EU and the euro zone similar issues are starting to show. Weaker euro zone economies such as Greece and Ireland are starting to show stress in the premiums demanded on their government bonds versus those of stronger members such as Germany.

Unfortunately Europe has so far not shown what is needed to solve these problems. Their refusal to overtly support Eastern Europe this weekend may in retrospect be seen as a costly mistake, especially given the exposure of Western European banks to the region.

Within the euro zone itself countries seeing issues such as Ireland, with a potential banking issue several times its GDP, appear somewhat protected at first glance. They cannot see a run on their currency as would normally happen. On the other hand they cannot devalue their currency to drive economic growth.  Absent a euro wide stimulus, or a willingness to drop rates to zero which the ECB seems loathed to do, their recession may well be longer and harder than needed. Perhaps a bigger issue is what would happen if a member state went into default. This is a stress test case that the euro zone is not immediately equipped to deal with, though it seems certain that the stronger states would step in to support the buying of the weaker states debt. This however may not be an easy sell to the voters back at home in Germany or France.

Ironically the biggest winner from this confusion may be the USA. We have seen a major strengthening in the value of the dollar versus many other reserve currencies, even though we have seen interest rates hit zero here first. Driving this is a flight to safety and an aversion to risk. The dollar is always a safe haven, but right now the predictability of the US, the structure of it institutions and its scale make this even more so.

As an investor, the working of the Fed in managing the money supply and interest rates, and the Treasury in managing the issuance of government debt is clear. In addition the framework for bank regulation while not perfect is defined. In the euro zone while interest rate policy may reside with the ECB, debt issuance and bank regulation is done by the member states. In fact a whole host of economic policy issues are spread between the central bank and the member states. This worked fine during the boom years, but the cracks start to show when issues hit, especially of the magnitude we are seeing now.

In some ways this crisis may accelerate the tighter integration and passing of responsibilities to a European level that has been so hotly debated for some time across the EU. This will be necessary if the EU is to ever truly rival the US, or the other large and upcoming economies such as China or India.