BY JOHN MAULDIN
Italy has been all over the news lately.
But it is not Europe’s only problem. The big Kahuna is Germany, which spent years offering generous vendor financing to the rest of the continent to entice the purchase of German goods.
The result: a giant trade surplus for Germany and giant, unpayable debts for those who bought German goods. Greece, for instance.
But a lot of that debt is on the balance sheet of European banks. S&P just cut its rating for Deutsche Bank to BBB+. That is only a few notches above junk status. And if there were Italian issues?
A lot of German banks could see their ratings fall to below junk. Ugh. Will Germany let Deutsche Bank fail? Simple answer, no. But they may not feel the same love for Deutsche Bank shareholders.
Spain is not quite the basket case that Italy is, but its banks are certainly wobbly.
The UK is still winding its way down the Brexit path, which doesn’t directly affect the euro but is disruptive nonetheless.
All it takes is one of them to bring the whole structure down. That’s why we see market moves like Italian two-year bond yields zooming from below zero to almost 3% within days and then falling below 0.8% the next few days.
That’s some serious volatility.
That’s not normal and doesn’t happen in a monetary union in which all the members share the same goals. And that’s kind of the problem: European governments have irreconcilable interests and thus don’t trust each other.
The EU is fatally flawed because it leaves each member state to set its own fiscal policy. There are good reasons for that, but it is not sustainable indefinitely. The eurozone must get either much more centralized or fall apart.
The Mutualization of European Debt
Here’s the problem that’s brewing. Germany and the other northern countries, but especially Germany, have prospered tremendously under the euro regime.
If the eurozone were to break up, German GDP would simply fall out of bed. Half its economy is comprised of exports. Further, the new German currency would get stronger which would even put more pressure on German exports.
The Italians have no solution for their debt. Greece has been in a seven-year depression. And while some of the other countries are improving, unemployment rates in most of Europe are still lackluster to say the least. Think about this: one in three Italian youth are unemployed.
And the further south you get, the higher the unemployment rate goes. That’s the Five-Star Movement’s base. The other part of the new majority is now called the League (formerly the Northern League) and is powerful in the low unemployment manufacturing regions of northern Italy.
This is why crazy measures as the proposed parallel currency in Italy are a real possibility.
The southern portion of the country wants to see more spending and the northern portion would like to ease out of the euro. Politics makes extraordinarily strange bedfellows in Italy.
It’s not quite as outlandish as President Trump and Bernie Sanders forming a coalition government, but it was unthinkable just a year ago.
Germany and the rest of the export driven countries need to stay in the euro in order for their economies to grow and prosper. The southern countries need to figure out how to deal with their debt. Italy is around 135% of debt-to-GDP today.
I still think the most probable scenario is that Germany and the Netherlands reluctantly agree to let the European Central Bank mutualize all the sovereign debt, taking onto their balance sheet and issuing new ECB-backed debt for the entire zone.
There would have to be serious constraints on running deficits after that point, but it would prevent a breakup, or at least delay it for another decade or so. Kind of the ultimate kicking the can down the road.