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European Debt Crisis

German endgame in sight? Mitteleuropa and the grosse Deutsche mark


Markets tumbled again this morning on news of new lows in German business confidence as well as terrible news from some of Europe’s biggest banks:

  •  Unicredit SpA, Italy’s largest bank, posted a historic loss of €10.6 billion, mostly on a one-time write-offs of impaired investments and goodwill. However, even excluding the one-time items, the quarterly loss was of  €474 million. Unicredit also announced a plan to lay-off 7,400 workers in Europe by 2015 and to close the Western European brokerage business. The share price fell 6%; (1)


  • Credit Suisse was threatened with a ratings downgrade by Moody’s after news of a loss in the investment banking business and poorer than expected results in the wealth management division. Credit Suisse has also been under scrutiny by German and US tax authorities; (2)


  • Over the weekend, Christian Clausen, the president of the European Banking Federation, stated that banks should keep dumping Italian bonds in order to “move out of the epicenter”. (3) European banks appear ready to divest themselves of more than €300 billion in Itailan bonds (4) which would make the ECB’s job of supporting Italian bond prices even more difficult.

As one would expect, spreads for Italian bonds began to climb again after dropping over the weekend with the resignation of Silvio Berlusconi and his replacement by Mario Monti, a technocrat. This is not a surprise: it is the consistent pattern of the past year. European leaders issue a statement or declaration of intent, the markets rise, then rapidly sober up to the truth of the underlying fundamentals.

Italian 10-year bond benchmark:                                                         Spanish 10-year bond benchmark:









Spain also faces an important test this week with bond issues on the 15th and 17th of November. The earlier issue is for 12- and 18-month notes with a face value between € 2.5 and €3.5 billion. On the 17th, the Spanish Treasury will attempt to sell between €3 and €4 billion in 10-year notes. These risk premium on these two issues will be critical for Spain’s credibility and access to international capital markets.

Throughout the hammering that bond markets have been undergoing for the past months, another chart shows a curious trend:











The Euro:Dollar exchange rate shows remarkable stability for currency that seems on the verge of dissolution. In fact, the Euro remains slightly above it’s average for the year, despite the woes of Europe’s periphery and the likelihood of a recession. Are currency traders are dumb, or bond traders for that matter?

My guess is that neither is true; and that, in fact, both the currency market and the bond market are right. The bond markets are telling us that Greece, Portugal, Ireland, Italy and Spain are all going to default. The currency markets suggest that the euro will remain strong vís-a-vís other hard currencies due to the underlying strength of the German economy and strict monetary policies inherited from the Bundesbank. These two stories are reconciled by an ejection of the periphery from the single currency, which will become essentially a “grosse Deutsche Mark”.

There are more than a few indications that this option is in the works. Nicolas Sarkozy and Angela Merkel have both floated the idea of a “two speed Europe” (Mr. Sarkozy on 8 November and Fr. Merkel on the following day). Both were quick to deny that this could possibly mean that any nation would be forced out of the Euro. Of course, just 6 months ago, both leaders categorically denied the possibility of a Greek default.

The most critical political indicators begin to accumulate witha  disheartening rapidity:

  • The German government and the Bundesbank, which has one vote on the ECB board, like the other 16 member states including troubled Greece, Italy and tiny Malta, are warning that the European Central Bank is straying from this core task.  Two German members of the ECB board have left this year in disgust at the bond-buying strategy. Bundesbank chief Jens Weidmann blocked attempts at the G20 summit to make further inroads into central bank independence by purloining Bundesbank gold and currency reserves to boost euro zone bailout funds.  “Bundesbank prevents trickery by euro partners,” was how the top-selling news magazine Der Spiegel hailed Weidmann’s stand. (5);
  • On top of that, Merkel’s CDU party voted yesterday to allow euro states to quit the currency, a move not currently allowed to members. While party spokesmen denied that they were “throwing anyone out” it is hard to conceive what other purpose such a measure could have. The only question is whether the exit is voluntary or involuntary. As the Germans will write the rules, it is safe to assume that they will be written so as to force an exit of “non-compliant” periphery members. (6);
  • The “technocrats” who have been hailed as the “solution” to the political embarassment that were Papandreou and Berlusconi are already facing serious revolts from their respective parliaments. The Greek right has said that it rejects more austerity measures that will only deepen the suffering of the Greek people and economy and Papademus must face a confidence vote on the 16 Nov – which, if he fails to survive it, will hit European markets like a bomb. Monti is also facing serious opposition from the Italian parliament, with Northern League members threatening outright secession (always something of a dream for them). It is difficult to believe that either nation will be able to force through and implement the large scale austerity measures that will be required of them this year and next; it is even more difficult to believe that these austerity measures will do anything but deepen the economic recession in these countries and make it even more difficult for them to pay back the interest they owe or outgrow their outstanding debt. (7);
  • The situation in Spain and Portugal is slightly different, with a new conservative government almost certain to win an absolute majority in the former country, and a conservative government already in place in the latter. Even so, Spain is a nation of 5 million unemployed (23% of the workforce) with an economy that did not grow at all in 3Q2011. How much more austerity can the central government impose without risking the wide-spread public disturbances already cropping up in Portugal? (8);
  • On 10 November, S&P “accidentally” downgraded France’s credit rating, the effects of which would be so disastrous as to be tantamount to throwing in the towel on the Euro (this is because France is one of the main contributors to the EFSF which would be used to “bail out”  weaker members…if France is seen to be unable to meet those commitments, the EFSF goes down the toilet). While S&P was quick to deny the report, leaving the French fuming, does anyone doubt that this is a clear warning to the French Republic that her financial house is in disorder? (9);
  • Adding to French gloom, Moody’s warned that France was the weakest of the AAA rated countries and that they would review their rating in three months. The Lisbon Council today issued their 2011 Euro Plus Monitor report echoing these concerns on French finances (10). In their assessment, they state that France is: “By far the least healthy of the AAA-rated eurozone members. A country full of potential that needs to be unlocked through labour market reforms, some product market deregulation and a trimming of the public sector to shift more resources into export-oriented activities.” At the same time, Dutch, French, Finnish and Austrian bond spreads have begun to diverge from the “safe haven” of German bonds. Especially the last three, which are rapidly approaching their maximum divergence of the past year. All were considered relatively immune to “contagion” from the periphery, but this assumption now seems less sure.

European leaders meet again on 9 December. I expect that Angela Merkel, with the previously negotiated agreement of France’s Sarkozy, will show up at the conference with two briefcases. In briefcase #1, there will be a rough draft of a revised Lisbon Treaty, incorporating all of the fiscal and regulatory changes the Germans are clammoring for. There will be new austerity measures demanded; closer fiscal union; punitive fines and EU oversight for delinquent euro members; and an exit mechanism for states that can’t or won’t play ball. Mrs. Merkel will attempt to strong-arm the “Club Med” to gain their quick ratification of the treaty changes, because she knows that there is very little time left if the euro is to be saved.

In briefcase #2, is the proposal to form a new eurozone that includes Germany, France, Belgium, the Netherlands, Austria, Finland and a few other “responsible members”. These nations will agree to closer fiscal union; punitive fines and EU oversight for delinquent euro members; and an exit mechanism for states that can’t or won’t play ball. The other members will be ejected.

In the briefcase #2 scenario, events would move with lightening speed. That’s a subject for another post, however. Suffice it to say, that briefcase #2 is no longer unthinkable. Goldman Sachs has estimated the exposure of Germany and France to the sovereign debt of the peripherals at €84.5 and €54.5 billion respectively (14 July 2011). These are not insignificant numbers, but certainly within the means of each country should they decide to stop trying to fill the moneypit that is Southern Europe and instead to pay it out to insulate their own financial systems from the damage of multiple exits from the euro.

The rest of “Mitteleuropa” would go along for similar reasons – the direct cost of insulating their banks is rapidly becoming less than the endless contributions to bail-outs and rescue funds. For France, itself straddling the Mediterranean and Atlantic cultures, the risk of being lumped in with the “poor South” and the cost of losing their AAA credit rating may be too much to bear. In any case, for geo-strategic as well as economic reasons, France must move with Germany.

The euro has perhaps three months of life left. Unless Germany caves in to demands to allow the ECB to become a lender of last resort, or Southern Europe agrees to a renunciation of fiscal and monetary authority to Northern Europe, then we will see the creation of a new “fast track” Europe centered on Germany and Mitteleuropa.

NOTE: As I was writing this post, the Spanish Treasury managed to place € 3.16 billion out of a maximum issue of €3.5 billion in 12- and 18-month notes during today’s sale, but at a higher than expected (or desired) rate. The 18-month paper sold at 5.159%, up from 3.801% just last month. The 10-year bond price is also up in advance of Thursday sale at 6.28%, up from an average of 5.25% last month.


1 http://www.bloomberg.com/news/2011-11-14/unicredit-rights-issue-to-total-as-much-as-7-5-billion-euros.html
2 http://www.bloomberg.com/news/2011-11-14/credit-suisse-rating-under-review-by-moody-s.html
3 http://www.bloomberg.com/news/2011-11-13/europe-s-banks-should-keep-dumping-italian-bonds-to-cut-risk-clausen-says.html
4 http://www.ifre.com/banks-to-dump-more-italian-debt/1615206.article
5 http://www.reuters.com/article/2011/11/10/eurozone-germany-history-idUSL5E7MA17O20111110
6 http://www.bloomberg.com/news/2011-11-11/german-cdu-is-set-to-back-motion-allowing-euro-member-exit-1-.html
7 http://www.reuters.com/article/2011/11/14/us-eurozone-idUSTRE7AC15K20111114
8 http://www.reuters.com/article/2011/11/14/portugal-gdp-idUSL5E7ME1M120111114
9 http://www.bbc.co.uk/news/business-15686580
10 http://www.lisboncouncil.net/publication/publication/68-the-2011-euro-plus-monitor.html

Additional Charts:

French 10-year bond benchmark:







Dutch 10-year bond benchmark:






Austrian 10-year bond benchmark:






Finnish 10-year bond benchmark:

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7 Responses to “German endgame in sight? Mitteleuropa and the grosse Deutsche mark”

  1. Est-il possible de emprunter certaines lignes pour mon blog perso ?

    Posted by http://unarmedcatcall625.Deviantart.com | June 26, 2014, 16:45
  2. Great stuff, fer. Best analysis I’ve read so far. But how do you get the time to write/research this stuff when you have a f/t job?!! You should quit and become Madrid correspondent for the Economist!!!!!
    Love to the family

    Posted by David White | November 15, 2011, 22:31
    • Thanks David. I usually get in to the office around 7 a.m. to avoid the Madrid traffic, so I spend a couple of hours on research and posting. Lunches too, sometimes. But I really don’t have time to do all the research I’d like to.

      Hope all is well with you and the family. Any chance of seeing you lot down here sometime soon? There’s not much chance of us traveling this year, not with Virginia due in about 2 weeks.



      Posted by fdbetancor | November 16, 2011, 07:26
  3. I have no doubt that the short term outcome is that the ECB will be allowed to be a lender of last resort as it will soon become the only option available (if it is not already)though probably things will get a lot worse before the germans finally permit it.

    Posted by graham | November 15, 2011, 21:57
    • It’s great to hear from you Graham!

      I wish I could be as sanguine about that outcome. While I agree that if Germany were to allow the ECB to become the lender of last resort, the Euro crisis would end almost overnight…oh, there’d be some messy details to work out, but the Italian and Spanish death spirals at least would be ended. But so far, Merkel and the German representatives on the ECB’s Board have vetoed every attempt to promote this solution. And if they are not willing to do it now, when Italian and Spanish debt is below 7%, it will be increasingly difficult for them to do so later….difficult politically that is.

      I would advance three arguments in favor of my interpretation:

      1. The Law of Low Probability Events – you know as well as I do, given our business, that it become increasingly difficult to estimate material effects for events that are considered to have a low probability of occuring. The lower the probability, the more likely that people will discount the event completely. A eurozone break-up is, in the minds of Europeans at least, a “zero probability” event. We should all know that this is not true, but it has been an important factor in the decision-making process of European leaders, causing them to take half-measures. I believe that this is still guiding the decision-making process. When Angela Merkel talks about treaty changes as the key to the solution, it makes one wonder what color the sky is in her world. Decisive measures are needed in the next few weeks, not treaty changes in the next few years (those are needed too, but after the storm has passed). I further believe that this is one of the more powerful drivers of human nature, hard-coded into us, and so it is unlikely to be easily set aside by those too close to the issue. Bismarck said that the Balkans weren’t worth the “bones of a single Pomeranian grenadier”, but not 40 years on from that speech, the First World War had claimed 4.5 million of them. A low probability event;

      2. The First World War is also a great example of another reason I think the eurozone will contract, what I call the Law of Random Events, or the Myth of Control. European leaders all knew that the Balkans were a powder keg, they all knew that any European war would almost have to start there, and yet a random event, the assassination of Franz Ferdinand, led almost overnight to the war that everyone was trying to avoid. That is to say, no one wanted the catastrophe that was the Great War, but everyone thought it could be contained and controlled. Hence, the Myth of Control. We are again hard-wired to believe that we exert more control over our lives than we really do – it’s just our way of not going insane. European leaders today are acting as if they could control the situation, which is false. The measures they have taken have been reactive, not proactive; and even proactive measures might fail in the face of a random event: the fall of the Greek government today, the outbreak of war in the Persian Gulf, large-scale rioting in Italy, an Enron-sized corporate scandal in the US or Europe, another natural disaster;

      3, The last reason I think what I think is more rational. It is in Germany’s interest to maintain a stable currency and low inflation. If those two goals become impossible because of “Mediterranean profligacy”, they may decide to keep the currency and ditch the Mediterranean. A contracted eurozone would be much easier to manage and mold in the Bundesbank’s image, which is after all what the Germans would prefer. In terms of actual costs, kicking out the Club Med and patching up the German financial system would cost them around €84 billion, but that may be cheaper than keeping the Italians and Spanish on a financial IV for years, as well as being more politically palatable (“Germans helping Germans” certainly sells better in Berlin than “Germans helping Italians and Greeks”). As for costs to trade, I’m not sure that those are as large as purported. Spain, Portugal, and Greece represent 5% of German exports; Italy is the big one, representing by itself 6% of German exports. But Germany is mainly exporting machinery, transport and electrical equipment, chemicals and other engineering products – unlikely to find easy substitutes. While trade will fall off for a couple of years, once the devalued economies start growing again, they will likely need to import capital and industrial goods from Germany. In other words, I think that the Germans need the Med far less than the Med needs Germany.

      In any case, we’ll see pretty soon what’s going to happen. I don’t think the current situation can last much longer.



      Posted by fdbetancor | November 16, 2011, 08:29

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