What the stalemate in the eurozone means for you
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MoneyWeek Editor
John Stepek Oct 21, 2011
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The 'Efficient Market Hypothesis' is the theory that stands behind the way that most economists and institutional investors view the market.
It sees the market as a sort-of-hyper-efficient supercomputer. All knowable information and perceptions about past, present and future are fed in at one end. Out of the other end pops a perfectly-formed price.
It's utter, utter drivel of course. If that's not self-evident by now, you just need to look at the European situation.
Every time the Europeans pretend they're about to come up with a solution to the Greek / Portuguese / Italian / Spanish / French crisis (delete as applicable), the market leaps.
When they inevitably fail, the market is despondent. For about five minutes. And then it leaps again at the sniff of the next solution.
It's no supercomputer. It's more like a bemused toddler, wondering where the trillion-euro note that nice Dr Merkel pulled out of funny little Mr Sarkozy's ear has got to now...
The deadline for saving the euro has been pushed back – again
At the start of the week, everyone was saying that this Sunday was 'the last chance to save the euro'.
The Germans spent the rest of the week talking down everyone's expectations. And now they've really flung a spanner in the works.
According to this morning's FT, there will have to be a second summit – probably on Wednesday – for the actual decision making, according to a "senior German official". When asked why they were bothering to even have a Sunday meeting anymore, the official told the paper: "That's a good question. Sarkozy wants one."
It's not the sort of comment that gives you a lot of faith that we'll get a positive, win-win outcome from all this. But then, that's no surprise. Europe has put off dealing with this problem for so long that it has snowballed from being merely troublesome (how do you solve a problem like Greece?) to potentially catastrophic (is anyone in Europe actually solvent?).
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As Lex points out in the FT, there are three things Europe needs to address. First, there's Greece. It's going to go bust. The question is, how much money do the speculators who bought Greek debt lose, over and above the already-agreed 21%? And is there any way to keep pretending it's not a default so that the CDS insurance doesn't have to pay out?
This is a sticky old subject in itself. Some of the private sector Greek debt holders are not too keen to take a bigger haircut. However, compared to the other problems the summit has to tackle, it's relatively minor-looking.
Second, there's Europe's banks. As James Ferguson pointed out in a recent MoneyWeek magazine cover story, unlike the US and the UK, Europe has never really tackled the gaping holes in its banking system. That means lots of its banks are vulnerable to any further financial shocks, and need to raise more money to remain solvent.
The biggest problem of all – saving Spain and Italy
Third, there's the question of how to make the markets stop worrying about bigger eurozone countries going bust. The European Financial Stability Facility (EFSF) is the big bail-out fund. The EFSF is a lot like one of those off-balance sheet vehicles that banks used before 2008 to pretend that their exposure to US sub-prime mortgage debt was at arm's length.
The EFSF itself issues bonds. These borrow money on the behalf of stricken countries like Ireland and Portugal. The rest of Europe agrees to guarantee the bonds. In other words, they'll stand behind the loans if the debts go bad.
Trouble is, while there is currently enough firepower in the EFSF to stand behind the smaller countries, there isn't for the bigger ones. That would require the rest of Europe to commit to bigger guarantees.
However, that in turn has the potential to hurt these country's credit ratings. And one in particular – France. This is the real sticking point between Angela Merkel and Nicolas Sarkozy.
Sarkozy doesn't want France to lose its AAA-rating. This is as much about political ego as anything else. He doesn't want to go down in history as the man who lost France's third Michelin star. So the French solution is basically for the European Central Bank (ECB) to do what the Bank of England and the Fed have been doing. Print money and buy European government debt with it, via the EFSF (you do this by turning the EFSF into a bank, which can then access funds from the ECB).
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But Merkel doesn't want the ECB to start printing money. Her countryfolk remember what happened the last time a local central banker started up the printing presses. You can point to the current absence of hyperinflation in Japan, Britain and the US all you like. But Weimar looms large in the German psyche, and with good reason.
Germany would rather figure out a way to boost the amount of firepower the EFSF has. It would do this by using it to guarantee the first 20-30% of each bond issue, rather than the whole lot. But of course, there are lots of problems with this too. Bonds without guarantees would sell off, losing out to those with guarantees, and all manner of market distortion would ensue.
What's it all boil down to?
In short, don't expect big things from this weekend meeting. Given that markets haven't really sold off this week, I suspect there might be some disappointment come Monday.
In the longer run, I'd expect more euro weakness ahead. Almost any solution would involve a weaker euro. If the ECB prints, then the euro will fall (although I think you could then expect a big surge in stock markets). But any unsatisfactory fudge is also going to be bad for the euro, because it raises the prospect of more turmoil ahead.
Spread betting of course is one way to play this, but it's very much a short-term trade (you can learn more about how to spread bet with our free email, MoneyWeek Trader). We'll be looking at more long-term, less risky ways to bet on a weaker euro in a forthcoming issue of MoneyWeek magazine (if you're not already a subscriber, get your first three copies free here).
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