December 27, 2012 at 09:23 AM EST
contemplating the euro zone
After describing since inception how the euro zone was going to get to where it is, here’s my guess on what’s coming next. First, to recap, it took them long enough and it got bad enough before they did it, but they did decide to ‘do what it takes’ to end the solvency issues and, [...]

After describing since inception how the euro zone was going to get to where it is, here’s my guess on what’s coming next.

First, to recap, it took them long enough and it got bad enough before they did it, but they did decide to ‘do what it takes’ to end the solvency issues and, after the Greek PSI thing, make sure the markets stopped discounting defaults as subsequently evidenced by falling interest rates for member nation debt.

But it’s solvency with conditionality, and so while they solved the solvency and interest rate issue, the ongoing austerity requirements have served to make sure the output gap stays politically too wide. The deficits are high enough, however, for an uneasy ‘equilibrium’ of
near/just below 0% overall GDP growth and about 11% unemployment.

However, all of this is very strong euro stuff, where the euro appreciates at least until the (small) trade surplus turns to deficit. This could easily mean 1.50+ vs the dollar (and worse vs the yen) for example. This process at the same time further weakens domestic demand which supports a need for higher member govt deficits just to keep GDP near 0.

So at some point next year I can see deficits that refuse to fall resulting in more demands for austerity, while the strong euro results in demands for ‘monetary easing’ from the ECB. Of course with what they think is monetary easing actually being monetary tightening (lower rates, bond buying, everything except direct dollar buying, etc.) the fiscal and monetary just works to further support the too strong euro stronger.

All this gets me back to the idea that the path towards deficit reduction in this hopelessly out of paradigm region keep coming back to the unmentionable PSI/bond tax. Seems to me we are relentlessly approaching the point where further taxing a decimated population or cutting what remains of public services becomes a whole lot less attractive than taxing the bond holders. And the process of getting to that point, as in the case of Greece, works to cause all to agree there’s no alternative. With the far more attractive alternative of proactive increases in deficits that would restore output and employment not even making it into polite discussion, I see the walls closing in around the bond holders, along with the argument over whether the ECB writes down it’s positions back on page 1. And just the mention of PSI in polite company throws a massive wrench (spanner) into the gears. For example, if bonds go to a discount, they’ll look towards ECB supported buy backs to reduce debt, again, Greek like. And if prices don’t fall sufficiently, they’ll talk about a forced restructure of one kind or another, all the while arguing about what constitutes default, etc.

The caveats can change the numbers, but seems will just make matters worse. The US going full cliff is highly dollar friendly, much like austerity supports the euro. This means less euro appreciation, but also lower US demand for euro zone exports. So the cliff does nothing good for the euro zone output gap. And Japan seems to be targeting the euro zone for exports with it’s euro and dollar buying weakening the yen, as evidenced by Japan’s growing fx reserves (where else can they come from?).

The price of oil could spike, which also makes matters worse.

In general, I don’t see anything good coming out of the current global political leadership.

Please let me know if I’m missing anything!

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