Europe Must Federalize and Monetize (i.e. Become Like the U.S.)

by Alpha Oculus Worldwide News

Dear Reader,

With each passing day, markets seem to get wilder and woollier.

This is only natural after a long, calm stretch. Volatility expands and contracts like an accordion. Mildness begets wildness and so on.

The sharp declines are also a function of harsh reality asserting itself. As we have said many times in these pages, the stimulus never actually worked (in terms of getting the U.S. economy going again). Corporate profits were pumped up, but unemployment levels and heavy household balance sheets were not addressed.

In fact the short-term solutions put in place, bent on avoiding downturn at all costs, only served to make the long-term danger worse.

And this goes as much for Europe and China as the United States...

In Europe, now that investors have shifted their focus to the bigger periphery countries -- Italy and Spain, rather than Greece and Portugal -- the eurozone crisis has entered a new and more dangerous stage.

Some time ago we argued that Europe is "being held together with duct tape." Now the duct tape is being violently ripped. When questions swirl as to how even Italy will hold it together, the end game is much closer.

All of this affects the United States (and the rest of the world) because financial institutions and trade flows are so deeply interconnected. Last week we saw huge gyrations in the S&P and the Dow keying off announcements as to what the European Central Bank might do.

How will the eurozone crisis finally be solved? Ultimately there are really only three paths:

• Kick some of the periphery countries out of the euro (or let them leave voluntarily).
• Move toward federalization, where Europe gets a central treasury and a unified set of rules (like the United States).
• Monetize the peripheral country debt (buy it up with printed currency).

There is widespread agreement that the first option -- kicking countries out of the euro -- could never work.

Just the threat of such an action is enough to inspire huge bank runs. Depositors who fear their local currency might depreciate 50% overnight on a euro exit, or that their local bank might close, have little reason to leave their savings at risk. In contrast, they have strong reason to transfer their cash elsewhere (into stronger currencies or precious metals).

As the pain gets worse, countries like Greece and Italy and Ireland will be tempted to leave the euro voluntarily. But the terror in that solution is a possibility of Zimbabwe-style fiscal collapse for the country doing the leaving. What would a new Italian lira or a new Greek drachma be worth? Who would stick around to hold onto it?

With the exception of Germany, any country attempting to leave the eurozone -- to swap the euro for their local currency -- would become a financial pariah overnight. Just the hint of such a move would accelerate mass capital flight. Exposed financial institutions would not survive.

And if Germany tried to leave, they would have the opposite problem. A new D-mark would be far too strong, creating the same type of problem experienced by Switzerland and Japan.

When a currency is in strong demand as a safe haven destination, it rises so high that exports are threatened, in turn threatening the whole economy. That is why Switzerland and Japan intervened to push their currencies lower in recent days. A new D-mark would go straight up, and the German export machine -- one of the most powerful in the world -- would be strangled by a euro exit.

That leaves the other options, federalize and monetize. Europe can become more like the United States in empowering a single financial body. And they can get over their inflation fears and start printing euros with which to buy (monetize) debt.

The Germans may not like the Greeks or Italians and vice versa, but, barring the acceptance of temporary catastrophe, there is no way to get out of the deal.

Germany will have to embrace the likes of Italy and Greece fully. They will have to say "Our credit is your credit... Our wallet is your wallet." German taxpayers may scream and yell and threaten open revolt at this prospect.

But what else is there? Where else is there to go, without letting the entire eurozone project turn to ash?

At the same time, the periphery countries will have to accept a permanent loss of sovereignty. Europe will have to move toward one ruling body that makes financial decisions for everyone. And Germany, being the "deep pocket," will call the shots.

At the end of the day, fiscal union is a basic requirement of currency union. You can only get by without it when times are good. When times are bad, the weak points in the system are tested to the breaking point.

It is a really harsh deal for everyone. There is plenty of reason for all parties to be furiously angry.

The Germans will be outraged at the prospect of spending huge amounts of money, conceivably without end and without limit, to prop up their Mediterranean currency partners.

The Greeks and Italians et al. will be outraged that, in exchange for this future flow of money, they will have to hand their financial destiny -- the ability to call the shots on important decisions -- to someone else.

And last but not least, the Germans' heads may nearly explode at the need to accept currency debasement, and the prospect of heavy inflation, in order to save the euro currency experiment from fatal disaster. The Bundesbank attitude that says "no inflation at all costs," deeply embedded in the DNA of the European Central Bank, will have to be abandoned.

It's an extraordinary situation. The changes being forced on Europe -- changes forcing it become more like the United States -- run so against the grain that politicians and the populace would NEVER accept them under normal circumstances. Not in a thousand years.

Now, though, the other avenues are all closed off... apart from letting Europe stumble into a "Lehman 2.0" event and total chaos.

Warm Regards,

Alpha Oculus.