Europe is on the verge of financial chaos. A market implosion there, like that triggered by Lehman Brothers collapse in 2008, may not be far off.

— Roger Altman, former Deputy Treasury Secretary under Bill Clinton

If you read press reports analyzing former hedge fund manager and pro-democracy activist George Soros’ June 2^nd speech on Europe, the typical headline is: “Soros sees the Euro Surviving.” But the survival of the Euro is not the important takeaway from his speech. My headline is much different because I believe Soros is much more concerned with the survival of Europe as a vibrant continent than the survival of the Euro currency.

Too often, people think that saving the Euro means saving Europe, but the truth is quite different. In fact, Soros believes that the Euro has damaged all of Europe except Germany and is one of the primary causes of the current debt crisis. Imposing a currency union before establishing a fiscal union was a mistake, causing severe trade imbalances and economic stagnation.

Don’t get me wrong: Soros wants the Euro to survive despite its mistaken birth. The damage caused by prematurely instituting the Euro more than a decade ago has been done, and Soros thinks that abruptly eliminating the Euro now would compound the problem even further. But it’s important to understand that Soros sees saving the Euro as a sideshow to what should be the real focus: saving non-Germanic Europe from economic stagnation. More on this later.  

Euro Currency Continues to Weaken

Prior to a tepid rebound on Monday of this week (June 4^th), the Euro currency fell for five consecutive weeks against the U.S. dollar and is now near a two-year low:

Source: Bloomberg

Against the Japanese yen the Euro has fared even worse, falling to an 11-year low:

Source: Bloomberg

The flip-side of Euro weakness is U.S. Treasury bond strength as money flees to risk-off save-haven investments. U.S. stock market strength is an entirely different matter, as Goldman Sachs is warning that the S&P 500 may be entering a bear market on account of Europe’s troubles and there is a one-in-three chance that Greece will exit the Euro after its June 17^th elections. In the last four polls permitted before the election, three show the pro-Euro New Democracy Party in the lead over the anti-Euro Syriza Party by a slim margin, whereas one poll shows Syriza in the lead.

European Leaders Don’t Understand What Caused the Debt Crisis

If Europe is the key to global economic growth and the price trajectory of the U.S. stock market, the question becomes very important how to fix the problem.  The European Union has taken several half-measures aimed at containing the crisis, including:

1. Offering European banks more than one trillion Euros in 1% three-year loans via the European Central Bank’s (ECB) Long-Term Refinancing Operations (LTRO); and
2. Signing a fiscal compact that commits most EU countries (the U.K. and Czech Republic excluded) to a reduction of their government spending until their fiscal budgets are balanced with revenues.

Despite these measures, the Europe debt crisis now appears worse than ever as evidenced by new panic lows in U.S. and German bond yields. According to Irish economist David McWilliams, the ECB’s LTRO was merely a “cash for trash” temporary fix that allowed European banks to invest more money in the sovereign debt of insolvent peripheral EU countries (e.g., Greece, Ireland, Italy, Portugal, Spain) without making these debtor countries any better credits. Consequently, the balance sheets of European banks are now even worse off because they own more “trashy” government debt destined to default.

Similarly, the March fiscal-compact agreement makes things worse because it paralyzes the ability of weak EU countries to employ the counter-cyclical deficit fiscal spending necessary to jump-start economies in recession. The worst thing you can do to a recessionary economy is starve it of fiscal spending, yet that is what the March fiscal compact does. McWilliams argues that government fiscal deficits and debt burdens were never Europe’s real problems. In fact, in 2008 Spain had a lower debt-to-GDP ratio than Germany! It was only after the 2008 financial crisis emanating from the U.S. that Spain’s government spending and debt exploded – which according to Keynesian economics was the right policy prescription to combat recession. The real problem involves trade deficits within the Eurozone caused by German industrial dominance, the inability of less-efficient EU countries (thanks to the single Euro currency) to compete through currency devaluations, and the ECB’s  willingness to support unlimited trade deficits by accepting IOUs from the non-competitive EU countries consuming beyond their means. McWilliams says employing fiscal austerity to treat a country’s trade-deficit and competitiveness problems is like treating heart disease with chemotherapy.

The European Union is holding a summit on June 29-30 to discuss the creation of a new European “fiscal union” that would have much more centralized power than the shaky fiscal compact agreed to in March. If economic decisions could be made at the European level rather than require ratification at each country’s national government level, policies could be implemented much more swiftly and enforced better than they are now. The problem is that most EU countries don’t want to give up their fiscal autonomy and are correctly afraid that European-level fiscal policymaking would be controlled by Germany and for Germany’s benefit. Even if EU finance ministers were to tentatively agree on fiscal union at the June summit, actual implementation would require EU Treaty changes that couldn’t occur without a lengthy country-by-country ratification process. Analysts estimate that fiscal union would probably take 5-to-10 years to complete.

Bottom line: Europe is burning and can’t wait for long-term solutions. It needs help now – help that only Germany can provide. But German Chancellor Angela Merkel continues to reject short-term solutions like joint Eurozone bonds or a “banking union” with cross-border deposit guarantees, arguing that such actions must await structural changes in the EU Treaties that would permit German supervision over other countries’ financial institutions.  In other words, Germany won’t give much more cash to its struggling EU neighbors unless they become much more Germanic in their policymaking.  As one German official put it:

The fundamental question is relatively simple. Do our partners really want more Europe, or do they just want more German money?

George Soros Urges Germany to Do the Right Thing — And Quickly

According to George Soros, Germany needs an attitude adjustment pronto and should stop putting the cart (EU governance reform) before the horse (debt crisis). Germany needs to loosen its purse strings now. In his June 2^nd speech, Soros argued that Germany has only three months to do the right thing or else there won’t be a European Union worth saving:

The real economy of the Eurozone is declining while Germany is booming. And the divergence is getting wider. Political and social dynamics are working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. Something has to give.

In my judgment the German government and the Bundesbank have a three month’s window during which they could still correct their mistakes and reverse the current trends. Correcting the mistakes and reversing the trend would require some extraordinary policy measures to bring conditions back closer to normal, and bring relief to the financial markets and the banking system. These measures must, however, conform to the existing treaties. The treaties could then be revised in a calmer atmosphere so that the current imbalances will not recur.

I expect that the Greek public will be sufficiently frightened by the prospect of expulsion from the European Union that it will give a narrow majority of seats to a coalition that is ready to abide by the current agreement. But no government can meet the conditions so that the Greek crisis is liable to come to a climax in the fall. By that time the German economy will also be weakening so that Chancellor Merkel will find it even more difficult than today to persuade the German public to accept any additional European responsibilities. That is what creates a three months’ window.

Soros sees three things that Germany must be willing to implement immediately:

1. Cross-border bank deposit insurance in order to discourage capital flight from banks in the weak EU countries
2. Direct bailouts of European banks by the ECB without the need to first funnel the money through national governments or subject the respective national government to a full EU/IMF austerity program.
3. Reduce the borrowing costs of weak EU countries by either guaranteeing their debt to by purchasing their debt.

Germany is worried that an unconditional bailout will create a moral hazard that encourages irresponsible behavior in the future because governments think they will get bailed out again. Soros says that moral hazard is a long-term concern, but should be dealt with later, and not be used as an excuse to avoid defusing the current crisis. 

Although Soros is confident that Germany will supply enough cash to ensure the survival of the Euro currency, he is worried that Germany won’t go far enough to reverse the diverging trend of German prosperity on one end and poverty for all other EU countries. Germany benefits from the Euro currency because the value of the Euro reflects the average industrial competitiveness of the entire EU, which is lower than the hyper-competitiveness of German industry. Consequently, Germany gets an un-deserved trade advantage from a weak currency. Whereas one Euro is currently worth 1.25 U.S. dollars, analysts estimate that one German deutsche mark would be worth 2.0 U.S. dollars. The corollary of this observation is that the Euro currency hurts less-competitive EU countries by forcing them to trade using a currency that is much stronger than their economies can handle.

The Euro Currency Created a Bubble Destined to Crash

Ironically, the Euro currency’s strength was actually a boon for the economically-weak EU countries before it turned into a curse. According to Soros, the Euro currency system created a “political bubble” of “unreal but immensely attractive” overconfidence in the economic strength of all participating European countries. The result of this political bubble was abnormally-low interest rates throughout the Eurozone which encouraged profligate consumption in the weak EU countries, which in turn created a speculative investment boom that actually discouraged the weak EU countries from making the structural reforms necessary for improved economic competitiveness:

When the Euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge.

Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive.

Consequently, there are two viable solutions for spurring European growth:

1. Either force Germany out of the Euro so that it has to trade with a super-strong deutsche mark or eliminate the Euro altogether and let the weaker EU countries devalue their respective currencies to better compete; or
2. Maintain the Euro but bail out the weaker EU countries through debt forgiveness and foreign direct investment so that they can have a chance to get back on their feet and become more competitive and successful – i.e., more German like.

Saving Europe Entails More than Saving the Euro

The worst solution is what Soros is afraid Germany plans to do: provide the weak EU countries along with an absolute minimum of financial help that will keep the Euro alive and enable these countries to make debt payments (most importantly huge debts owed to Germany) but do nothing to improve their competitiveness:

Germany is likely to do what is necessary to preserve the Euro — but nothing more. That would result in a Eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of a constant transfer of payments.

Although Germany may be enticed to be the leader of a weak Europe full of vassal states dependent on it, in reality Germany would be much better off with a strong Europe full of healthy economies producing quality and low-cost goods and services. A smaller slice of a much larger economic pie is preferable to a larger slice of a small economic pie. But providing the substantial financial subsidies now to create healthy EU partner states requires courage and leadership, something Germany’s parochial temperament has never been good at.

Follow Shakespeare’s Advice: Forgive Debt

Yale economics professor John Geanakoplos recently argued in a speech before the University of Athens Economics and Business School (pp. 11-12) that U.S. banks have a choice to make similar to Germany’s when it comes to recouping delinquent debts. For U.S. banks, the debt at issue is underwater home mortgages. U.S. banks can insist on full payment and experience a cascading number of foreclosures that generate a payback of roughly 25% of the debt’s principal amount, or they can accept debt forgiveness (i.e., principal reduction) of more than 40% and achieve a debt payback of more than double the payback achieved through foreclosures.  

Germany faces a virtually identical decision:

The [U.S. housing] situation is of course reminiscent of what has happened to Greece and other sovereign borrowers. Lenders should never have lent so much money. Now that the situation has become bad, the borrowers cannot possibly pay it all back. Of course the borrowers must be forced to put their houses in order, and to pay as much as they reasonably can. But to ask the impossible will work against even the lenders. Eventually part of the Greek debt will have to be forgiven.

If Greece makes the needed reforms, mostly by collecting taxes from the rich who evade them, and reforming the business sector, and if the Eurozone is rational, part of the debt will be forgiven. Greece will get a fresh start. And in this global economy there will be no reason for you to abandon a country you love to find opportunity elsewhere as my grandparents had to.

The most effective way to solve a debt crisis is through debt forgiveness. Geanakoplos cites William Shakespeare’s play The Merchant of Venice for the proposition that debt forgiveness helps not only the borrower but the lender as well. Portia unsuccessfully tries to convince Shylock to accept a monetary payment for Antonio’s debt default rather than insisting on the contractual collateral of “a pound of flesh”:

The quality of mercy is not strain’d, It droppeth as the gentle rain from heaven upon the place beneath. It is twice blest: It blesseth him that gives and him that takes.

Shylock’s refusal to compromise resulted in him losing his claim to the entire debt. For the sake of Europe and the global economy, let’s hope German Chancellor Angela Merkel remembers her Shakespeare sometime over the next three months and doesn’t make the same mistake Shylock made.