The following is an excerpt from John Mauldin’s weekly letter:

In trying to decipher Europe it is hard to know where to start, but let’s begin with some assumptions:

For the euro to survive, one of two things must happen. Either the Germans (and the Dutch and Finns and French) decide to back the concept of some sort of eurobond financing of the balance sheets of the peripheral countries, OR there need to be massive write-downs of insolvent-country debt and the various countries need to backstop their banks, because bank losses will be massive.

The former needs buy-in from German voters. Polls show Germans are against the idea of eurobonds by something like 5-1 (75% against, 15% for). (More on Germany below.) The latter option assumes the peripheral countries will lose access to the private bond markets, thus forcing sudden and enormous austerity (read Depression levels or worse). Will they simply throw in the towel and leave the euro on their own, remaining in the free-trade zone but with their own currencies, much as Denmark, the Czech Republic, or Sweden are now? Or opt to suffer and remain in the euro?

Germany could decide not to back the peripheral country debt, and leave the Eurozone. But this would be painful for Germans. If you think the Swiss franc trade is crowded (and way overvalued) because people are looking for a safe haven, what would a new Deutschmark look like to investors? Switzerland is a country (and one of my favorite in the world, so no slight intended – I will be in Geneva for my birthday in October) of just over 7 million people, only somewhat larger than the population of the greater Dallas-Fort Worth, Texas area where I live (although with much better weather!).

Germany, on the other hand, is the world’s 4th largest country by GDP, with a population of over 82 million. It is well-run and respected. The new mark would climb to far higher levels against the remaining euro countries and other currencies, which for an export-driven nation would not be very helpful. Mercedes and BMWs cost a lot now (and don’t forget tool parts and other things Germany excels in making). Double the value of your currency in a short time? Watch your market share drop. Painful is perhaps an inadequate word.

So, what to make of the remarks this week by respected German leaders? Let’s fire up a few quotes here (

“German President Christian Wulff has accused the European Central Bank of violating its treaty mandate with the mass purchase of southern European bonds. In a cannon shot across Europe’s bows, he warned that Germany is reaching bailout exhaustion and cannot allow its own democracy to be undermined by EU mayhem.

“ ‘I regard the huge buy-up of bonds of individual states by the ECB as legally and politically questionable. Article 123 of the Treaty on the EU’s workings prohibits the ECB from directly purchasing debt instruments, in order to safeguard the central bank’s independence,’ he said. ‘This prohibition only makes sense if those responsible do not get around it by making substantial purchases on the secondary market,’ he said, speaking at a forum of half the world’s Nobel economists on Lake Constance to review the errors of the profession over recent years.

“Mr Wulff said the ECB had gone ‘way beyond the bounds of their mandate’ by purchasing €110bn (£96.6bn) of bonds, echoing widespread concerns in Germany that ECB intervention in the Italian and Spanish bond markets this month mark a dangerous escalation.’” (London Telegraph)

Who Will Rescue the Rescuers?

From the same article: “The blistering attack follows equally harsh words by the Bundesbank in its monthly report. The bank slammed the ECB’s bond purchases and also warned that the EU’s broader bail-out machinery violates EU treaties and lacks ‘democratic legitimacy’. The combined attacks come just two weeks before the German constitutional court rules on the legality of the various bailout policies. The verdict is expected on September 7.”

Yet “Nobel laureate Joe Stiglitz told the forum that the euro is likely to fall apart unless Germany accepts some form of fiscal union. ‘More austerity for Greece and Spain is not the answer. Medieval blood-letting will kill the patient, and democracies won’t put up with this kind of medicine.’ ”

His solution? Germany will either have massive banking losses (see below) or assume some debt. Why give up the dream of a united Europe over a few trillion and your credit rating? Yet (Ambrose Evans-Pritchard writing in the Telegraph):

“Marc Ostwald from Monument Securities said Germany is drifting towards a major constitutional crisis. ‘This has all the makings of the revolt that unseated Helmut Schmidt [in 1982], and indeed has political echoes of the inefficacy of the Weimar regime,’ he said.

“Mr. Wulff said Germany’s public debt has reached 83pc of GDP and asked who will ‘rescue the rescuers?’ as the dominoes keep falling. ‘We Germans mustn’t allow an inflated sense of the strength of the rescuers to take hold,’ he said.

“ ‘Solidarity is the core of the European Idea, but it is a misunderstanding to measure solidarity in terms of willingness to act as guarantor or to incur shared debts. With whom would you be willing to take out a joint loan, or stand as guarantor? For your own children? Hopefully yes. For more distant relations it gets a bit more difficult,’ he said.”

The final option is for the peripheral nations to eschew austerity and leave the Eurozone, launching their own currencies again. This would mean long and painful bank holidays and massive losses for European banks and local citizens, depending on how many countries left. And the lawsuits would last for decades – nothing short of a full-employment act for lawyers all over the world.

And Merkel was not helped by her own Labor Minister, Dr. Ursula von der Leyen. Rather than simply hand over further loans to Athens – money many Germans believe they will never see again – Dr. von der Leyen suggests Berlin should ask for collateral. Gold, preferably. From theIrish Times:

“One month after euro zone leaders agreed a bailout reform package, and a month before the package goes to vote before national parliaments, a senior German minister appeared to be calling for a renegotiation.

“On an aircraft back from Belgrade, a thin-lipped chancellor Angela Merkel reportedly told advisers: ‘I’m going to have to have a word with Ursula.’

“Even before she landed, German officials were in full damage limitation mode, working the phones and issuing statements denying the minister spoke for the government. ‘This is sub-optimal,’ groaned a senior government source. ‘No one is amused.’ ”

Some back-bench minister? Hardly. Dr. von der Leyen, a 52-year-old mother of seven, is one of Dr. Merkel’s most ambitious ministers and one of two names regularly mentioned as a possible successor.

But she only reflected a rather contentious Bundestag meeting this week, in which one after another representative voiced opposition, invariably noting that the voters disapproved.

Of course, none of this is helped by Finland negotiating a side collateral deal as part of their conditions for approving their portion of the next loan to Greece. And a chorus of countries have jumped on that wagon. How do you explain to YOUR voters that the Finns got actual in-the-bank collateral and you got nothing but Greek promises? But if everyone gets collateral, the whole deal will fall apart. What’s the point if you give back a large chunk of your loan? It just means you need even more!

The Problems of Debt in the Eurozone

Let’s look at some charts. This first one is the amount of principal debt in terms of GDP from July 2011 to July 2012 (plus budget deficits, in red) needed by ten European countries. Note that France and Italy are well over 20%! Source: Peterson Institute of International Economics (hat tip, Simon Hunt!)

From the same report this chart illustrates how Germany could become the banker for the Euro Zone. The question is will it? The question will be more clearly defined in September when Germany’s Constitutional Court will rule on the legal complaints against the Euro Zone rescue packages. If the comments being made by the Bundesbank and by the country’s President are a hint as to the outcome of the court then a negative ruling is a real risk. Who then will take the losses?” (Simon Hunt)

Note in the chart that Germany holds the largest percentage of net debt.

Claims of Euro Area members from netting of Euro System cross-border payments (in billions of Euros):

And then there are the interest-rate issues. Rates were rising rapidly in Spain and Italy until the ECB stepped in. Everyone knows Greece, Ireland, and Portugal are on life support and cannot get debt on their own. The ECB inserted an IV into Spain and Italy and started them on a slow drip. The real question of the moment is, can they get off that support and stand in the markets on their own? The answer a few weeks ago was starting to look like “No.”

And look at the massive growth in ECB lending to Italian banks, which are getting shut out of the “normal” market. It has literally more than doubled in a few months:

Credit spreads at French banks are blowing out. Review how much France has to borrow in the next 12 months, in the first chart. Then look at their deficit-to-GDP (above 10%, according to Charles Gave) and realize that there is no reason why S&P should not downgrade them as well. How do they cut spending? Taxes are already at 50% of GDP. Wealthy French have voted with their feet by moving away.

The list of country woes is long in Europe. Massive unemployment in Spain and Portugal. Deficits everywhere. Voting populations in both creditor and debtor nations are upset.

It is only a matter of time until Europe has a true crisis, which will happen faster – BANG! – than any of us can now imagine. Think Lehman on steroids. The US gave Europe our subprime woes. Europe gets to repay the favor with an even more severe banking crisis that, given that the US is at best at stall speed, will tip us into a long and serious recession. Stay tuned.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

John Mauldin

John Mauldin is a renowned financial expert, a New York Times best-selling author, and a pioneering online commentator. Each week, over 1 million readers turn to Mauldin for his penetrating view on Wall Street, global markets, and economic history.

More Posts - Website

  • theta

    What is the total Eurozone’s external debt/GDP?

  • Daniel

    well, since the EU trade deficit with the rest of the world is quite small, I’d guess that the eurozones external debt is also small. Or which number do you mean?

    I find it surprising that Ireland has such a bad net debt number. wouldn’t that mean that Ireland has to run huge trade deficits with other eurozone countries? Today (after reading the latest Michael Pettis article on his blog ;)) I looked at some numbers from destatis who are the main trading partners of germany.,property=file.pdf

    On page 2 on the right side, you can find the trade surplus/deficit that germany has with country XYZ. Interestingly, germany has a trade deficit with Ireland, the only larger trade deficit country is china.

  • Achtung Grenaden!

    We are all going to be royally screwed. Cash will be the safest bet when this happens. As the EUR tanks, the USD will strengthen relatively. Combine that with a slowing economy and commodities will tank. If you were to believe Nouriel Roubini, Gold is overleveraged and that will tank too. Brace yourself for some fun.

  • Aqi

    Basically, Germany has two options.

    Either it chooses doom now(massive banklosses) or it postpones the doom but makes it larger but accepting a fiscal union.

    Of course, Europe being Europe, what will be seen is somekind of extend-and-pretend scheme that is very gradual and is bit by bit. Look for partial, highly conditioned Eurobonds with tons of details in the fine print with limited time frames and so forth.

    Europe does not look a complete, full solution. It likes gradualist extending.

    At some point, the market will force a decision the best it can. We’re close to that point.

  • theta

    I mean the accumulated deficit, i.e. the debt. If you consider Eurozone as a whole, its total debt is very small, and all denominated in its own sovereign currency, the Euro, in which the ECB has a monopoly of issuance. All this drama wouldn’t have happened if a proper fiscal union was in place, as then markets would only focus on the total numbers and they would see a country (let’s call it United States of Europe) with a very small external debt compared to its GDP, and in fact debt wholly denominated in its own currency.
    As there are already baby steps towards this fiscal union, what will actually happen is not the end of the world but rather the end of the crisis.

  • Mercator

    The global debt will slowly disappear through eternal stagnation, or someone will absorb the debt in the short term, thus enabling more immediate growth for whomever. You can bet our politiions are racking their brains on how to achieve the latter. I cannot get Mr. Mungers recent comment out of my head… “buy gold if you think your government is going to kill you”. I wonder what the American Indian would say to that comment.

  • Steve

    Enough already, create a whole lot of new Euro fertilizer, and start spreading it. Whats’ the worst thing that can happen, they overshoot and create some inflation transposed against revolution and/or depression.

  • Daniel

    the average public debt level of the EU is more or less comparable to the USA, the current deficit is half the size.

    “All this drama wouldn’t have happened if a proper fiscal union was in place,”

    There’s a small problem: Nobody wants a fiscal union, that’s why there were several years of negotiations on how to prevent that one EU state has to bail out another EU state. It’s called the Maastricht treaty.
    A fiscal union would have to change the complete system how states and the EU is currently organized and from the status quo, it would make government elections needless because then governments can’t decide any more how to spend the money. Is that compatible with a functional democracy? I don’t think so. You see, it’s not that easy…

  • GCT

    I stated this here before and kinda sorta got trashed. This is a political problem and even though the EU countries have partialy given up their financial soverignty, they have not given it all up. For a so called united states of Europe (I call it the dictatorship of Europe myself) to work every country involved must change its constitution and that will not happen at this time. Sometimes even though MMT would work you must remember that Europe is not the USA.

    There are alot of countries that do not want a cental institution telling them what to do. Especially one that is not elected. I honestly do not blame Finland and some other countries wanting collateral. What is sad is some big players stated Finland and the others backed off and then announcements from said countries stated they were not going to back off. Europe is currently a mess. This is going to be painful.

  • Frenchy

    Don’t totally agree with you. Gold has become a better bet than any other currency. Dollar may get stronger but the US economy overall will suffer. Gold is obviously overbought but look at how it has been behaving over the last year. Be it a hedge against falsely feared inflation or real deflation, gold does it and still has a lot to go in my opinion.

  • boatman

    you got it, GCT

    buckle up buddy

  • joe

    MMT newbie here. So if there’s deficits all over the place in the eurozone, there has to be a corresponding surplus somewhere, right? So where are the surpluses, and who is all this debt owed to (private german and french banks I believe)? Who’s the currency issuer? How are new euro NFA’s created? Wikipedia seems to suggest money is loaned out from the ECB, but must be paid back, so where’s a bank’s capital come from?

    Maybe someone could just share a link giving an overview of all this, I’m having a tough time finding it with the google…(In “Where’d the money come from” I think mitch explained it, but I didn’t really understand it)

  • pvk22000

    joe, many of the readers are much more knowledgable than me but, ….

    there is a difference between horizontal and vertical interactions. a typical private transaction in which one person’s asset becomes someone else’s liability is a horizontal interaction. Assets and liabilities always match.

    when the govt spends (or prints money) this is a vertical transaction that doesn’t nescessarily add net financial assets. in practice, the govt’s deficit spending is offset by bond issuance (there is the asset and liability). but the government is NOT REQUIRED to issue bonds in order to fund the spending. they have the power to create money ex nihilo without a corresponding liability.

  • joe

    Yeah I get all that (except I think govt spending always creates new NFA and taxing destroys them, I think you meant govt spending doesn’t create a corresponding liability in the private banking system the way horizontal money does, but I don’t want to put words in your mouth), but the eurozone is a collection of governments, and Cullen has often said Greece is in a position similar to a US state (a currency user), so what’s the eurozone equivalent of a federal government that transacts vertically with the system? I’m kinda looking for a Euro version of Cullen’s MMT 101.

  • Daniel

    there is no (real) european government in europe and I don’t think that this will change in the near or medium future.
    We have some kind of european parliament, but they don’t have any real rights, they can’t tax and can’t decide how each state spends its money. The “EU government” mainly harmonizes things like product liability laws etc through issuing guidelines.

    As mentioned above, it’s pretty unlikely that european democratic states will accept an institution that decides for them how to spend and tax. You would need such a thing so that you can issue eurobonds that are backed by a real government, not just some kind of representive parliament that has no rights. That would, in my view, inevitably have to end in a catastrophe.

  • joe

    Right, I get all that, there’s no overarching fiscal authority, EU is primarily single currency, open borders, harmonized trade policies, etc.

    But where do NFA’s come from, new euro money? Where’s the corresponding surplus to the Eurozone govt’s deficits (sectoral balances, one person’s deficit is another person’s surplus)? I assume the debt Greece has to the German and French banks is a horizontal relationship, Greek debt (liability) is a German bank’s asset. It seems like I’m missing a few (or many) key pieces to tie the thing together in my mind.

  • Daniel

    yes, that’s more or less the story. Germany has by far the largest surplus in the eurozone, so most of the money comes from german savings, see this chart

    it comes from this posting

    btw if you’re interested: Germanys large surplus is, in my view, pretty much the result of the german unification in the early 90s. The result was a housing / credit bubble and companies became a net safer after the internet bubble. So it’s not just the household sector, it’s also the corporate sector that paid down debt. That money had to go somewhere and it went mainly to spain to fuel the housing bubble there.

  • Anonymous

    i struggle to understand how gold is needed as a hedge against deflation. in a deflationary time, seems like just holding your currency, which should buy more and more as time goes by, would be the better strategy. can you explain?

  • joe

    Thanks! The european sectoral balances were definitely part of what I was looking for.