A conspiracy theorist's dream

Is Dominique Strauss-Kahn the victim of a sinister, diabolical plot? Is Europe being brought to its knees by dark forces pulling strings in the shadows? Who would have the motive and the means? Can it really be a coincidence that the man responsible for bringing Europe together to rescue the EU's economic basket cases was locked up as a monster just days before Europe's heads of government were to meet to work out a deal for Greece?

Conspiracy theorists have ample material to let their imaginations run wild this week.

If the allegations against DSK are true, then the greatest tragedy of this story will be a personal one: the woman who was apparently attacked in the Sofitel on the weekend. We shouldn't forget that.

But it can be said that two groups stand to gain from this absence of IMF support for Europe. The first are the currency speculators, who stand to make a lot of money if the euro zone fails, or becomes smaller. The second are emerging market countries, who are already questioning the notion that a European should succeed DSK as the head of the IMF. Not only will DSK likely leave, but the second in command as well, American John Lipsky.

A number of names have already been floated, from Turkey, South Africa, Singapore and India. The most important of these emerging markets is China, which has strengthened its influence in Europe by lending the money that others--European creditor countries, American investment companies, and the IMF--are not.

Now, the idea that the euro zone could collapse or could become smaller depends on creditor countries like Germany taking an unrealistically tough line with debtor countries like Greece and Portugal. Until DSK's departure from the scene, it was hoped that he would be able to make a deal possible. The EU's finance ministers are finishing up a two-day meeting, and appear to have reached an impasse.

DSK, the IMF and Europe

This weekend brought a WTF moment from New York that will be bad for Europe, regardless of how the trial turns out.

DSK, Dominique Strauss-Kahn, has been arrested on allegations of attempted rape at the Sofitel in NYC. Since he heads the IMF, folks are now speculating whether it will impair the IMF's ability to play its role in the Euro crisis.

You would think it need not, but the euro zone fund is complex. One-third of the money is provided by the IMF, and Finland reluctantly agreed at the end of last week to support financial aid for Portugal if the IMF is totally happy with the deficit reduction measures that the country's government is implementing.

What DSK's effective departure does is open up a power play for the top role of the fund. With that contest comes an opportunity to upset the existing status quo, and to set new priorities within the fund. You can bet that various camps within the IMF are assessing each other's strengths, thinking of whom they can best work with, securing alliances, hatching plots and so on. 

Europe can only lose from this. In a tradition dating back to the original Bretton Woods agreements of the 1940s, America heads the World Bank and Europe heads the IMF. Both institutions have been reformed to  increase the representation of emerging markets within them, but the effects this will have on the institutional leadership have never been tested. Europe can only get weaker from here on in. It would be revolutionary if a non-European were to take the helm of the IMF. It is inevitable, however, that the opinions of the BRIC countries in particular will carry more weight from this morning onward. America should not be too smug either. The new constellation of interests is somewhat more critical of American public borrowing practices than pre-crisis.

For the moment, the immediate impact will certainly be that the IMF, as it deals with Portugal, will be in the process of transforming itself after a long period of pushing for internal reform. This is less likely to be a naked power struggle and more likely to be one that is done in secret. But DSK is politically finished, his parting has sped up something that has been in the works for years.

This means that Portugal will become the first test of what the new IMF is transforming into. What will it demand? Will it be harder? Or will it be lenient, considering that the Chinese have been lending money when other sources dried up, and are now more powerful in the IMF?

This case will not be the last, for it is now clear to all European leaders that Greece will default on its debt this fall. They've been talking about how to deal with this.

It's time to watch both the IMF and national governments very closely indeed.

Finland, Portugal and the future of the euro

European Commissioner Olli Rehn warned Finland today that it would cause a 'Portuguese Lehman' if it refused to back emergency funds for Portugal. The term is a bit off, as Lehman was private company, but the message is on target.

Then, as now, an important financial player will go bust without further assistance. If it goes bust, the contagion to other markets will be fast and hard. Portugal can be allowed to fail as a state just as Lehman was allowed to fail as a bank. But does Europe want that?

In concrete terms, if Portugal fails, there may be serious consequences for Spain. It's not the only country that would be hurt, but it is the most vulnerable. And when financial markets smell blood, the sense of weakness can become a self-fulfilling prophesy.

Germany blocks the ECB

Jean-Claude Trichet, the President of the ECB, has a term of office that extends into October and cannot be renewed under the existing rules. And yet, Europe cannot agree on a replacement.

Let me rephrase that. Germany cannot bring itself to support the candidate that everyone else seems to have agreed on. This is despite the fact that the Chancellor herself has praised the candidate, his policies and his credentials. Mario Draghi is the current Chair of the Financial Stability Board, the global body responsible for ensuring that there will not be another financial crisis. In terms of policy, Draghi brings everything to the table the Germans want. He is clear on the question of whether the ECB should continue to purchase bonds from bankrupt eurozone governments as Trichet has reluctantly done. He says the ECB wouldn't do that on his watch. He would be tough on inflation. What more can Germany want?

That is the question. Germany seems to want to teach Europe a lesson. Not just the 'deficit sinners' who will be cast into the fire, but France and Italy as well. The level of hysteria in the German press and in German politics against foreigners is breathtaking. They're not only mad at the so-called PIIGS, they're mad at the ECB as well. And that is run by a Frenchman.  Chancellor Merkel wanted a German candidate, Bundesbank President Axel Weber, to be the next head of the ECB. He withdrew from the running after citing opposition from Europe and from within the Bank itself to his intent to run a tight ship. And it seems in her eyes, the German chanting for European blood could only be appeased by a Teutonic captain at the helm of the ECB.

There is a saying coined by Carl Jung that what you resist persists. In the context of German hysteria, the Weber Affair blew up because it had to. Weber came across outside Germany as arrogant and contemptful of his European colleagues, echoing what Europe hates about Germany most. Only 10 years ago, Germany was an economic basket case. It flouted the rules that it demanded be applied to others. It defied the application of economic penalties in the mid-2000s when it passed one emergency budget after another. Now that it is back on track, it is screaming for obedience and punishment according to terms it would never accept for itself. 

Germany has been rightly criticised for a lack of sensibility in how it deals with its European neighbours. One might argue that there is little the German government could do in the face of such domestic revulsion for Europe. Except for one thing. Merkel forgets that Germany has been here before and chose European cooperation rather than an all-out War of the Roses. In 1991, Merkel's mentor, Chancellor Helmut Kohl, conceded minor points to the hysterical politicians who wanted to torpedo EMU. But he insisted that you had to compromise in Europe, that Germany actually had to get on with its neighbours. Germany's past, he argued, demanded that. 

Germany is at the verge of destroying Europe. It may not in the end, but it is making it weaker every day.

Finland gives the finger to Portugal

Finland's elections yesterday have generated a right-wing government that has promised to block Finish money going into the fund that will be used to help countries like Greece, Ireland and Portugal. Portugal is up for emergency funding now.

Oops.

There is no immediate clue that Finland will oppose the others moving forward. Nevertheless, it makes it harder to argue that everyone should be involved in the rescue.

American investments and European problems

It's possible that America is headed for a patch of economic trouble. If that happens and further American investments are liquidated in Europe to shore up the books on the left side of the Atlantic, that will spell further trouble for the entire EU, not just the euro zone.

The IMF yesterday warned that public finances in the United States are spinning out of control--specifically, that the deficit is growing whilst the economy is not declining. Financial papers and pundits are all over it, from the mildly crazy to the staid and respected. There is therefore a convergence of attention and assessment. Public debt levels are at 100% of GDP. It is not too late to recover. Belgium and Italy both came back from debt levels exceeding 130% of GDP, but that road was hard.

The problem for Europe is this. Once the US government starts reducing borrowing and spending, the economy will shrink, and with it, corporate profits and investment positions. The likely impact will be large enough to incite companies and other investors to sell off some of what they have abroad to make up at least some of the difference. This means redemptions (investors cashing in their positions and repatriating the funds) from investment houses in Europe, reflected in reduced volumes of cash in European financial markets.

We saw what happened last time this occurred in 2008/2009. The dollar started out low in 2008 and then rose in value in 2009 as American redemptions meant selling euros and converting them into dollars. This means that they value of the euro will be pulled in two ways that may cancel each other out initially, but drag Europe down in the medium term. There will be a push upward on the euro for a short time, but those redemptions will lead to stock market declines that may very well spill into the real economy.

Ultimately, Europe will have to start thinking about how it will deal with American decline. When a key global institution joins the chorus of critics who demand you live more modestly, change will eventually happen. What we don't know is what exactly the timing will be or what event will start the rush toward the fire exits. There are no elections this year which serve as a defining moment of political clarity. But the current American showdown between Republicans and Democrats over the national budget will probably play the biggest role of all. 

The Coming Earthquake: Spain and EMU

Spain is already in denial mode: that it won't be the next target in the war to collapse the euro zone. Public finances are suffering due to the general economic downturn. This has to be bitter. It has managed its public finances as well as can be expected, and better than most northern EMU members expected. And as I've said before, Spain has the political wherewithal to make cuts when they're needed. But they also have to be possible.

And yet, none of the political austerity may matter in the end, which would deal a crushing blow to those who argue that public austerity is a public virtue. The problem is Spanish banks. They are enormous, and they are not only exposed to Portugal to the tune of 100 billion euros , but we don't know what toxic assets of their own they have. That makes them (potential) zombie banks. If one or more of them were to fail, the pressure on the Spanish governmment to cover the losses will be enormous. If there is any doubt about that, look toward Iceland, which Britain and the Netherlands are now suing because the Icelandic public rejected a taxpayer-funded bailout of Dutch and British depositors.

It will be interesting to see how the European Banking Authority deals with the stress testing of these banks, in addition to how they deal with stress testing more generally. Will they choose the harsh reality or to assuage public fears about the state the banks are in?

But...if there is some sort of catastrophe, it would be wise for the Spanish government and the Spanish electorate to allow some bank failure if it is required, rather than write a blank check. The government have managed their finances relatively well. If banks fail, it will not be the Spanish government's fault. Other countries (particularly Germany) will say it is, but Madrid should ignore them. The choice between a sharp, deep cut into the economy from which the country can recover quickly and decades of indentured servitude of the Spanish taxpayer to nothern creditors is pretty clear when you look at it in those terms.

When the rage in Spain comes, it should be properly directed at bank practices that have not yet been sufficiently targeted. Yes, the state allowed and encouraged these things and should be critiqued for that, but it is not the same. The corporate governance of banks is still insufficient, and therefore consequences have not been drawn for the causes of the crisis. A good collapse may be just what Europe needs to expose the rot where it really is, in the private sector. Ireland failed to do that. Iceland did do it, but the message hasn't gotten across to the Dutch and the Brits and the Germans. And until it does, the regulatory measures to prevent another crisis won't be forthcoming.