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With fiscal time bombs ticking in both Europe and the
United States, the pertinent question for now seems to be which will explode
first. For much of the past few months it looked as if Europe was set to
blow. But Angela Merkel's refusal to support a Federal Reserve style bailout
of European sovereigns and her recent statement the she had no Hank Paulson
style fiscal bazooka in her handbag, has lowered the heat. In contrast, the
utter failure of the Congressional Super Committee in the United States to
come up with any shred of success in addressing America's fiscal problems has
sparked a renewed realization that America's fuse is dangerously short.
Chancellor Merkel has been emphatic that European
politicians not be given a monetary crutch similar to the one relied on by
their American counterparts. Her laudable goal, much derided on the editorial
pages of the New York Times, is to defuse Europe's debt bomb with substantive
budget reforms, and as a result to make the euro "the strongest currency
in the world." Much has been made of the poorly received auction today
of German Government bonds, with some saying the lack of demand (which pushed
yields on 10-year German Bonds past 2% --hardly indicative of panic selling)
is evidence of investor unease with Merkel's economic policies. I would argue
the opposite: that many investors still think that Merkel is bluffing and
that eventually Germany will print and stimulate like everyone else. It is
likely for this reason that yields on German debt have increased modestly.
In contrast, the U.S. is crystal clear in its intention
to ignore its debt problems. With the failure of the Super Committee this
week it actually became official. American politicians will not, under any
circumstances willingly confront our underlying debt crisis. While the
outcome of the Super Committee shouldn't have come as a great surprise, the
sheer dysfunction displayed should serve as a wakeup call for those who still
harbor any desperate illusions. Some members of Congress, such as John
McCain, have even come out against the $1.2 trillion in automatic spending
cuts that would go into effect in January 2013. Expect more politicians of
both parties to cravenly follow suit.
Over the next decade, the U.S. government expects to
spend more than $40 trillion. Even if the $1.2 trillion in automatic cuts are
allowed to go through, the amount totals just 3% of the expected outlays. In
a masterstroke of hypocritical accounting, $216 billion of these proposed
"cuts" merely represent the expected reductions in interest
payments that would result from $984 billion of actual cuts. These
cuts won't make a noticeable dent in our projected deficits, which if history
can be any guide, will likely rise by much more as
economic reality proves far gloomier than government statisticians predict.
Finally, the cuts are not cuts in the ordinary sense of the word, where
spending is actually reduced. They are cuts in the baseline, which means
spending merely increases less than what was previously budgeted.
In the mean time, the
prospect of sovereign default in Europe is driving "safe" haven
demand for the dollar. So contrary to the political blame game, Europe's
problems are actually providing a temporary boost to America's bubble
economy. However, a resolution to the crisis in Europe could reverse those
flows. And given the discipline emanating from Berlin, a real solution is not
out of the question. If confidence can be restored there, each episodic
flight to safety may be less focused on the U.S. dollar. Instead, risk-averse
investors may prefer a basket of other, higher-yielding, more fiscally
sustainable currencies.
The irony is that Europe is actually being criticized
for its failure to follow America's lead. This misplaced criticism is based
on the mistaken belief that our approach worked. It did not. Sure, it may
have delayed the explosion, but only by assuring a much larger one in the
future. In the mean time, many have mistaken the
delay for success.
However, if Merkel's hard line works, and real cuts
follow, Europe will be praised for blazing a different trail. As a result the
euro could rally and the dollar sinks. Commodity prices will rise, putting
even more upward pressure on consumer prices and interest rates in the United
States.
Any significant reversal of the current upward dollar
trend could provide a long awaited catalyst for nations holding large dollar
reserves to diversify into other currencies. My guess is that Merkel
understands the great advantage the U.S. has enjoyed as the issuer of the
world's reserve currency. I believe she covets that prize for Europe, and
based on her strategy, it is clearly within her reach.
There is an old saving that one often does not
appreciate what one has until it's lost. The nearly criminal foolishness now
on display in Washington may finally force the rest of the world to cancel
our reserve currency privileges. The loss may give Americans a profound
appreciation of this concept.
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