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Europe's Choice: To Capitulate or Decapitate

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Now that we have scraped through the U.S. debt ceiling drama, leaving in its wake the worst five-day loss for the S&P 500 since May of last year, attention rightly so returns to Europe and its own fiscal woes.

Yes, the new debt ceiling agreement has been ratified by Congress and signed by the President, allowing for at least a couple of months of headline freedom from the media (until the bi-partisan 'super committee' makes its recommendation on where the remaining deficit cuts should come from). And then it's a wait until 2013 before we encounter the debt ceiling issue again. During that period, it is quite likely that one or more eurozone countries will clamber up to the trough for another helping of bailout money, putting more even more pressure on a growth-challenged region and the foundation of the euro itself. Unless some tough decisions are taken soon, this will at a minimum create several quarters of volatility as markets gyrate to news from the region.

Not to make this too simplistic, but the EU really has only one decision to make and that is whether or not to take the 'union' to its logical endgame. Creation of a single currency zone, without the strength of a centralized fiscal power to effect stabilization and redistribution, was never a sound economic idea. It was always a political idea, designed to create and economy with economies of scale and to hopefully right the wrongs of a 20th century which saw the region ripped apart by war.

When the euro stumbled out of the gate in 1999 and fell below 90 U.S. cents in 2000-2002, critics wrongly claimed that this was it for the new currency. That, however, was pure market adjustment and nowhere close to the test that Europe faces now. Re-appreciation of the euro over the remainder of the decade was a reflection of not only of a troubled U.S. dollar, but a positive view to economic fundamentals in Europe. And why not? The peripheral countries of the group were presented with sharply lower interest rates to fuel domestic demand. Unfortunately, those countries acted like North American homeowners and disregarded the need for sound foundations, while becoming overly dependent on what were now (in hindsight) artificially low rates for the credit quality of a few of these nations.

Investors and rating agencies have become smarter and no longer care where the lowest common denominator rates are in Europe, nor where the ECB sets short-term rates. Market yields have spiked, ratings have been cut and we now have a dislocated economic region. The economic answer is to punt and re-group, with the removal of certain nations from the eurozone group. Give the Greeks their Drachmas, the Irish their Punts and the Portuguese their Escudos. Re-nationalizing outstanding debt will clearly involve a haircut by investors, as these countries devalue to re-ignite their economies, but it looks like haircuts all round anyway. With any luck, this carving out of the worst offenders would prevent the next in line from taking a hit (Spain, Italy, UK, and France).

Despite some of the economic arguments in favour of this course of action, politics will forbid it -- just like politics drove the euro idea through in the first place. Officials fear the market with good reason and know that one country's exit will only prompt speculation of additional departures -- not an orderly retrenchment, but a vote of non-confidence on the region as a whole. So, if punting is not the option, then Brussels has to drive forward and get members to entertain the idea of a complete union -- akin to Canada and the U.S. In other words, a central treasury to complement the European Central Bank and the ability to re-distribute tax revenues from haves to have-nots.

Here in Canada, we have taken our federal equalization system for granted, forgetting sometimes that it was responsible for keeping provinces like Newfoundland afloat during challenging economic times. That support inevitably allowed or those provinces to re-engineer themselves and slowly to become non-dependent partners in the economic and fiscal region. True, we're talking about a project that is ten times the scale of Canada's, but not unattainable either. The problem is that this next stage of evolution will take time and patience -- something that investors don't have in abundance. In the meantime, we need to be cautious as to where our European equity exposures are (no Greece, for example) and that goes for bonds as well.

As for the currency, it is unlikely that the euro will be able to sustain levels between US$1.40-1.50 if the fiscal drag on the region builds. Ironically, some calm in Washington over the U.S. debt situation might allow for the U.S. dollar to regain some strength and allow the euro to weaken (and hopefully stimulate export demand for the region). This would be the wrong focus for Brussels. Better to swallow the pride and whatever pain killers are needed and look for a deeper and longer-lasting solution.

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