The EU Treats the Addict not the Dealer

Betting against a crisis is almost always the right approach. If you invest without leverage, you’re afforded the luxury of waiting to see how events play out without caring too much about the path equity prices take. It might very well be that the latest round of negotiations will result in the ultimately more stable Euro the whole world now desires. While being long equities reflects a belief that things will work out, borrowing money to do so would reflect more conviction than is warranted. A big question is precisely what mechanism will be used to enforce budgetary discipline in the future, since the Maastricht Criteria (limits on deficits at 3% of GDP; debt at 60% of GDP) were as much use as the Maginot Line against the German panzers in 1940. In fact, Germany and France were among the first countries to violate this law, and consequently the fines (set at implausibly high levels such as 1% of a country’s GDP) were never imposed. It’s unclear how such fines could ever be imposed, and a key element supporting the imposition of fiscal discipline remains to be defined.

It occurred to me that one solution might be to limit each country’s banking exposure to profligate nations. Instead of emphasizing rules for the borrowers, impose rules on the lenders. Germany could pass a law preventing its own banks from incurring country risk to, say, Spain in excess of 5% of a bank’s tier one capital. All the current measures impose penalties on the debt addicts, but the dealers who provide the fix are part of the problem too. This would seem to be a solution well within the ability of each creditor country to impose unilaterally without requiring a treaty overhaul, and would also limit creditor nations’ exposure to rule-breaking profligacy in the south. It seems a simple measure, I’m not sure why it’s not part of the solution.

The Economist magazine noted on the weekend that Sweden (an EU but non-Euro member) has imposed 12% Tier 1 Capital to Risk Weighted Assets requirements on its own banking system. Overleveraged banks are no doubt a substantial part of the problem. Sweden has prospered outside the Euro zone (though its export-driven economy is expected to suffer next year given a likely Eurozone recession). More countries should follow the model of Sweden and adopt more realistic leverage rules in their banking systems.

Meanwhile, long $100 of SPY and long $40 of EUO provides exposure to attractively priced stocks in combination with a short € position since most disaster scenarios for the stock market start in Europe. The relationship between the two has tightened in recent weeks – Eurozone sovereign debt solutions promote austerity and are negative for growth; a melt-down clearly is; muddling through with neither of the above should be (in fact, has already been) positive for equities and only mildly bullish for the €.

Disclosure: Author is Long SPY, Long EUO