Europe: Don't Forget the Sixth Man

In basketball, with 5-person teams, the crowd is often referred to as their "sixth man". (My webmaster, an Ann Arbor Native, would like us all to take a moment and realize this year marks the 20th anniversary of the Fab Five) Ahead of tomorrow's summit, there are numerous proposals being floated that involve modifications to the EFSF and different schemes for private sector participation.

It is not yet clear how the dust will settle, or even if an agreement, which Merkel warned yesterday would not spectacular, is even sufficient for the dust to settle for long. Speculation of some agreement has helped lift the euro, peripheral bonds, and generally has underpinned the risk appetite in recent days. This leaves the market vulnerable to disappointment or a "buy the rumor sell the fact" type of activity.

Merkel's comments yesterday seemed more than posturing Germany is not the "sixth man". Indeed, the German Constitutional Court is. They heard a case a few weeks ago and a decision is expected in the next 4-6 weeks. The Court's rulings previously seemed to insist on preserving a role for the German parliament in making aid decisions. That is part of the reason why an EFSF being able to make loans or grant lines of credit to peripheral countries seems to be a non-starter. Anything that looks to close to a fiscal transfer, leaving aside what the ECB does, will face stiff opposition in Germany and several other countries, like Austria, Finland and Netherlands ahead of her meeting with Sarkozy today. They seemed to reveal that Germany was not prepared to budge very much. Indeed, in response to talk that EU officials are considering, among other things, EFSF bond purchases, news wires note that Germany is still not supporting such measures.

More broadly the "sixth man" refers to all those forces and interests that will not be sending representative to the EU summit that are serving to constrain policy options. Taken together, this is important because although investors can be expected to work through the economic and financial implications of whatever is decided, the political considerations that shape those decisions are often beyond the ken of many.

We have argued that the EMU itself is ultimately an economic solution to a fundamentally political problem: on what terms could Germany be reunited after the Berlin Wall fell ? EMU--sharing of the uber-mark (and yes the euro continues to trade more like the DEM than GRD) and the Bundesbank's anti-inflation credibility (which means low interest rates) with others. The crisis is both a cause and effect of limitations of this strategy.

In addition to this European narrative, the debt crisis also is part of a more generalized narrative. The end of the global credit cycle and the deleveraging unleashed squeezes all debtors--households, corporations and sovereigns. The cost of this in the US is clear--collapse in home prices, high unemployment, slow growth and weak consumer. The cost of this in Europe is the sovereign debt crisis.

Contagion implies the innocent getting punished along with the guilty. In this crisis, no debtor is innocent. They are all vulnerable. The US appears to be trying to mitigate the impact of the deleveraging, but not reverse it. European officials seem to be trying to resist it. It is a more difficult battle to wage.

Lastly, what also makes the European situation more difficult is that it is still early days for the EMU experiment of monetary union without political union. It is being forged in the hearth of crisis. It is restrained by desires to preserve sovereignty; treaty and constitutional obligations, and the weak or fragile political leadership.