resignation last Friday

Jürgen Stark, a respected and politically-connected economist representing Germany on the ECB, resigned from that body’s board on Friday at about the time US markets opened for trading last Friday.  You can see the sharp drop in stocks that followed the announcement of this news.  Why?

some background

1.  Deeply scarred by the hyperinflation of the Weimar years after WWI, Germany has always been the strongest advocate of price stability (i.e., no inflation) in modern Europe.  Unlike the US, which is willing to accept a moderate amount of inflation (currently the upper bound is 2% or less–and we wish it could get that high) in return for faster GDP growth, Germany is willing to sacrifice almost any amount of growth to maintain stable prices.

As a result, Germany has traditionally acted as the economic “policeman” of Europe, enforcing sound fiscal and money policy rules and acting as a lightning rod to deflect local political criticism in the rest of the EU for governments taking unpopular but necessary economic actions.

Mr. Stark’s resignation from the ECB for “personal reasons” –but apparently in protest over the ECB’s decision to prop up the finances of weaker EU member states by buying their bonds–suggests the ECB is deciding/has decided to break with the traditional no-inflation-first policy stance.

2.  Mr. Stark is the second German official to resign from the ECB in recent months.  In February, Axel Weber resigned as head of the German central bank and withdrew from consideration to head the ECB–apparently with similar concerns to Mr. Stark’s.

3.  The Stark resignation may cause enough political fallout inside Germany to force the Merkel government to say openly whether it approves of ECB actions.  So far, Germany has been pretending it doesn’t see the drift away from the traditional German policy stance and just, little by little, letting the drift continue.  I’m not an expert on internal German politics.  But it doesn’t seem clear whether Germany would back Ms. Merkel vowing unconditional support for a Greek bailout–meaning German taxpayers would foot a large part of the bill.

stock market reaction

World financial markets are acting as if the Stark resignation is the tipping point that will force the EU to stop hoping the problem disappears and confront the fact that Greece can’t service the large amount of euro-denominated sovereign debt it has amassed since joining the EU.

possible solutions

In general terms, two approaches to resolution are possible:

–the German price stability mentality holds.  If so,

Greece will be allowed to default.  Holders of Greek sovereign debt, including big EU banks which are stuffed to the gills with these bonds, will suffer large losses.  The problem with this solution is that the markets will just turn to the next country with wobbly finances–Portugal or Spain–and the whole destabilizing question of bailout or not arises anew.  Look at the Asian debt crisis of 1997 if you don’t think so.

–the EU as a whole assumes responsibility for the sovereign debt of weaker members.  There’d have to be some mechanism for ensuring that a repeat of their debt expansion doesn’t happen.  To the stronger countries’ eyes–and certainly to Germany’s–this has to look like a rerun of the reunification of the two Germanies after the fall of the Berlin Wall.  A decade of economic stagnation followed.  So this solution (which I think is more likely) probably also entails a bias toward a weaker euro and tolerance of a bit of inflation.

what do investors do?

Solution 1 is bad for Greece, and bad for banks and other financials that hold Greek debt.  It might just shift the focus of worry away from Greece to Portugal or Spain.

Solution 2 is bad for the less-indebted EU members and bad for the euro.

The intersection of the bad-ness is the financial companies in the less-indebted EU countries.  So for traders, selling them is a no-brainer.  Even if these stocks are the epicenter of weakness–and they have been so far–arbitrage tends to drag everything down.  So just selling anything in the EU is a close second choice.

If there’s any silver lining to the selling, it’s that it may force a resolution to the Greek debt issue.  A sharp market decline may provide the political cover EU authorities feel they need before they act in a way that could threaten their ability to be reelected.  Also, as the selling exhausts itself, there may be an opportunity to pick up the stocks of well-run EU-based multinationals at a cheap price.