Euro End Game: All Roads Lead to Monetary Breakup

The ultimate capital contribution to the European banks will be in the trillion euro range, and it is likely that the EFSF will attempt to use leverage. But, because the capital contributions to the EFSF already being discussed (and I expect they aren't as large as they need to be) are large relative to Europe's GDP, there are likely to be ratings downgrades, causing interest costs to rise and making austerity in the EU even harder to bear. Under existing discussions, France, one of the two major characters in the whole crisis, is expected to make a contribution to the EFSF that is equal to 8% of its GDP. This alone will surely result in a ratings downgrade, as its Debt/GDP ratio has risen nearly 20 percentage points this year alone.

How long will the public endure the resulting austerity? Only long enough for the political process to elect leaders who promise to get rid of it. And, how do they do that? Exit the EMU.

Fiscal Capacity

It is clear that Germany and France are the key players (who are expected to be saviors) in this European drama. As explained above, as the drama unfolds, it is likely to put a tremendous strain on France's fiscal capacity making it impossible for France to contribute further resources to the crisis (they are already on the hook for a significant contribution to resolve the Dexia issues). That leaves Germany as the last bastion of the euro. Think of the irony. The German people, by a large majority, never wanted to join the EMU. Their politicians brought them in kicking and screaming. Now, they are going to be asked to pay for all the entitlement and profligacy of their European neighbors. This just isn't going to fly. When it gets to this point, and it will, Germany will simply say no, and that will be the end of the EMU.

Conclusion

It is already too late. The euro cannot be saved without the adoption of the U.S. federal model where the countries become the equivalent of U.S. states with one monetary and fiscal policy, ultimately run by Germany. Because of culture and history, the odds of this happening are about 0%.

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