Europe's Last Resort: The (Very Much Doomed) Maginot Line Part Deux

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As those who have studied some history know all too well, any mention of the Maginot Line usually does not have a Hollywood ending. Alas, the same can be said for the highly unique analysis by JPM's Michael Cembalest who looks at Europe's latest "Maginot Line", this time however for the insolvent, 21st century, generation. "Rather than focus on what EU politicians said at yet another summit this week, let’s look at the lines of defense they may eventually have to rely on to defend the European Monetary Union. For illustration’s sake, we have superimposed these defenses on a map of the Maginot Line constructed by France in the early 1930’s to defend against an attack from the East." The 8 steps outlined present, from start to finish, the flow chart of what will happen in the next few months as Europe scrambles to avert one crisis after another, which as we pointed out months ago, ends with the "last resort" federalization of Europe, via the Eurobond paradigm. Alas, the response to that is (or isn't) revolution, in which the people finally tell their treasonous (there, we also used that word) governments they have had enough of funding other people's greed, gluttony, and overall mistakes. Just as the idiotic Maginot line, praised back in its day as a work of genius, was circumvented in one simple move when the German army simply invaded France through the Ardennes forest and took over in hours, so this latest Maginot line will do absolutely nothing to prevent the final outcome which even Europe's deranged bureaucrats know is coming: the end of the most flawed generational experiment in globalization history.

From Eye on The Market by Michael Cembalest of JPM:

The Maginot Lines. Rather than focus on what EU politicians said at yet another summit this week, let’s look at the lines of defense they may eventually have to rely on to defend the European Monetary Union. For illustration’s sake, we have superimposed these defenses on a map of the Maginot Line constructed by France in the early 1930’s to defend against an attack from the East. Right now, the weak link in the European chain is Italy. It looks like Italy will run out of cash some time in September. The good news is that 10-year Italian bond yields have declined by 1% since early August, most likely due to ECB purchases in the secondary market. But if new issue sovereign debt markets are not available to Italy at acceptable yields 1, the defenses shown below would presumably begin to kick in, one after the other, and only should the prior one fail.

There are quite a few gaps in some of these defense lines:

  • Insufficient firepower. Increasing the EFSF to 440 bn does not create enough capacity if Italy does not access debt markets, since most of it is already promised to Greece, Ireland and Portugal
  • Unproven weaponry. I cannot remember a situation where an exogenous buyer (central bank, the IMF, an alien from outer space) through its own non-economic purchases, drives up a credit-impaired secondary market price and thereby resets the new issue price at that level. In other words, if the ECB pays champagne prices for spumante, will anyone else?
  • Self-inflicted losses. Some lines of defense entail ever-growing contingent obligations taken on by AAA-rated Germany and France. Their gross debt to GDP ratios already range from 80%-87%. Could EFSF expansion trigger a downgrade?
  • Tepid allies. The IMF does not appear to be in the mood to increase its contribution.
  • Vulnerability to attack from within the ranks: some lines of defense might be hard for national parliaments to accept. The
    basis of Germany’s entry into Maastricht was that it would not be a fiscal transfer union of commingled national obligations. Even Sarkozy conceded that Eurobonds would lack necessary the democratic legitimacy right now.

It’s hard to handicap the backdoor politics, given conflicting views across the EU. What we do know is that these steps are unlikely until there is some kind of market riot, which means asset prices may be much lower by the time they happen. I agree that there’s a wide array of defenses to prevent a disorderly default or unwind of the EMU. However, back to history: despite perceived impregnability, the Maginot Line 2 was an exercise in futility, as the German army simply went around it, crossing into France through Belgium and the Ardennes Forest. Similarly, if the European Periphery is stuck in a structural growth rut from which it cannot emerge without weaker exchange rates, financial engineering can only delay the inevitable. I have not seen a country be able to indefinitely endure low growth, high unemployment, austerity  imposed from abroad, large debt burdens and limited prospects for a way out. As shown below, that’s where the  European Periphery is right now, in sharp contrast to the prior 40 years of close connection to the Core. Optimists believe that Peripheral growth will rise once the multiyear fiscal adjustments are complete; I’m not so sure. European equities are priced cheaply, but are likely to stay that way.

The Maginot Lines crossed by European banks make this crisis harder to navigate and assess:

  • Listed Western European banks rely much more than US or Japanese banks on volatile wholesale (non-retail) funding. We have seen reports from Gavekal Securities which suggest that US branches of EU banks have at least 33% of their assets  in cash. This could be an indication that they are preparing for a pretty severe storm.
  • Many European banking systems, relative to their economies, are much larger than the US banking system
  • European banks have raised roughly half the capital (as a % of total assets) compared to US banks since March 2009

Message to the ECB, quoting Police Chief Martin Brody: “I think you’re gonna need a bigger boat” (Jaws, 1975).

  • 1. Italy last issued 10 year debt at 5.7% on July 28th, and Spain issued at roughly the same level the prior week. German bunds are at 2.10%.
  • 2. The Maginot Line was considered an amazing achievement at the time: a series of anti-tank barriers, bunkers, fortresses and heavy artillery, all connected by road and underground rail, stretching for hundreds of km from Luxembourg to Switzerland, and which was often 25 km deep. Cost back then: 5-6 billion francs. In 1964, the French government began to sell off parts of the Line through public auction. The purchasers (many from Germany) turned the casements and shelters into holiday chalets, garages, mushroom farms and a disco.