Kicking The Can Down The Road - European Debt Crisis

How Are Europe's Peripheral Countries Staying Afloat?

The US is actually involved in bailing out the European banks.

This is because the Federal Reserve is giving funds (over $100 billion so far) to the ECB through a "temporary US dollar liquidity swap agreement". Since the ECB won't buy the bonds from Europe's peripheral countries itself, the ECB is now lending to European banks by giving the banks unlimited 3-year funding at a 1% interest rate (the ECB has now lent some $639 billion to banks, double the amount analysts predicted). The European banks are now hoped to turn around and buy the bonds of the peripheral countries with those funds.

Ultimately, the Fed is lending to the ECB, the ECB is lending to European banks, and the banks are taking those loans and are supposed to buy the bonds of the peripheral countries so that their governments don't default on what they already owe, at least for now.

The ECB balance sheet is now at a record high of 2.73 trillion euros.

Italian Debt Auction

Today, Italy was still unable to raise the maximum amount it wanted (8.5 billion euros) when it auctioned 7 billion euros of 10-year government bonds, even though Italian lenders borrowed 116 billion euros as part of the ECB's offer of unlimited 3-year funds. Yesterday, however, the 3-year Italian treasuries were sold more easily, as the ECB's funds made a big difference for yields, which dropped more than 2% to 5.62%.

Some European analysts say that the auction today was successful, because bond yields were lowered a bit below 7 percent as there was more demand for these bonds. Investors, some analysts say, are becoming more comfortable with the higher bond yields. However, in the US, the analyst's sentiment is a little different as there was only a small reduction in Italy's 10-year yield, after the bold lending move by the ECB, a near 7 percent yield is still very high. 

In my opinion, the just under 7 percent yield of Italian 10-year treasuries is unsustainable in the long-run, and since Italy has debt of around 120 percent of GDP and needs to raise another 150 billion between February and April, I have serious concerns about Italy meeting its bills. If Italy is unable to find buyers of its debt at an affordable rate and if the ECB does not use its power to buy Italian bonds with newly created money (which would remove the incentive for governments to control their spending (Mchugh)), then Italy very well be on its way to default.

Unfortunately, adding to the problem, is that the stress tests by the European Banking Authority (EBA) has revealed that European banks need to raise another $149 billion in extra capital to offset a fall in the value of their existing holdings of government bonds issued by troubled peripheral European countries (the economist). European banks may be using the 3-year funds from the ECB to meet these requirements rather than buying short-term bonds from peripheral European countries.

Still, there is no doubt that the ECB gave a huge short-term debt boost to Italy. But, the investors who bought 10-year Italian bonds are taking a major risk as there is a lot of uncertainty surrounding Italy and its potential default.

 Stay Out: All Of EU Will Be Affected By Potential Defaults

With banks holding back lending to meet their capital requirements and perhaps buying government debt that still may default in the future, I am short Europe and the Euro. Although some of the stronger northern European countries may be showing signs of growth (ex: Germany), I believe that the concerns of the weaker southern European countries and their potential default will prove to outweigh some growth and ultimately that those concerns will be costly for all of the EU.

I am short the Euro vs USD because there are significant signs of growth in the US, while Europe struggles to get its debt problems under control. I believe that over the next few months investors will start pulling their money out of Euro denominated securities and start buying dollar denominated securities, pushing the dollar up against the Euro.

Guest Commentator: Ralph Vaz -- Bank Regulation Since 2008

 Banks: Regulation vs Free Market

Since the 2008 financial crisis, the financial sector has come under criticism for its behavior leading to the crisis, generating a classic economics debate of regulation versus free markets and highlighting the predator-prey relationships between the government, businesses, and the people. The government argues that businesses prey on the people, while businesses argue that the government preys on them through regulations. So we again face the age-old question of how much (if any at all) regulation is good or necessary?

Glass-Steagall Act: 1933

After the bank failures during the Great Depression, the Glass-Steagall Act was passed with the intention of separating commercial banking activities from investment banking activities. Many considered the growing involvement of commercial banks with stock market investments to be both highly inappropriate and one of the main causes of the stock market crash. The banks took on excessive risk by investing depositors' money into high risk assets. As a result, the objectives of banks came under scrutiny. The companies that banks invested in were given shady loans by those same banks.  

This was seen as a major conflict of interest. The Glass-Steagall Act aimed to solve this conflict by forcing banks to specialize in either commercial banking or investment banking, but not both, setting a maximum of 10% on the amount of income a commercial bank could get from securities. Most of the banks reacted harshly to the regulations; many argued that some diversification is necessary to help banks reduce risk.

As the years passed, banks became more transparent about their practices. Consumers and regulators came to believe that this growing transparency would keep banks from assuming too much risk. As a result, in 1999, Congress passed the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act.

Period of Deregulation

Repeal of Glass-Steagall through the  Gramm-Leach-Bliley Act has often been attributed with contributing to the financial crisis of 2008. This argument stems a concept everyone will remember: sub-prime loans! Sub-prime loans are those given to people who are not very credit-worthy. A higher interest rate is placed on these loans to compensate for the higher risk of lending. In general, sub-prime loans are considered risky loans. Before the Glass-Steagall Act was repealed, sub-prime loans made up about 5% of all loans. After its repeal, by the peak of the crisis in 2008, sub-prime loans had grown to 30% of all loans.

Post-Crisis impact 

There have been several attempts to re-enact the Glass-Steagall Act, most notably by Senator John McCain in 2010. President Obama also supported the "Volcker Rule," which proposed several laws similar to Glass-Steagall. The main goal of the "Volcker Rule" is to ban proprietary trading, which is trading on the banks' accounts with customers' deposits. Proprietary trading was very common in the period leading to the crisis and firms such as Goldman Sachs made as much as a quarter of their profits from proprietary trading.

In 2010, President Obama signed into law the Dodd-Frank Act, which includes many provisions of the Volcker Rule. Dodd-Frank was meant to reform Wall-Street and protect consumers from the type of predatory lending that led to the sub-prime crisis. However, there has been much debate about this law. Although the law passed, bankers still are arguing that the law imposes regulations that are too strict, while consumers maintain it does not offer enough regulation to protect the borrowers. So far,  the main components of the act have yet to be felt, although they are certainly in progress.

Stress Tests

Recently, there have been further developments on the regulation of large banks. For instance, there will be a heavy emphasis on using stress tests to determine how banks would do under conditions like those seen in 2008. The EU already has implemented such tests, and major European banks have been struggling to meet them due to the illiquidity of the markets. 

Additionally, by 2013 financial firms will be required to hold at least 5% of their assets in reserves at all times, or face a surcharge penalty for assuming too much risk. In the years leading to the  crisis, most banks were holding only around 3% of their assets as reserves. The increase in the capital requirement was adopted because a greater reserve could be used as a cushion in periods of high distress on the markets. However, banks argue that greater reserve requirements will stall growth by reducing lending.

Basel III

Many of the Dodd-Frank regulations are based upon the Basel III, an international regulatory standard, although they are not nearly as severe as Basel III. In fact, some U.S. banks fall under both US and the Basel III regulations and therefore will face stricter capital requirements. Both the U.S. and the Basel regulations are targeting banks deemed "systematically" important, or important enough to impact the market as a whole.

There are concerns that the regulations will result in less liquidity in the markets, and increase costs for banks at the absolute worst time. But the Fed believes the benefit of reducing the chances of another crisis outweighs the short-term costs of making loans available at cheap rates.

How Will This Impact U.S. Markets

In the short run, I feel that most of the impact from regulations is already built into the stock market price. We saw the markets struggle immediately after the announcements of further regulations, and the financial firms impacted by the regulations took the biggest hits. It is still important to note that all the provisions of the regulations are not finalized. The Fed is expected to release further details in the months to come (likely by March). Pay close attention to all details released and the reaction of lenders to those details. If the regulations turn out to be more severe than expected, then I would certainly expect more of a short term hit to the financial sector.

As Jon pointed out to me, the next few years look to be very gloomy for banks until the business cycle repeats itself (regulation vs deregulation). Until there is more stability in the markets, a large concern for banks is that they will have to find new ways to make profits without making risky investments. 

Guest Commentator: Ralph Vaz

President of the Society of Individual Investors (SII)

http://www.sii.org.vt.edu/

The Federal Deficit -- Is Another Downgrade Aaa Big Deal?

A Little History on US Debt

The US government has not always run a deficit. In fact, when looking back at the US debt’s financial history, the US has really only run deficits during wartime or during financial crises-- until the 20th century. In the 20th century, the US acquired more significant deficits both in war and peace times. These occurred following WWI, the Great Depression, and WII, and in almost all years since 1960, whether we were at war or not (Chantrill).

 US Debt (% of GDP since 1792)

In the current millennium, public debt has increased by over $500 billion each year since 2003, with increases of $1 trillion in 2008, $1.9 trillion in 2009, and $1.7 trillion in 2010. As of mid December, the gross debt was over $15 trillion, $10.5 trillion held by the public and $4.65 trillion from intergovernmental holdings.

What Is A Deficit And Is It A Problem?

How is this deficit created? Simply, the federal government spends more than it takes in from its receipts (ex: taxes), so it borrows money to carry out what it promises that we will receive as benefits, including Medicare, new roads, defense, education funds, and so on. Is this really a problem?

Yes in the long-run and no in the short-run. In the long-run, if the US continues to borrow to meet its bills, there will come a point when its loans become more risky and lenders will start requiring higher interest rates. The concept is similar to when an investor requires a higher rate of return when he lends money to a company that is already in debt up to its eyeballs, and continues to acquire more debt. If the US government were a company, it would be selling junk bonds. Ironically, though, US Treasuries are currently considered among the safest assets in the world. Funny, isn't it?

In the short-run, it is not a problem and this is because, believe it or not, markets are not nervous about lending to the US. In fact, last August when S&P downgraded the US government's credit rating, its borrowing costs actually fell further. Clearly, the markets disagreed with the rating agency. But, what if another rating agency downgrades US government debt?

Another Downgrade?

Today, another rating agency, Fitch, warned the US of a credit downgrade, unless we solve our growing debt problem. Last month Fitch put the US on negative outlook, citing the failure of the special congressional committee to agree on at least $1.2 trillion in deficit reduction measures.

Fitch said in a statement, "Federal debt will rise in the absence of expenditure and tax reforms that would address the challenges of rising health and social security spending as the population ages... the high and rising federal and general government debt burden is not consistent with the U.S. retaining its 'AAA' status despite its other fundamental sovereign credit strengths" (Huffington Post).

So, what are we doing to fix this problem?

Fixing the Budget: What is the Super Committee?

We've all heard of the US budget "super committee" but what exactly is it, and what has it done to help fix the debt problem? The super committee, formally the "Congressional Joint Select Committee on Deficit Reduction," was created through the Budget Control Act of 2011 signed by President Obama and is made up equally of Republican and Democrat lawmakers to help control our federal government's budget deficit. The hope is that the committee will agree on some $1.2 trillion in budget cuts over the next 10 years. Now, however, we are just scuttling by, as last August we did not default on our debt by immediately raising the debt ceiling (a power of Congress) by $400 billion. So basically, we just borrowed more to pay off the interest payments and debts we already owe.

Last month, because of political gridlock, the super committee failed to come up with a budget plan. The Republicans did not want any tax increases and wanted to protect the tax cuts for high earners while Democrats did not want to make cuts in Social Security -- Medicare & Medicaid -- unless Republicans agreed to tax increases. Unless the committee comes up with $1.2 trillion in cuts by 2013, there will be automatic across-the-board spending cuts by our government.

Surely, controlling our spending will be one of our greatest challenges in coming years. As for now, there seems to be no real solution as Fitch continues to threaten a downgrade.

Another Downgrade May Not Be A Big Deal? What Now?

Fitch will probably cut the US's AAA rating by the end of 2013 if Congress is unable to formulate a plan to reduce the budget deficit after next year's congressional and presidential elections. For now, rating agencies will continue to warn Congress to get its act together and make cuts. Overall, like the European sovereign debt crisis, this issue is a slow moving train wreck and will continue to make headlines until fixed. 

Although a major problem in the long-run, the US government has the ability and tools to help avoid the consequences of overspending--such as higher borrowing rates-- by limiting our spending. Also, unlike individual EU nations, we are able to control our money supply more easily and if we have trouble paying our debts, the Federal Reserve can print more money to help repay them. Based on the past response of the markets to a downgrade and the faith of the markets in the US government to repay what it owes, I do not think that another downgrade by a rating agency, such as Fitch, will have a large impact on markets.

Current Financial Figures and Organizations You Should Know

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US Department of the Treasury: Headquartered in Washington, DC the Department of Treasury is an executive department that is responsible for producing all US currency, collecting taxes, paying bills, managing government accounts, supervising national banks, advising on domestic and international financial, monetary, economic, trade and tax policy (advises on fiscal policy, the ultimate responsibly of Congress), enforcing tax laws, and publishing statistical reports (wiki).

Timothy Geithner 

(Secretary of Treasury)

Who is in Charge?

Timothy Geithner, former President of the Federal Reserve Bank of New York, has been the Secretary of the Treasury since January 2009.

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The Federal Reserve System (the Fed): Headquartered in Washington, DC the Fed is the central banking system of the US responsible for addressing problems with banking panics, to strike a balance between private interests of banks and the centralized responsibility of government, to manage the US money supply, to maintain the stability of the financial system, to provide financial services to depository institutions, and to ultimately strengthen the US standing in the world economy.

The Fed structure is composed of the presidential appointed Board of Governors, the Federal Open Market Committee (FOMC), twelve regional Fed Reserve Banks, privately owned US member banks, and various advisory councils. The FOMC is the committee responsible for setting monetary policy and these policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches. The authority of the Fed is derived from statutes enacted by the US Congress and is subject to congressional oversight (wiki).

Ben Bernanke

(Chairman)

Who is in Charge?

Ben Bernanke, former tenured professor at Princeton and scholar of the Great Depression, has been the Chairman of the Federal Reserve since February 2006.

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International Monetary Fund (IMF): Headquartered in Washington, DC the IMF is an organization of 187 countries that work towards fostering global monetary cooperation, securing financial stability, facilitating international trade, promoting high employment, sustaining economic growth and reducing poverty around the world (wiki).

Christine Lagarde

(Managing Director)

Who is in Charge?

Christine Lagarde, a former French lawyer, has been the managing director since July 5^th, 2011

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The European Central Bank (ECB): Headquartered in Frankfurt, Germany the ECB is in charge of defining and implementing monetary policy for the Eurozone, to conduct foreign exchange operations, to take care of the foreign reserves of the European System of Central Banks, and promote smooth operation of the financial market infrastructure. The ECB has the authority to issue euro banknotes and members states have to ask the ECB for permission before issuing euro coins. Recently, in May 2010, the European Financial Stability Facility (EFSF) was created to safeguard financial stability in Europe by providing financial assistance to Eurozone Member States (wiki).

Mario Draghi

(President)

Who is in Charge?

Mario Draghi, former governor of the Bank of Italy, has been the President of the ECB since November 2011.

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A Few Faces You Should Know:
Lloyd Blankfein (CEO and Chairman of Goldman Sachs): http://en.wikipedia.org/wiki/Lloyd_Blankfein

Jamie Dimon (Chairman, President & CEO of JP Morgan): http://topics.bloomberg.com/jamie-dimon/

Henry Paulson (former Secretary of the Treasury & CEO of GS): http://en.wikipedia.org/wiki/Henry_Paulson

Bill Gross (Co-Founder of PIMCO): http://www.forbes.com/lists/2009/20/power-09_William-H-Gross_3ESQ.html

Warren Buffet (Chairman & CEO of Berkshire Hathaway): http://en.wikipedia.org/wiki/Warren_Buffett

Bill Gates (Chairman of Microsoft): http://en.wikipedia.org/wiki/Bill_gates

Be Wary of Emerging Markets: BRICS & N-11

What Are the BRICS and N-11 Countries?

The BRICS refer to Brazil, Russia, India, China and South Africa. These countries are at a similar stage of newly advanced economic development and have symbolized the shift in global economic power away from the developed G7 economies (US, UK, Canada, Japan, Germany, Italy, and France). In fact, it is estimated that the BRICS economies will overtake the G7 economies by 2030.

The N-11, or "Next Eleven," are the countries (along with the BRICS) that have a high potential of becoming the world's largest economies. These countries are: Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey, and Vietnam.

Jim O'Neill, the Chairman of Goldman Sachs Asset Management, coined these phrases and evaluated these countries based on their macroeconomic stability, political maturity, openness of trade and investment policies, and quality of education.

Investment Strategy: Following Growth Around the World

O'Neill's criteria in determining which countries are among the fast growing economically (the BRICS and N-11) are important to consider when deciding which investments to make, especially when analyzing individual companies. For example, a new company with an exciting new product may be attractive, but if its country's government does not have strong patent or copyright laws, it may be difficult for that company to make sustained profits; the weak laws of the government could end up slowing growth in certain industries.

In other words, there are many factors that may be outside a company's control that should be considered before investing in that company. Fundamental analysis -- the analysis of income statements, balance sheets, etc. -- is not enough.

Instead of simply diving deeply into the specifics of an individual company with fundamental analysis, O'Neill takes a different, wider approach, stepping back to also look at which countries he believes will have the most growth in the future. O’Neill maintains that finding the country with the right infrastructure, economic policies, and laws, such as strong patent and copyright laws that promote the potential for growth, could be just as important as finding a profitable company. A growing economy gives a company more opportunity to grow itself, which goes back to the saying, "a rising tide lifts all boats."

After evaluating these countries, a process similar to evaluating an individual company, and then deciding where the best potential lies, the next step is to determine which industries are high growth and likely to be successful in those countries. Finally, decide which companies within those industries have good growth potential, and why. In sum, finding a good investment begins with a snapshot of which countries will likely have growth in the future, then narrowing the search to specific industries and companies. I call this strategy "Following Growth Around The World."

In analyzing countries –and companies-- some questions to ask are: What laws or economic policies will affect it? Is it likely these laws or policies will change? Is there a growing population and what will its consumption most likely look like in the future? Is such population growth good or bad for the company/country? Who is in charge, and why, and where does he/she want to take the country/company?

Emerging Markets Hot or Not During Potential European Recession?

It is also important to remember that these emerging markets are just that, up and coming. They are not already as developed as, say, the U.S. or Germany, and their economies and markets may swing with more volatility than the economies of developed countries, especially in times of economic turmoil. In contrast, during good times, their economies may flourish and expand more quickly than a more economically developed country.

Currently, however, if you are not an investor with a high risk tolerance, I would recommend avoiding the N-11, as they have experienced over 20% decline during the past 6 months, according to Goldman Sachs' N-11 Equity Fund. Similarly, the BRIC 40 Index, which provides exposure to 40 leading companies in the BRIC countries, also has fallen over 20%. This is in comparison to the S&P 500, representing 500 large US companies, which has fallen only 4% over the past 6 months. Europe, while facing sovereign debt problems, has fallen almost 30% during the same time period according to Vanguard's European ETF, which is composed of over 450 stocks of companies in 16 different European countries.

Recommendation: Stay Out, Wait Until The Dust Clears, And Then Re-Evaluate

Overall, I suggest avoiding companies that have their core businesses in the BRICS or N-11. This is because, in general, emerging markets such as the BRICS and N-11 are more sensitive to market swings. During extreme crisis, market correlations tend to go to 1. However, while this correlation means all markets are brought down by a significant economic crisis, markets such as the BRICS or the N-11 whose economies are more underdeveloped, have greater volatility and a greater likelihood of being dragged down significantly.

With continued uncertainty about the economy after the 2008 crisis, in addition to the unknown economic reforms and restructuring that Europe will make after its sovereign debt crisis subsides, I recommend waiting out the storm by playing it safe in US large cap stocks. Although investors may think that each dive in the market presents a buying opportunity, I believe this is just speculation keeping the market afloat. I think an appropriate approach with this strategy would be to wait until the dust clears, identify which countries' economies survived the best, and then re-evaluate which countries have the greatest potential for growth.

Why Be Bearish On Gold?

How Do Gold Prices Generally Work?

With a peak price of around $1,900 an ounce in September, 2011, gold prices have been on the rise almost every year since 2006. But why has gold continued to rise? Why do we see workers on street corners flipping their signs to buy our gold jewelry?

In general, gold moves in the opposite direction of the dollar; this is because gold, similar to oil contracts, is denominated in USD. So while the value of the dollar decreases, the price of gold generally increases; a relationship shown in Graphs 1 & 2. Although the graphs are not well-aligned, both demonstrate that, over the years, relative to the Euro, the USD has decreased in value, while gold prices have sky rocketed.

Price Per Ounce of Gold Since 2000 (Graph 1)

 

Price EUR/USD Since 2000 (Graph 2)

The example of the USD decreasing in value against the Euro is just an example of how the value of the dollar can affect gold prices. But why has the value of the USD decreased in value relative to the Euro?  

 QE1 & QE2 - The Increase in Money Supply Decreases Value of Currency

We can partly attribute the decreases in the value of the dollar versus other currencies over the past few years to QE1 & QE2, the buying of Treasuries from the Fed, which increased our money supply, and has been keeping our interest rates artificially low. This monetary control was "Helicopter Ben's" attempt to spur growth and keep us out of a full-blown depression, and so far it has seems to have worked.

However, the increase in money supply is a primary cause of currency devaluation; whenever you see a country increase its money supply, you can assume that the value of its currency will decrease in value - the same amount of goods, but more money, means things will cost more (inflation). The decrease in value is also caused by less demand for our currency; a simple supply/demand graph can explain the relationship. Basically, since rates are so low, investors look elsewhere to place their money for a higher return.

Also contributing to the low value of the dollar is the fact we run large trade deficits with the EU, which means we have more dollars to exchange for Euros than the Europeans have Euros to exchange for dollars. 

Overall, the devaluation of the dollar makes gold more expensive because gold is denominated in dollars.

Gold: Inflation Hedge and Fear

There are a few, but major, traditional concerns that leads investors fleeing to buy gold: inflation and fear. If investors believe there will be high inflation (sometimes caused by the devaluation of currency or high demand for goods), they will feel the need to buy gold. Ironically, if you look back at which asset classes have outperformed inflation over 18 year periods, gold has not been a good hedge against inflation. In fact, equities almost always outperform inflation. Those who make the claim that gold is a good inflation hedge have never looked at the data.

Fear is another reason investors buy gold. With many EU countries potentially defaulting, and with the US budget/deficit issue becoming more politically complicated, gold may seem appealing to those who fear a global default. Although gold has no real value, other than being used in jewelry and in a few other industrial applications, investors still flock to it in times of crisis.

Why I'm Short Gold

The fear of European default, the US deficit issues, QE1 & QE2 increasing the money supply, and the fears of inflation in the US, have all helped to prop up the price of gold. Still, I believe that gold is overvalued and that it will fall in value over the coming months. Why?

The first reason is that trade deficit gaps with Europe have been slowly closing, leading to a small relative increase in the value of the dollar to the Euro. Furthermore, as the European sovereign debt crisis continues to worsen, there may be a flight to quality out of European denominated securities and into securities such as Treasuries, which are considered among the safest assets in the world, backed by the US government. This flight to quality, because of the fear of default, would require Europeans to exchange their Euros for dollars, further increasing the value of the dollar.

Another reason why I believe gold will decline in value is that there has been no significant inflation in the US or Europe, mainly because there has been a slowdown in economic activity. I believe the European sovereign debt crisis will also slow down the Asian markets, eliminating the fear of inflation there as well. Moreover, the QE2 ended in June, and the Fed has signaled that there won't be more quantitative easing, plus the US economy has been signaling signs of slow recovery.

Finally, I believe that those who invested in gold years ago will now dump gold to take their gains before the end of the year. While there seems to be no real reason to buy gold at its current elevated price, I think that there will be a large sell-off because investors will want to dump gold as the dollar increases in value, the trade gaps narrows, and as Europe leans towards a potential recession.

Follow this link to an article that came out this morning on CNBC:
http://finance.yahoo.com/news/gold-sheds-cant-lose-status-165243054.html

The European Sovereign Debt Crisis Continues ------ Market News Dec. 14, 2012

Europe's Sovereign Debt Crisis - Controlling Global Markets

Although US markets are down about 3% this week, European markets have been hurting much more, taking all markets on a wild roller coaster ride. Let's focus on a major market mover over the past months, the sovereign European debt crisis, and the policies that are being implemented to try to fix it.

Angela Merkel, Germany's chancellor and central banker, and French President, Nicolas Sarkozy, lobbied for euro zone members to open their budgets in order to deter the crisis. But what exactly does that mean? It means that they want countries to sign an intergovernmental treaty "to make it easier to force governments to balance their budgets and trigger automatic sanctions if they don't" (Latham).

They want to control how much countries are spending, borrowing, etc. so that this kind of debt crisis doesn't happen again. But this runs into two problems. First, who will be the European authority implementing strict budget oversight (will they really be able to say to a sovereign country, you can't spend more money?)? And, how will this treaty help the current European sovereign debt crisis in the short-run?

Simply, the leaders don't know who will be responsible for oversight, and the treaty does not solve the current crisis. In my opinion, this integration of oversight in budgets will only pose a greater political threat in the future, as the countries become too integrated. The countries that agree to the treaty will have to submit their budgets for central review and then may be asked to limit the deficits they can run. Last Friday, 23 countries said they were in favor of the treaty, while one straight out said no: Britain.

A Little History on European Monetary Union

I think Britain knows best, being one of the countries to stay out of the European Monetary Union (they are still on the Pound), they have avoided the structural problems of sharing a common currency with other EMU nations. While some of the goals of the euro in 1991 were to create lower transaction costs, to lower financial risks for independent countries, and to increase international cooperation (rather than wars), the EMU caused unforeseen consequences for its members such as the inability of one EU member, Greece, to repay what it has spent. In the past, countries such as Greece whose governments overspent, would be able to devalue their currency to pay back their debts more easily. Yet by giving up its own currency to join the euro, Greece gave up the power to increase its money supply since power over the euro is granted to the ECB.

While many money managers believe that there may be a partial break-up of the euro zone, I believe that it will stay together. First, there is so much "red tape"; there are many legal ramifications from members trying to leave that breaking up would be extremely complicated; in fact, it is illegal for a member to leave the zone. Secondly, it would be very difficult in terms of feasibility for  these countries to revert back to their old currencies. Third, countries leaving the euro zone could cause a global economic crisis much worse than the debt crisis we are experiencing now.

Furthermore, all of the countries have benefited greatly by sharing the same currency, especially Germany, the economic powerhouse of Europe. Instead, I believe reforms and new policies, similar to the open budget treaty, will be the next steps to be taken after the crisis.

Although the proposed treaty lifted European markets for a day, on hopes that this new treaty will spark an opening of credit to debtor nations, lowering the cost of borrowing (helping to spur growth), the market has been slumping as no short term solutions from EU leaders arise.

Additionally, with no help from the European Central Bank (ECB), stating that it will not buy up bonds to lower yields for the PIIGS (Portugal, Ireland, Italy, Germany, and Spain -- the countries with the largest debt problems), the costs for European countries to borrow has risen dramatically.

US Looks Better As Europe Looks Worse

While the economy in the US is looking better (especially during the holidays with the markets propped up on retail sales and dropping unemployment, although a closer look reveals this is because workers are leaving the workforce, not because of more job creation), Europe has shown no real solutions. The recent EU summit failed in resolving the euro zone's debt problems and Germany is urging now that the ECB not interact in the market to try and put off the debt problems by artificially bringing down the yields of PIIGS.

Opinion: Long US Large Cap Stocks and USD --> Short Europe

Because of the issues above, I believe that in the next few months there will be a large decline in European markets, and recommend being short the PIIGS, and even larger countries such as Germany. The S&P downgrade watch on the EU will especially play a major role, as it pushes the EU countries to get their acts together. I believe that the Euro will fall relative to the USD, as there is a flight to quality (safety), and that US markets will prove to be more attractive. Because we are so connected to the EU through international trade (although not too much) and debt, I recommend buying stable US stocks in the next few months, rather than speculative stocks, just in case Europe does go into a free-fall, bringing the rest of the world with it. As the Euro declines, market participants will search to invest in non-Euro denominated securities, and I believe this search will find its way to large cap US companies.