There is so much uncertainty surrounding the European debt crisis right now. Are more downgrades imminent now that France has lost its vaunted AAA rating? Will Italy and Spain and others see bond auctions slowly improve, or slowly backslide? And of course, should investors seek out eurozone investments as bargain buys that may soon come roaring back?
Though there are many moving parts in play right now, the bottom line is that the fundamental trouble with the eurozone is…well, the euro. Monetary union has allowed disparate countries to use the same currency and enjoy the fruits of easy trade, but the lack of true fiscal union has resulted in the current state of affairs.
This is my favorite graphic of the entire euro debt crisis. As you can see, before the formation of the euro, countries such as Greece and Portugal were paying the price for their spendthrift ways. Bond yields were high for these countries because they had borrowed way too much, didn’t have great growth prospects and had little chance of cutting spending anytime soon.
Click to EnlargeAfter the euro? Well, the only thing that changed was that Greece and Portugal now had access to easy money — better interest rates thanks to naïve investors thinking the eurozone shared more than a common coin, and growth prospects by virtue of its partners in Europe and not sound domestic economic prospects.
So where do we go from here? Well, there appear to be only three options for the eurozone:
1. The Eurozone is Disbanded
This is the simplest doomsday scenario: Germany (or some other fiscally responsible country such as the stable but relatively low-profile Netherlands) says, “Enough is enough.”
Granted, this would not be an easy course. By some estimates, Germany would see its exports collapse by as much as 25% if it were no longer part of the currency union and benefiting from its trade ties. Siemens (NYSE:SI), Daimler AG (PINK:DDAIF) and others would feel the burn.
Besides, if you believe the math from UBS, it would actually be cheaper for German banks to bail out their eurozone lackeys rather than allow the euro to fail and watch all that European sovereign debt in Germany’s banks turn into worthless scraps of paper. Deutsche Bank AG (NYSE:DB), for instance, would be in rough shape — and so would Netherlands-based ING Groep (NYSE:ING).
But when emotions run high, people don’t think clearly. And German taxpayers are obviously not very pleased with the prospect of big bailouts.
So let’s speculate. Germany decides to go it alone. Then another nation drops out. Then another. Next thing you know, the only countries left are the ones that can’t pay their bills.
There are two ways this could shake out.
One: The remaining member states suffer through a shadow of the former currency union — a motley crew of rather disappointing nations. Two: The players realize a eurozone without stability or German economic might is kind of pointless.
Either way, the result of this scenario is a gut-wrenching drop in the euro versus major currencies, such as the U.S. dollar. But the most disturbing scenario would be that the lack of a European Union currency leaves a legal black hole for all euro-denominated contracts.
A precipitous drop in the euro could be endured since most investors should be smart enough to not bet the farm on the currency rising anytime soon. However, the global chaos created by the euro going “poof!” cannot be understated.
2. A Smaller but Stronger Coalition
Clearly, countries such as France and Germany have growth prospects and can see a way out of this mess. And clearly, countries such as Greece and Portugal seem like dead weight. But what if instead of going solo, the stronger countries decide to give underperformers the boot?
This is an intriguing option, and given the strange dynamics of talk from German Chancellor Angela Merkel and French President Nicholas Sarkozy — harsh rhetoric directed at the weaker EU economies, coupled with talk of how the euro must survive at all costs — it’s not outside the realm of possibility that this is the path that lies ahead. As early as November, Sarkozy was talking about “a two-speed Europe” and allegedly floating the idea of a leaner, meaner European Union.
However, reading into political speeches is a slippery business, and it remains to be seen whether the global financial markets would be willing to give a “better” eurozone a fair shake. What’s the point of kicking out the worst performers, after all, if the bond markets are still going to punish you?
Those are some big “what ifs” facing Germany, France and the others, but probably no less daunting than other challenges facing the eurozone. A plan like this might just be crazy enough to work.
3. Bailouts to Preserve the Status Quo
The most humdrum scenario is that European politicians decide, when all is said and done, that the pain of parting is worse than the pain of staying together. So, like high school sweethearts who have grown apart but are too afraid of change to break up, the eurozone muddles through.
This option, however, would have little to do with future planning or philosophical concerns. No, keeping the eurozone together would depend on number-crunching and a line-by-line review of sovereign debts.
It’s strange that casual observers may think that this is the best of all options simply because it’s familiar. But the reality is that this could be the hardest path of all. It involves not only bailouts of debtor nations such as Italy and Greece by stronger nations such as France and Germany. It also demands that the European Central Bank and World Bank enter into policy areas they had never dared to enter before. It requires politicians to swallow their pride and state employees to suffer bone-deep cuts.
Of course, much of this work is already half-done. Austerity continues to ramp up, and politicians seem to resigned to the reality of the situation.
And let’s not forget that the Bank of England and China’s central bank shuffled hundreds of billions of dollars into the eurozone in December due to fear of a credit freeze akin to the 2008 crash. It’s not just the eurozone that has decided that this currency union needs to stick around.
The Takeaway for Investors
There are no easy answers here. But investors should fall back on the old saw that they should “hope for the best and prepare for the work.”
It seems unlikely that any resolution will result in a big boon for the European Union. Germany teeters on the brink of recession, and keeping the eurozone together will not remedy the situation. Greece and Italy are likely going to wander in the wilderness for a decade as deep cuts brutalize national economies that have been propped up by government spending, while private-sector jobs, of which there are few, are left to fill the void. Why would you bet on a recovery in Europe anytime soon?
True, a weakening euro could boost export powerhouses such as Germany — a thesis that InvestorPlace contributor Charles Sizemore is banking on for 2012.
But with so much remaining unclear and emotions running high, discretion is the better part of valor here. If you want to invest, stick with equities with as little European exposure as possible.
After all, none of the three scenarios outlined above seems particularly appealing unless you want to bet the farm on a big currency move either way.
Jeff Reeves is the editor of InvestorPlace.com. Write him at editor@investorplace??.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. Jeff Reeves holds a position in Alcoa, but no other publicly traded stocks.