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Europe's Indian summer to yield to a harsh winter of volatility.

The EU Summit in June was hailed as a game changer and the big winner was the Spanish president Rajoy. Last week's EU Summit was a different story, as the announced banking union remains merely a plan to have a plan because Germany and Club North have decided that 'conditionality' is an integral part of a future compromise.

German Chancellor Merkel also finally sent a clear message on the key issue of legacy debt: there will be no direct injection of European Stability Mechanism (ESM) funds into Spanish or Irish banks, so this means that Rajoy has lost his escape route and is now reduced to a prisoner's dilemma situation with Germany and the EU where he has the most to gain from doing nothing - essentially the same position Greece has had for years after its first rescue plan was put in place.

Spain is now where Greece was three years ago: it is facing negative fiscal multipliers as any move toward austerity will aggravate the negative economic spiral. Even the International Monetary Fund (IMF) has now admitted that fiscal multipliers are far higher than they previously assumed (0.9 to 1.7 vs. the previous 0.5), meaning the end is not near to this crisis. Rajoy has tried - he really has, but the problem for Spain is the same as for Greece and soon Italy: a mandate for change forced on the population by unelected and non-accountable officials in offices in Brussels or Frankfurt is never going to last for long. (As an aside, the same applies for the US, where policy is not being made on Capitol Hill or at the White House, it is being made in the Federal Reserve's Eccles Building.)

Difference between June and October EU summits: Ms. Merkel's re-election campaign

But what was the main difference between the June and the October EU summits? In June, Ms. Merkel had not yet launched her re-election campaign. Now she has. Here in October 2012, not only is the September 2013 election fast approaching, but the SPD opposition is rather wisely going with former finance minister Peer Steinbrueck, who happens to be more pro-EU than Ms Merkel.

So from here, Chancellor Merkel will need to show herself as more EU sceptical to contrast with the SPD position of being "all-in" on the EU fiscal union. Secondly, she can no longer ignore her core voters, who have been EU sceptics all along. This will change - and already has changed, to a degree - with the expected macro outcome. Between now and September, Merkel's only goal is to win votes, while in June it was to keep the Euro alive at all costs. Expect less EU from Merkel and no big compromises. We entered a period of Nein, rather than the endless non-solutions and "perhaps, but let's make a plan".

The window for Club Med is now closing and this is the most visible in the enormous gap between President Hollande and Ms. Merkel. Hollande is publicly scapegoating Merkel for what ails the EU - despite the fact that he has refused to sign the fiscal compact into the French constitution, which smacks of hypocrisy.

Ms Merkel has at least a few practical reasons for opposing a quick-and-dirty solution for the banking union, that will supposedly start on January, 2013.

Outstanding EU banking union issues

An EU banking union can't be conjured into existence with a pro-forma decision - it needs a legal and practical framework as well. A Pandora's box of legal questions arise from the implications of a new banking union. A few examples: Which court will the banks go to when they disagree with the Pan European regulators and its 'banking police'? The EU Court of justice? Or the local court where they have their shareholders and legal identity? Where are those same shareholders going to express their legal grievance with a 'local bank'? Who is the EU banking union ultimately reporting to - the 'supervising body of the ECB' or the EU Council of Ministers? Where is the EU going to find enough employees to write the strategy documents, conduct the implementation and the modus operandi to secure cross-border compliance and timeliness in the reporting?

I could continue - but I think we need to agree that this will not be pulled off in one week, one month or even one year unless it is going to be another of the EU's hack jobs. The idea driving the desperate move to create the banking union is that by disconnecting the underfunded governments from the underfunded banks, we can move forward. But the only real reason for a banking union is as a predecessor to a full fiscal union.

There are huge risks to blundering forward in this manner. If the EU undermines the integrity of the banking union from day one by rushing the legislation, it risks repeating the mistakes the politicians made in creating the Euro/EMU in the first place: creating a house without a foundation and thinking that down the line, we can always enforce a Stability-and-Growth Pact, only to find that there was no will for enforcement. Now, the next generation of European politicians risks repeating the same mistake - taking an idea that looks great in theory, but because of problems of accountability and the legal framework, is doomed to fail even before it is launched.

The EU summit as such crystallised my main premise on this crisis: you can extend-and-pretend for a long, long time, but everything eventually reaches its saturation point.

Final phase of great illusion

I am increasingly thinking/trading the idea that we are now in the final phase of this great illusion and that the next phase will be driven by the inability of central planners to conduct any further 'experiments'. When I went to school, infinity was the biggest number around! How is the Federal Reserve going to raise the ante on the infinity it has already promised?

The same goes for Draghi and his monetary transmission. Besides the entire sovereign debt debacle and the balance sheet hindrances of "legacy debt" everywhere, easy policy guarantees do not matter when, for example, Dutch and Spanish banks need to charge at least 300 basis points over the policy rate on mortgages just to stay alive.

Keeping banks alive just for the sake of avoiding the short-term pain of admitting a loss will never work. And creating a banking union will not make individual banks more solvent. As with all measures and plans in this crisis, the only thing macro policy has been accomplishing is to distort relative prices through the printing of money and maintaining a power base of a financial lobby that is too strong for the greater good, and taking us closer to a point of falling marginal utility.

Last week's EU Summit clearly shows us that the marginal utility of extend-and-pretend is now exhausted. When politicians know they will be held accountable for something, they will show their true face. That was what Ms Merkel did last week and as Germany goes, so goes Europe. You have now been forewarned as Europe's Indian summer of 2012 will yield to a harsh winter of volatility where an understanding of history and context become critical. It's about time.

2012 CPI Financial. All rights reserved.

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Publication:CPI Financial
Date:Oct 25, 2012
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