Argument

12 Signs of the Europocalypse

From the Chinese buying spree to the rise of extremism, here's what to watch for as the continent teeters on the brink of disaster.

Two short years ago, if anyone had suggested that we would be considering pan-European bank regulation, cross-border deposit guarantees, joint and several Eurobonds, and the very survival of the common currency, they would have been dismissed as nothing short of crazy. But what was unthinkable then appears to be verging on the inevitable now. With last weekend's announcement of a bailout for Spanish banks and with potentially euro-shaking elections in Greece this weekend, we can now say with certainty that the staid European Union we knew for its first two decades is a thing of the past.

What we're not yet sure of is just what will take its place. The complexity and breadth of the unfolding European financial crisis, with another imminent flash point seemingly around every corner, have made it particularly difficult to distinguish noise from signal and the valuable data from the spin in each day's headlines. In particular, the news focus on daily -- or hourly -- developments in the crisis often obscures the broader dynamics that will shape the European response over the next few months, which will in turn shape Europe itself over the next few decades.

Here are 12 key trends to watch over the next few weeks for help in projecting what the new Europe will look like if it finally emerges from the mire.

1. Continuing Greek dysfunction. Pundits and analysts are waiting with bated breath for the results of Greece's elections on June 17, with many declaring it as a virtual referendum on whether the country will remain in the eurozone. But here's the truth: The possible outcomes are narrower than people think, ranging only from pretty bad to worse.

If the Coalition of the Radical Left (Syriza) gets the most votes, even with the 50-vote bonus for finishing first, a fractured electorate and lack of suitable coalition partners make its prospects of forming a workable government slim. But even if an ostensibly "pro-bailout" combination of New Democracy and former ruling party PASOK was to squeak through with a collective majority, the effectiveness of their coalition will be severely limited and Greece's future far from clarified. These two parties are once and future rivals, and in actuality they agree on very little. Expecting that they can quickly reach consensus on the specifics of some 15 billion euros in austerity measures over the next two years is highly doubtful.

Any renegotiation of the terms of Greece's bailout, moreover, will be merely a matter of spreading the pain over an additional year or two, ensuring continued political deadlock and a disgruntled electorate. Besides, the math doesn't work, and every day the country remains politically paralyzed, the costs to the country and its creditors increase. The upshot is that regardless of the election's outcome, Greece and its European partners are in for an almost unimaginable set of politically unpalatable choices. The likelihood of an election that definitively ensures that Greece remains in the eurozone is very low.

2. Spanish banks as catalyst. Some in Greece think that Athens can successfully blackmail its European partners into caving and lightening conditions on the country, lest Greece blow up and take the rest of the eurozone with it. They are probably miscalculating. Greece is, in the grand scheme of things, too small to sink the European experiment. But Spain (in part because it is too grande to fail) actually does hold some pretty daunting cards, as demonstrated by the rescue package it received over the weekend. The dynamics to watch now are how Europe's official sector lenders proceed. Although the basics of the Spanish rescue were announced, the plan is far from fleshed out, with crucial details -- like where's the money coming from and on what terms will it be disbursed -- remaining unresolved. When providing Spain its lifeline, policymakers are acutely conscious of the precedent that this rescue will set.

This "conditionality-lite" Spanish program (with the Germans emphasizing the "conditionality" and Spanish Prime Minister Mariano Rajoy the "lite") might conceivably provide political cover for the Spanish government while maintaining the "no money without strings attached" restrictions required by the Germans. It could also, however, catalyze a more far-reaching process of reform: federalizing banking supervision and regulation within the eurozone, the possible migration of bank deposit guarantee schemes from the auspices of national governments to a pan-European one, some form of Eurobonds, and, in the end, fiscal union. Recall that the U.S. Constitutional Convention was held in part because the Articles of Confederation weren't sufficient to resolve conflicts between those states that had repaid their Revolutionary War debts and those that couldn't or wouldn't. The Articles of Confederation's drafters did not envisage a federalized entity any more than the crafters of the Maastricht Treaty foresaw a "United States of Europe." The Spanish banking crisis won't trigger a formal constitutional convention, but it could have much the same effect, setting in motion a more dramatic shift in how Europe operates for decades to come.

3. Rise of extremist parties. They seem to be ascendant everywhere in Europe these days, on the right and on the left. In Greece, Syriza threatens the bailout while the neo-Nazi Golden Dawn received nearly 7 percent of the vote in May's elections. In Germany, the idiosyncratic Pirate Party has drawn a significant following. In France, Marine Le Pen's far-right National Front and Jean-Luc Mélenchon's Left Front are actually battling over the same voters, while in Italy, even corruption scandals and the resignation of its longtime leader, Umberto Bossi, hasn't stopped the virulently anti-immigrant Northern League from playing a role in Italian politics. And Geert Wilders's PVV has already caused one Dutch government to fall and continues to play an outsized role in the Netherlands.

Europe is not about to lurch dramatically left or right. But the rise of these and similar extreme parties pose two big problems -- one short-term and the other long-term. First, they drastically increase the difficulty of forming stable coalitions, which in the European periphery makes imposing structural reforms and fiscal discipline hard and in the core makes agreement on comprehensive solutions even harder. The parliamentary structure of most European governments provides these smaller parties with disproportionate influence, as they are needed to create majority coalitions. Second, the extreme parties, both left and right, tend to be populist and anti-immigrant. Europe's economic woes are already decreasing its attractiveness as a destination for immigrants; xenophobia only exacerbates this dynamic. But Europe desperately needs immigration to combat its declining demography and rejuvenate economic growth.

4. Merkel gets bold. Perhaps more than Greek elections or Spanish balance sheets, German domestic politics may be the single-most crucial factor in shaping the response to the crisis. With federal elections scheduled for autumn of next year, Chancellor Angela Merkel, her allies, and their challengers gauge every move and its impact on that vote -- and the regional and local ones in the interim. Merkel has stepped up to a leadership role that few would have predicted only a year ago. But her calm and deliberate leadership style is calculated to kick the can down the road while ensuring that she can deliver her party and the German people. Merkel may well move to support a more ambitious and robust response, especially around federalizing eurozone banking-sector governance, and garner support from center-left parties (the Social Democratic Party and the Greens) that would set herself up to take the helm of a grand coalition government following next year's elections, if she's unable to win outright.

But Merkel's current governing coalition includes her own Christian Democratic Union (CDU) and its partner, the Free Democratic Party (FDP) -- a far less popular party rapidly plummeting in the polls. The FDP remains staunchly opposed to any move that smacks of European fiscal union, and Merkel's CDU boasts a large contingent of skeptics as well. If she bucks her own party and the FDP, Merkel could potentially save Europe. But that would be a bold move from a chancellor who has rooted her effectiveness and popularity in incrementalism.

5. The United States keeps quiet. Here's a not-so-well-kept secret: The United States doesn't possess the inclination, the ideas, or the financial capacity to materially influence the endgame in Europe. Here's an even less-well-kept one: The White House is enormously concerned about a European implosion damaging the fragile U.S. economy and taking President Barack Obama's reelection chances with it. The Federal Reserve has played an enormously important and somewhat unsung role in Europe, keeping large U.S. dollar swap lines open for the European Central Bank that have been crucial for supporting banks in the European periphery. But the Obama administration maintains a public stance that the Europe crisis is largely for Europe to solve on its own. Not only are U.S. coffers empty, but even benign efforts to think creatively about ways to address Europe's problems often meet with public criticism on the continent, with the oft-repeated refrain "Get your own house in order first."

In any case, despite Obama's speech last Friday, June 8, you won't hear much about Europe on the campaign trail. The president will limit talk about it for fear of highlighting America's inability to solve a major economic crisis with its European brethren, while Republican presidential candidate Mitt Romney doesn't want to appear to give the president an "out" on responsibility for any setbacks in the U.S. economy. All in all, Washington will be speaking softly, but without any stick to back it up.

6. Rating agencies get tough. Let's face it. More often than not over the past two years, the "solutions" presented by European leaders to drag the eurozone back from the abyss have involved more than a dollop of ambiguity. European leaders have announced big headline numbers at the last minute to calm markets, almost always on weekends (see Spanish bank announcement on Saturday) and sometimes in the dead of night on an early Monday morning just before Asian markets open, as was the case with the creation of the European Financial Stability Facility (EFSF) and its successor, the European Stability Mechanism (ESM). But regardless of when these announcements are made, these crisis responses usually are based in large part on rhetorical announcements designed to trigger a favorable market reaction, not on binding financial commitments backed up by real cash.

Grand pronouncements have worked fairly well and may continue to do so -- but only until third parties like credit-rating agencies pull back the curtain and expose the schemes for what they are. Having suffered serial blows to their credibility during the 2008 financial crisis and beyond, the credit raters are more determined than ever not to let the smoke get in their eyes, especially as they face increasing criticism from politicians seeking to limit their authority and influence. But shooting the messenger is not likely to solve Europe's problems. Engaged and independent rating agencies may provide more clarity to markets but also make political deals with embedded ambiguity or internal inconsistencies -- which are often necessary in the absence of consensus -- harder to craft and implement.

7. The fracturing troika. Throughout the crisis, the IMF has sought to maintain its critically important independence and market credibility while working closely with the European Central Bank (ECB) and the European Commission (EC) and its member states. Now, ECB-EC-IMF tensions revolve around something much simpler: who pays.

Greece owes more than 300 billion euros to its official sector lenders, and regardless of the outcomes of the Greek elections, the country's ability to pay it all back is seriously doubtful. Someone will have to bear the brunt of these losses, and the private sector, which took a large haircut in the recent restructuring, no longer holds enough debt to make much of a dent in any future restructuring that may be necessary. But with the IMF asserting its "preferred creditor status" and the ECB claiming a newly created level of seniority just below the IMF (and refusing to discuss anything that it deems to violate its prohibition against "monetary financing"), that leaves European governments holding the bag.

And that's just for Greece. Add in the potential costs of Spain and Italy and the ongoing assistance to Portugal and Ireland, and the numbers get pretty big pretty fast. What's more, neither of the funding programs the EU governments have set up -- the EFSF and the ESM -- have any significant capital. They both rely on capital markets, leverage, and to some extent "alchemy" to reach their headline funding capacity. At some point, bonds need to be redeemed and debts paid. The Spanish bank recapitalization plan just announced is noteworthy as it does not include funding commitments from either the ECB or the IMF. It could well be the shape of things to come as the appearance of a harmonious troika is likely to come under increasing internal strain as the music comes closer to stopping and there aren't enough chairs to go round.

8. Britain vs. Europe. Tensions between the 27-member European Union and the 17-member eurozone are increasingly causing a formal, two-track Europe to become the rule, not the exception. The crisis has exposed in gory detail the need to use the European Union to solve the problems of some, but not all, EU members.

In particular, Britain's red lines against any outside supervision of its financial sector, given the country's dependence on the City of London's role as a global financial center, are likely to bring this division to a head sooner than many imagine. The financial reforms likely to emerge as part of a potential solution to the European crisis will bind the eurozone more tightly together. But with Britain unwilling to subject its banks to European regulatory oversight, transaction taxes, and other similar schemes, the Brits (and other non-eurozone states) will find themselves further on the outside, and the divisions between the European Union and the eurozone will become increasingly apparent.

9. Italy's fragile future. In many ways, Italy reflects the very same stresses that buffet Europe writ large. It has a fractured political landscape, sharp economic divisions between a prosperous and industrious north and a laggard south, severe demographic challenges, and a crisis-enabled technocratic government -- the effectiveness of which is eroding by the day. Growth in Italy has declined in an almost-straight line, from 5 percent in the 1950s to 4 percent in the 1960s, 3 percent in the 1970s, 2 percent in the 1980s, 1 percent in the 1990s, and stagnation in the 2000s (though, of course, the food, wine, and landscape are as wonderful as ever).

Italy's story is not wholly that of Europe. Its north has propped up the Mezzogiorno with an internal transfer union (from north to south) for almost 150 years, and for the most part the country has hung together. But the necessity for Prime Minister Mario Monti's technocratic government to cut political deals points to a broader truth: a non-elected technocratic government can be a savior in times of imminent crisis, but is otherwise constrained by a lack of democratic legitimacy and an inability to play the game of politics. So Monti's success in pushing through necessary structural reforms as he navigates his way to next year's elections may be a valuable indicator of the ability of European supranational institutions to take necessary measures even as they too are long on technocratic skill and a bit lacking in democratic legitimacy.

10. Central Europe wins. As Germany picks up the pieces, no matter what the outcome of the crisis, the former Soviet satellites in Central Europe look to be potential winners. A weak euro bolsters German exports, and the Czech Republic, Hungary, Poland, and Slovakia all have deep connections to the German manufacturing machine. They could be collateral beneficiaries from any resulting German export-led strength. These countries, having emerged a scant two decades ago from behind the Iron Curtain, have less skepticism of the European idea, attach a different valence to the meaning of Europe, and, ironically -- in part because many have yet to join the common currency -- have far less of the embedded economic problems of their Western and Southern European counterparts.

In many ways, "new Europe" harks back to the old "Old Europe." The newfound centrality of Central Europe is a return to the Concert of the 19th and early 20th centuries, with the continent's geographic core setting the tone for the periphery. It bears reminding that the last European transnational currency to collapse was the Austro-Hungarian crown after World War I, which eventually set in motion the geopolitical dynamics that led to the euro. Stresses on the eurozone could reorient Europe back toward Mitteleuropa, leaving the Visegrád countries as the crisis's surprising winners.

11. The Cyprus effect. It's a bit odd that the commentators who continually harp on the need to impose austerity on those who "deserve it" and warn of the dangers of moral hazard don't have Cyprus in their sights. Most Europeans do not consider the Cypriots bad actors, and the Cypriot economy is a rounding error within the context of the eurozone. Yet, with enormous exposures to the Greek financial sector and Greece more broadly, Cypriot banks have all the problems of their Greek counterparts, but no access to the 50 billion euros for Greek bank recapitalization contained in the troika program. Cyprus thus sits on a precarious perch, with the potential spillovers from Greece, through both financial and economic channels, a very real risk. A bailout request appears imminent.

The real story here is more geopolitical than financial. The Cypriot economy, in particular the Cyprus's financial sector, has close ties to Russian finance -- some openly acknowledged (favorable tax treatment for Russian financial firms driving vast sums and transactions through Cypriot banks) and some not (rumors of less savory activities and murky accounts). The Kremlin will likely go a long way to ensure that Cyprus remains stable, sovereign, and free from external monitoring (witness the "no strings attached" 2.5 billion euros that Moscow lent to Nicosia last year).

Whether the Russians come to the country's rescue again, and on what terms, remains a strategic question mark. But Cyprus, as a member of the European Union and eurozone with deep, somewhat opaque financial ties to Russia, potentially opens another as-yet-untold chapter in the European crisis. Russia has thus far been relatively silent and removed from direct involvement. If that changes, the dynamic of the crisis and its potential resolution would likely shift in unpredictable, but undoubtedly strategic ways. And that's not even mentioning the potential impact of Cyprus on Turkey, which could see any European intervention in the historically conflict-prone country as part of a broader conspiracy.

12. The Chinese shopping spree. Despite the headlines and political rhetoric, China is not coming to Europe's financial rescue. That's not to say that every time a senior Chinese economic official lands in a European country promising increased investment, they're lying. But there's a big difference between bailing out a country with huge amounts of cheap funding for its sovereign and looking around for potential bargains once forced sellers of distressed assets find themselves without other options. Beijing is also free from blame in the eyes of European public opinion. That won't change, and it will allow China to become a player in the eurozone -- just not necessarily in the way that the Europeans want.

All the reasons that some Europeans see China as a potential financial savior remain valid: It has liquid capital that it is ready, willing, and able to deploy. China will likely use its war chest not for bailouts, however. Instead, it will buy assets. Beijing may ultimately see the crisis as a huge shopping opportunity in an enormous, generally stable, rule-of-law-driven economic zone. Investment and influence are likely to follow.

The European Union remains one of the greatest experiments in history. In little more than a half-century, Europe evolved from a war-ravaged continent to the world's largest economic zone and the only place in the world where countries voluntarily agreed to pool major elements of their sovereignty, on the principle that all countries are (more or less) equal and should follow collectively agreed-upon rules and work through supranational institutions. But the next version of Europe may well be created not by great strategists and visionaries like Jean Monnet and Robert Schuman, but rather by anonymous and impatient financial markets around the globe and by the weekend crisis responses of bureaucrats, technocrats, and politicians in Brussels, Berlin, and Frankfurt.

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Argument

Fed Up

Yes, Jamie Dimon should lose his seat on the New York Fed board. But why stop there when America's financial regulation is such a mess?

The $2 billion and counting that JPMorgan Chase's chief investment office recently lost in London has turned the spotlight on CEO Jamie Dimon's seat on the board of the Federal Reserve Bank of New York, better known as the New York Fed. Dimon is due to testify on Capitol Hill starting on June 13, and things could get ugly.

It's about time Dimon felt the heat over his board seat. As one of 12 regional reserve banks that make up the Federal Reserve, the New York Fed's responsibilities include regulating big Wall Street banks like JPMorgan and Goldman Sachs. If Dimon sitting on the organization's board sounds like a conflict of interest to you, you're right: Nearly four years after the implosion of Lehman Brothers triggered a global economic meltdown, the fox is still guarding the henhouse.

JPMorgan's trading loss has already prompted many calls for Dimon's ouster from the Fed board. Treasury Secretary Timothy Geithner, who previously headed the New York Fed, conceded in mid-May that Dimon had a "perception problem," and Senate Democrats have explicitly called on the JPMorgan chief to step down from the board. In late May, Esther George, the president of the Kansas City Fed, made the same point more obliquely, noting that "when an individual no longer meets these [high] standards, the director resigns voluntarily to allow someone who does meet the criteria to serve."

I couldn't agree with George more. At the same time, her suggestion brings up a larger point: Why stop at Dimon? The entire system by which Wall Street banks are regulated needs to change, and urgently.

On June 13 and 19, Dimon will testify in front of the Senate Banking Committee and the House Financial Services Committee and be asked to explain his losses. It won't be easy. Many details of the loss-generating credit trades that JPMorgan -- the largest bank in the United States by assets -- engaged in remain unknown. And for good reason: The more information becomes public, the harder it will be for JPMorgan to unwind the deal. (Why? Because if you know which contracts the bank must dump, it's easy to wait for the price of the contracts to drop, thus adding to JPMorgan's losses.)

From the few snippets of information that have become available since the trading loss was first reported in May, it is clear that the bank's chief investment office bought so many contracts in certain credit indices that it was distorting the market. (Credit index here is shorthand for credit-default-swap index, the opaque and under-regulated "insurance policies" blamed by many for the 2008 financial crisis.) Credit-default swaps (CDSs) do not require that the owner of the derivative contract actually stand to lose from a credit default. When CDSs lack such an insurable interest they are considered "naked" -- the financial market's equivalent to buying insurance on your neighbor's house.

Although JPMorgan's risk positions remain obscure, one particular credit index seems to have been at the heart of the $2 billion loss: the Markit CDX.NA.IG.9. In less than a few months, the bank's position in the index almost doubled from under $80 billion to a whopping $145 billion, which makes one wonder where regulators were in all of this. The Depository Trust Company, a data warehouse, keeps information on 99 percent of all CDS trades all of which is accessible by the bank's regulators. Each and every regulator could easily have looked up who was moving the market and made further inquiries.

Dimon's problem, in other words, stems from a lack of oversight by both his bank and his regulators. But it's also problematic that Dimon sits on the board of the organization that's supposed to supervise his bank. It is entirely possible that officials at the New York Fed, which collects and reports data on individual banks' credit exposure, raised alarm bells about JPMorgan but somehow got rebuffed by Dimon, in much the same way that he brushed off initial press reports about a JPMorgan trader taking outsized positions as a "tempest in a teapot."

Turns out it was a pretty big teapot.

Even if JPMorgan's loss completely blindsided regulators, as supposedly happened to Dimon himself, there is still a conflict of interest. The Fed is tasked with implementing financial regulation to guarantee financial stability and prevent a new financial crisis from happening. But JPMorgan's chief has done everything in his power to preserve the old system, where the too-big-to-fail banks were able to make outsized profits by taking gargantuan risks thanks to taxpayers' backing.

Dimon has ranted against the Volcker rule, which prohibits banks from making bets for their own gain, and the Basel III bank capital rules, which prescribe the minimum ratio of equity to debt on a bank's balance sheet (last September, Dimon told the Financial Times that the latter were "anti-American"). And while Dimon has asserted that JPMorgan's money-losing trade did not violate the Volcker rule, it is close to impossible to lose more than $2 billion in a little over a month with a simple credit index, as the Financial Times's Lisa Pollack has pointed out. The bet that turned sour was most likely aimed at beating the market and earning big bucks for the bank, which is considered proprietary trading and banned under the Volcker rule. (Luckily for Dimon, the Federal Reserve announced in April that enforcement of the Volcker rule will be delayed until at least 2014, rendering the question of whether JPMorgan's trades violated the regulation moot.)

As the economist Willem Buiter noted in his keynote address at the Federal Reserve's Jackson Hole conference in 2008, the Fed listens to Wall Street and believes what it hears. Call it "cognitive regulatory capture" -- instead of special interests buying, blackmailing, or bribing the government, the big banks have somehow persuaded their ostensible regulators not to do their jobs properly. The Fed, under both Alan Greenspan and his successor, Ben Bernanke, has treated the stability, well-being, and profitability of the financial sector as an objective in its own right, regardless of whether this goal contributes to the Fed's dual mandate of maximum employment and stable prices.

So let's not stop with ousting Dimon from the New York Fed board. Groupthink, cognitive capture, and even direct capture (in the form of corruption) are ever-present threats for central banks, not only in terms of financial oversight but also with respect to monetary policy. And today they're out of control.

If we want to further reduce the hold that the big Wall Street banks have on central bankers and supervisors, we should make an eight-year, non-renewable term the maximum anyone can serve in any capacity as a regulator, supervisor, or member of the interest rate-setting committee. Greenspan served as chairman of the Federal Reserve from 1987 to 2006, more than twice what would be allowed under the term limits I propose. Bernanke is now serving a second four-year term as Fed chairman, and would be barred from reappointment if term limits were in place.

Since proximity tends to blur vision, it might be wise to place the financial supervision of the big Wall Street banks at a geographic distance as well -- say, with a regional reserve bank such as the Kansas City Fed. The New York Fed is literally too close to Wall Street for comfort. When he was the New York Fed president, Treasury Secretary Timothy Geithner was extremely close to Wall Street CEOs, enjoying private dinners at Jamie Dimon's home. Not coincidentally, Geithner shrugged at President Barack Obama's suggestion that banks that are too big to fail need to be broken up.

On the regulatory front, it is time to outlaw naked credit default swaps, for which there is no better economic rationale than horse betting. China took this step right after the 2008 financial crisis and the European Union has restricted naked CDSs on sovereign debt (though this appears to be more of a futile attempt to contain the debt crisis in the eurozone). Had naked CDSs been outlawed, JPMorgan would not have incurred its massive trading loss.

Smaller steps like demanding more coordination among regulators would also help. The Commodity Futures Trade Commission is now examining how JPMorgan's trading affected the market for credit derivatives and the Security and Exchange Commission is looking into the bank's public disclosures regarding the troubled trades. Neither agency, however, supervises banks like JPMorgan. That is left to the New York Fed and the Office of the Controller of the Currency, a little-known branch of the U.S. Treasury. When I asked both agencies which entity was primarily responsible for spotting exposures like the one incurred by JPMorgan, each organization discreetly pointed at the other.

Many a commentator has said that the 2008 financial crisis exposed the flaws of free-market capitalism. But the crisis could just as easily be attributed to a political system where people and corporations with deep pockets have an outsized influence on public policy and tilt the playing field in their favor. Under the right rules, capitalism works just fine. Maybe it's American democracy that's the real problem.

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