Fwd: The Case for a Fed Rate Hike - John Mauldin's Weekly E-Letter

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Date: Sat, May 22, 2010 at 3:26 PM
Subject: The Case for a Fed Rate Hike - John Mauldin's Weekly E-Letter
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Thoughts from the Frontline Weekly Newsletter The Case for a Fed Rate Hike by John Mauldin May 22, 2010
In this issue: The Case for a Fed Rate Hike Employment Is Turning the Corner The Headwinds of Money Supply Who Stole the Inflation? The Fed Is On Hold An Inverted Yield Curve? LA, Vancouver, San Francisco, and a First Often Wrong, Seldom in Doubt
Everywhere there are arguments that we are in a "V"-shaped recovery. And there are signs that in fact that is the case. Today we will look at some of those, and then take up the topic of when the Fed will raise rates. We open the case and look at the evidence. Is there enough to come to a real conviction? I think there is. (And at the end of the letter I mention two conferences I am speaking at in the next few months, in Vancouver and San Francisco.) But first, a little housekeeping. The delivery rate for this letter has not been good for some time now and we are aware of it. We get tons of letters and calls from long-time readers who want to know why we have dropped them from the list. They keep resubscribing but not getting the letter. It is a problem. I was not getting delivery on my own personal accounts from well-known email providers. We apologize for any inconvenience. Please know that we do not drop anyone from the list unless they request it or we get hard bounces or undeliverable messages. Hopefully that has all changed with this letter. The problem has been that the list is so large that it is blocked long before the letter ever hits your inbox. The computers at service providers just assume anything this large can't be for real. We are now using a service that is a third-party verification of our letter, which hopefully will fix the problem (not a cheap solution, by the way!). So, there may be a lot of you for whom this letter is (hopefully) a pleasant surprise after not getting it for some time. If that is the case, we would like to know. If you have the time, drop me a response that says "got it" in the subject line. And of course, if you don't want to get the letter you can hit the unsubscribe button at the bottom. But even better, why not forward this to a friend and tell them to subscribe? For the record, we are working on a MAJOR revision of the website and the letter. There will be a lot more ways for you to interact with me and each other. A lot more information and capabilities. We are excited. It should be here by the fall. Tiffani and I think you are really going to like it. And now to the letter. Employment Is Turning the Corner There is a little-known employment report that the BLS (Bureau of Labor Statistics) releases late in the month that is a summary of the employment reports from the 50 states. Of late, this number has been higher than the federal government survey. Adding the states together, we find that 412,200 jobs (non-seasonally adjusted) were created in April, higher than the establishment survey (which for whatever reason gets the headlines) and more in line with the household survey, which showed an employment gain of 550,000 (seasonally adjusted). I think it is well established by now that I am not a fan of the birth/death employment estimates in the establishment survey. That is where the BLS estimates the number of new jobs created by the birth or death of new businesses. It is often a significant portion of the jobs survey and it is a seasonally adjusted guess. There really is no alternative but to make this estimate, but at the beginnings of recessions it always overestimates the number of jobs, and at the beginnings of recoveries it will underestimate them. Remember the "jobless recovery" of 2002-2004? Eventually (several years later) the BLS gets hard data from tax and other sources and goes back and revises the employment numbers. No one cares, because it is "old news." But we can now look back and see the jobless recovery we thought we were in was not all that bad. The birth/death estimates decidedly understated the growth that was going on at the time. That may be the case now, too. The much stronger state and household surveys suggest that we *may* be at the beginning of a labor recovery that will be understated by the establishment survey, as the birth/death model just won't catch that growth. If this pattern continues for the next few months, I think we should begin to pay more attention to the state and households surveys. Let's hope it does. That being said, the level of reported increases is not showing up in the income tax reports. There may be several reasons for that, one of which is that people are going back to work for less money and thus paying less taxes. And that would make sense, as there are now five out of work people seeking jobs for every job opening. The employers have the negotiating power. Businesses are cautiously building inventories and bringing people back to work. Sales-to-inventory levels are not out of line and suggest we may see more inventory building this quarter, which will directly help boost GDP. Retail sales growth is modest by previous recovery standards, but there is at least growth. The Headwinds of Money Supply  But (and you knew there would be a but coming), there are some headwinds we need to deal with before we can sound the all-clear horn. First, growth in the money supply is slowing. Let's look at the measure of money supply called MZM, or Money of Zero Maturity. Notice it was flat for well over a year and actually down the last two months. A broader measure of money is M2.  Notice that it too has flat-lined for well over a year. If we look at the last 30 years, there is nothing you can see in the chart that even comes close to this. I don't have access to a graph of M3, though it is still produced by several groups (the Fed stopped several years ago), but that chart would show that even M3 has gone negative. Remember the conspiracy guys who thought the Fed stopped reporting M3 because they thought the Fed wanted to hide the fat that it was going to increase the money supply by large amounts and destroy the dollar? Hardly. The economists at the Fed simply felt for a number of very public reasons that M3 doesn't have any real meaning any more. They have a strong case, although I never understood why they just didn't go ahead and keep publishing it anyway. It was just a few computers programs. But what do I know? Now, notice that with both graphs you see a large increase beginning in the middle of 2008 as the Fed pumped the money supply in order to inject liquidity into the system. This was basically the $1.25 trillion purchase of mortgages, but toward the end even that was not boosting the money supply as much as it did in the beginning. Why? Partially, because of the following graph. This shows total commercial lending at US banks. It is down almost 25% in less than a year and a half. Notice that in the last recession commercial lending dropped by "only" 18% in 3.5 years. Lending to consumers is also down in a similar fashion. Notice that money supply begins to go flat in 2009, just a little after bank lending dried up. Remember our old friend the equation that GDP is equal to the money supply times the velocity of money (GDP=MV)? If GDP is growing and the money supply is slowing, that means the velocity of money is starting to turn back up. That would be a good thing, but we must be somewhat cautious, in that the velocity of money is mean reverting over time, and it is still well above its mean. If it started to once again slow down, as it has for several years now with the current slow or no growth in the money supply, that would not be good for GDP growth. As a practical matter, that means the Fed will not be reducing its mortgage holdings any time soon. They will wait until it is obvious that a recovery is firmly entrenched. I don't see how they can risk reducing the money supply any more than they already have, especially given the next few charts. Who Stole the Inflation? Inflation just isn't what it used to be. Core inflation is basically flat over the last year. We haven't seen that since the '50s. Since the beginning of 2009 it is only up around 0.1%. About five years ago, the Dallas Fed developed a new methodology for measuring inflation, called the Trimmed Mean PCE. It was developed by Dallas Fed economist Jim Dolmas. Dolmas notes (quite correctly, I think) that to exclude food and energy, just because they are volatile, ignores that other quite volatile measures of inflation are still left in. Further, energy and food inflation do have meaning in the real world. What Dolmas does is use a statistical device called "trimming." From the field of statistics, trim analysis borrows the idea of ignoring a few "outliers." A trimmed mean, for example, is calculated by discarding a certain number of lowest and highest values and then computing the mean of those that remain. How accurate is his measure? Dolmas suggests it is a lot more accurate: "That is to say, compared to the usual ... measure, on average the monthly Trimmed mean measure would be expected to come closer to true monthly core inflation by roughly .75 of a percentage point, when the inflation rates are expressed in annual terms." That is huge, at least in my book, especially when we look at how great the difference is with the Fed's favorite methodology. In 2006, the trimmed-inflation methodology suggested the core inflation was understating inflation. Today, the same methodology suggests that core inflation is overstating inflation. Look at the tables below, which were last updated in March. The trends in inflation are clearly down, and when the April data comes out it will be down again. My good friend David Rosenberg pointed out this morning a new study by the Cleveland Fed on inflation, which concludes that: (i) the decline in recent months has transcended the housing effect; and, (ii) the principal risk is for a further slowing. Treasury yields are likely headed even lower. The title of the report is Are Some Prices in the CPI More Forward Looking Than Others? We Think So, by Michael F. Bryan and Brent Meyer. It's well worth a read. ( http://www.clevelandfed.org/Research/commentary/2010/2010-2.cfm) "Abstract: Some of the items that make up the Consumer Price Index change prices frequently, while others are slow to change. We explored whether these two sets of prices - sticky and flexible - provide insight on different aspects of the inflation process. We found that sticky prices appear to incorporate expectations about future inflation to a greater degree than prices that change on a frequent basis, while flexible prices respond more powerfully to economic conditions-economic slack. Importantly, our sticky-price measure seems to contain a component of inflation expectations, and that component may be useful when trying to gauge where inflation is heading. "Conclusion: Where is inflation heading? Well, the last FOMC statement held the view that 'inflation is likely to be subdued for some time.' We certainly don't have reason to question that outlook. Indeed, while the recent trend in the core flexible CPI has risen some recently (it's up 3.3 percent over the past 12 months ending in March) the trend in the core sticky-price CPI continues to decline. Even excluding shelter, the 12-month growth rate in the core sticky CPI has fallen 1.1 percentage points since December 2008, down to 1.8 percent in March. So on the basis of these cuts of the CPI, we think 'subdued for some time' sums up the price trends nicely." And speaking of the latest minutes from the last Fed meeting, which came out this week, let's review a paragraph. "In light of stable longer-term inflation expectations and the likely continuation of substantial resource slack, policymakers anticipated that both overall and core inflation would remain subdued through 2012, with measured inflation somewhat below rates that policymakers considered to be consistent over the longer run with the Federal Reserve's dual mandate." The Fed Is On Hold Let's review. Economists tell us it will take GDP growth rates of 3.5% or more to have any real impact on employment. As I have noted elsewhere, that is 300,000 jobs a month for five years to get us back to where we were in 2007. Losing 8 million jobs is a big hole. What are the prospects for 3.5% GDP growth, with high unemployment and large tax increases coming in 2011from not only the Fed but state and local governments? My thought is, not so great. The trend in inflation is down. Unemployment is way too high. The money supply is somnolent. The Fed is on hold for the rest of the year and well into 2011. Case closed. An Inverted Yield Curve? A quick thought on inverted yield curves. As long-time readers know, I have written extensively about research done on the inverted yield curve, that condition where short-term rates are higher than long-term rates. It is the best single indicator of recessions, and following it allowed me to "predict" the last two recessions a year in advance. We won't go now into why it seems to work, but it is useful, or has been in the past. Clearly, if the Fed is on hold for at least another year, it will be impossible for quite some time to get an inverted yield curve. Obviously, long-term rates will not go below zero. Yet long-term rates are headed down of late, and are lower than they were when we last had an inverted yield curve in 2006. What would the yield curve look like without the Fed massively intervening? Is there a way to "normalize" the short-term rates that would give us a proxy for short-term rates without active Fed intervention? Would it matter? If you have any thoughts on that topic, feel free to share. LA, Vancouver, San Francisco, and a First Often Wrong, Seldom in Doubt I am off to LA tomorrow with son-in-law Ryan to meet with the team at Fahrenheit Studios that is helping us design the new websites. Then home for ten days, and then it's some much-needed vacation time with the family (kids and spouses and grandbabies - a total of 12 of us), to Italy. I will be speaking at the Agora Financial Investment Symposium in Vancouver July 20-23rd. There are some really great speakers and this is a fun crowd. I got them to knock off $200 for my readers if you use the link and order form below. You can find a link to the list of speakers a little ways into the link. Hope to see you there! http://agorafinancial.com/reports/vancouver/2010/vancouver2010_2.php?pub=C2010AFVAN&code=E400L5NC I will also be speaking at the San Francisco Money Show August 19-21. I will have more on that show in the coming weeks, and links for registration. And a big thanks to Greg Buoncontri and his team at Pitney Bowes. I spoke there last Wednesday and was made to feel quite special. It was a very upbeat conference with great speakers on how the world is changing. I learned a lot. Finally, after ten years of writing this letter, I had a first tonight. At 9:30 I realized what I was writing was just not ready for prime time. You can't take the cake out of the oven until it is fully baked. I have had some half-baked ideas before, but never knowingly. As I say, I am often wrong but seldom in doubt. I really thought I knew where I was going, but the longer I thought and the more I wrote the more I kept disagreeing with myself. I still think there is some meat in the topic, but I need to think some more on it. You, gentle reader, deserve nothing less. I take this letter seriously. I had to stop, pour myself some scotch, take a deep breath, and start over with a brand new topic. And since I haven't written about Fed policy for some time, a letter on it was due. It is now 1 AM and past time to hit the send button. Let's hope this doesn't happen for another ten years. Your ready to begin to slow down (at least for tonight) analyst, John Mauldin John@FrontLineThoughts.com Copyright 2010 John Mauldin. All Rights Reserved Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.
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You have permission to publish this article electronically or in print as long as the following is included: John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore To subscribe to John Mauldin's E-Letter please click here: http://www.frontlinethoughts.com/subscribe.asp To change your email address please click here: http://www.frontlinethoughts.com/change.asp If you would ALSO like changes applied to the Accredited Investor E- Letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com To unsubscribe please refer to the bottom of the email. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to jmiller2000@gmail.com Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

Fwd: Germany, Greece and Exiting the Eurozone - Outside the Box Special Edition

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From: John Mauldin and InvestorsInsight <wave@frontlinethoughts.com>
Date: Thu, May 20, 2010 at 1:19 PM
Subject: Germany, Greece and Exiting the Eurozone - Outside the Box Special Edition
To: jmiller2000@gmail.com

	Contact John Mauldin Print Version Volume 6 - Special Edition May 20, 2010 Germany, Greece and Exiting the Eurozone By Marko Papic, Robert Reinfrank and Peter Zeihan The cause célèbre these days is the potential reconstitution of the eurozone: ie, Germany leaving it, or Greece getting kicked out. To look a little deeper, today I'm sending you STRATFOR's take on these two scenarios. STRATFOR explores the geography of the continent and the historical context of the EU to understand what a German exit or a Greek expulsion might mean for the rest of the region. After you read the article, sign up here to receive more STRATFOR global intelligence reports like this one. John Mauldin Editor, Outside the Box Germany, Greece and Exiting the Eurozone By Marko Papic, Robert Reinfrank and Peter Zeihan Rumors of the imminent collapse of the eurozone continue to swirl despite the Europeans' best efforts to hold the currency union together. Some accounts in the financial world have even suggested that Germany's frustration with the crisis could cause Berlin to quit the eurozone - as soon as this past weekend, according to some - while at the most recent gathering of European leaders French President Nicolas Sarkozy apparently threatened to bolt the bloc if Berlin did not help Greece. Meanwhile, many in Germany - including Chancellor Angela Merkel herself at one point - have called for the creation of a mechanism by which Greece - or the eurozone's other over-indebted, uncompetitive economies - could be kicked out of the eurozone in the future should they not mend their "irresponsible" spending habits. Rumors, hints, threats, suggestions and information "from well-placed sources" all seem to point to the hot topic in Europe at the moment, namely, the reconstitution of the eurozone whether by a German exit or a Greek expulsion. We turn to this topic with the question of whether such an option even exists. The Geography of the European Monetary Union As we consider the future of the euro, it is important to remember that the economic underpinnings of paper money are not nearly as important as the political underpinnings. Paper currencies in use throughout the world today hold no value without the underlying political decision to make them the legal tender of commercial activity. This means a government must be willing and capable enough to enforce the currency as a legal form of debt settlement, and refusal to accept paper currency is, within limitations, punishable by law. The trouble with the euro is that it attempts to overlay a monetary dynamic on a geography that does not necessarily lend itself to a single economic or political "space." The eurozone has a single central bank, the European Central Bank (ECB), and therefore has only one monetary policy, regardless of whether one is located in Northern or Southern Europe. Herein lies the fundamental geographic problem of the euro. Europe is the second-smallest continent on the planet but has the second-largest number of states packed into its territory. This is not a coincidence. Europe's multitude of peninsulas, large islands and mountain chains create the geographic conditions that often allow even the weakest political authority to persist. Thus, the Montenegrins have held out against the Ottomans, just as the Irish have against the English. Despite this patchwork of political authorities, the Continent's plentiful navigable rivers, large bays and serrated coastlines enable the easy movement of goods and ideas across Europe. This encourages the accumulation of capital due to the low costs of transport while simultaneously encouraging the rapid spread of technological advances, which has allowed the various European states to become astonishingly rich: Five of the top 10 world economies hail from the Continent despite their relatively small populations. Europe's network of rivers and seas are not integrated via a single dominant river or sea network, however, meaning capital generation occurs in small, sequestered economic centers. To this day, and despite significant political and economic integration, there is no European New York. In Europe's case, the Danube has Vienna, the Po has Milan, the Baltic Sea has Stockholm, the Rhineland has both Amsterdam and Frankfurt and the Thames has London. This system of multiple capital centers is then overlaid on Europe's states, which jealously guard control over their capital and, by extension, their banking systems. Despite a multitude of different centers of economic - and by extension, political - power, some states, due to geography, are unable to access any capital centers of their own. Much of the Club Med states are geographically disadvantaged. Aside from the Po Valley of northern Italy - and to an extent the Rhone - southern Europe lacks a single river useful for commerce. Consequently, Northern Europe is more urban, industrial and technocratic while Southern Europe tends to be more rural, agricultural and capital-poor. Introducing the Euro Given the barrage of economic volatility and challenges the eurozone has confronted in recent quarters and the challenges presented by housing such divergent geography and history under one monetary roof, it is easy to forget why the eurozone was originally formed. The Cold War made the European Union possible. For centuries, Europe was home to feuding empires and states. After World War II, it became the home of devastated peoples whose security was the responsibility of the United States. Through the Bretton Woods agreement, the United States crafted an economic grouping that regenerated Western Europe's economic fortunes under a security rubric that Washington firmly controlled. Freed of security competition, the Europeans not only were free to pursue economic growth, they also enjoyed nearly unlimited access to the American market to fuel that growth. Economic integration within Europe to maximize these opportunities made perfect sense. The United States encouraged the economic and political integration because it gave a political underpinning to a security alliance it imposed on Europe, i.e., NATO. Thus, the European Economic Community - the predecessor to today's European Union - was born. When the United States abandoned the gold standard in 1971 (for reasons largely unconnected to things European), Washington essentially abrogated the Bretton Woods currency pegs that went with it. One result was a European panic. Floating currencies raised the inevitability of currency competition among the European states, the exact sort of competition that contributed to the Great Depression 40 years earlier. Almost immediately, the need to limit that competition sharpened, first with currency coordination efforts still concentrating on the U.S. dollar and then from 1979 on with efforts focused on the deutschmark. The specter of a unified Germany in 1989 further invigorated economic integration. The euro was in large part an attempt to give Berlin the necessary incentives so that it would not depart the EU project. But to get Berlin on board with the idea of sharing its currency with the rest of Europe, the eurozone was modeled after the Bundesbank and its deutschmark. To join the eurozone, a country must abide by rigorous "convergence criteria" designed to synchronize the economy of the acceding country with Germany's economy. The criteria include a budget deficit of less than 3 percent of gross domestic product (GDP); government debt levels of less than 60 percent of GDP; annual inflation no higher than 1.5 percentage points above the average of the lowest three members' annual inflation; and a two-year trial period during which the acceding country's national currency must float within a plus-or-minus 15 percent currency band against the euro. As cracks have begun to show in both the political and economic support for the eurozone, however, it is clear that the convergence criteria failed to overcome divergent geography and history. Greece's violations of the Growth and Stability Pact are clearly the most egregious, but essentially all eurozone members - including France and Germany, which helped draft the rules - have contravened the rules from the very beginning. Mechanics of a Euro Exit The EU treaties as presently constituted contractually obligate every EU member state - except Denmark and the United Kingdom, which negotiated opt-outs - to become a eurozone member state at some point. Forcible expulsion or self-imposed exit is technically illegal, or at best would require the approval of all 27 member states (never mind the question about why a troubled eurozone member would approve its own expulsion). Even if it could be managed, surely there are current and soon-to-be eurozone members that would be wary of establishing such a precedent, especially when their fiscal situation could soon be similar to Athens' situation. One creative option making the rounds would allow the European Union to technically expel members without breaking the treaties. It would involve setting up a new European Union without the offending state (say, Greece) and establishing within the new institutions a new eurozone as well. Such manipulations would not necessarily destroy the existing European Union; its major members would "simply" recreate the institutions without the member they do not much care for. Though creative, the proposed solution it is still rife with problems. In such a reduced eurozone, Germany would hold undisputed power, something the rest of Europe might not exactly embrace. If France and the Benelux countries reconstituted the eurozone with Berlin, Germany's economy would go from constituting 26.8 percent of eurozone version 1.0's overall output to 45.6 percent of eurozone version 2.0's overall output. Even states that would be expressly excluded would be able to get in a devastating parting shot: The southern European economies could simply default on any debt held by entities within the countries of the new eurozone. With these political issues and complications in mind, we turn to the two scenarios of eurozone reconstitution that have garnered the most attention in the media. Scenario 1: Germany Reinstitutes the Deutschmark The option of leaving the eurozone for Germany boils down to the potential liabilities that Berlin would be on the hook for if Portugal, Spain, Italy and Ireland followed Greece down the default path. As Germany prepares itself to vote on its 123 billion euro contribution to the 750 billion euro financial aid mechanism for the eurozone - which sits on top of the 23 billion euros it already approved for Athens alone - the question of whether "it is all worth it" must be on top of every German policymaker's mind. This is especially the case as political opposition to the bailout mounts among German voters and Merkel's coalition partners and political allies. In the latest polls, 47 percent of Germans favor adopting the deutschmark. Furthermore, Merkel's governing coalition lost a crucial state-level election May 9 in a sign of mounting dissatisfaction with her Christian Democratic Union and its coalition ally, the Free Democratic Party. Even though the governing coalition managed to push through the Greek bailout, there are now serious doubts that Merkel will be able to do the same with the eurozone-wide mechanism May 21. Germany would therefore not be leaving the eurozone to save its economy or extricate itself from its own debts, but rather to avoid the financial burden of supporting the Club Med economies and their ability to service their 3 trillion euro mountain of debt. At some point, Germany may decide to cut its losses - potentially as much as 500 billion euros, which is the approximate exposure of German banks to Club Med debt - and decide that further bailouts are just throwing money into a bottomless pit. Furthermore, while Germany could always simply rely on the ECB to break all of its rules and begin the policy of purchasing the debt of troubled eurozone governments with newly created money ("quantitative easing"), that in itself would also constitute a bailout. The rest of the eurozone, including Germany, would be paying for it through the weakening of the euro. Were this moment to dawn on Germany it would have to mean that the situation had deteriorated significantly. As STRATFOR has recently argued, the eurozone provides Germany with considerable economic benefits. Its neighbors are unable to undercut German exports with currency depreciation, and German exports have in turn gained in terms of overall eurozone exports on both the global and eurozone markets. Since euro adoption, unit labor costs in Club Med have increased relative to Germany's by approximately 25 percent, further entrenching Germany's competitive edge. Before Germany could again use the deutschmark, Germany would first have to reinstate its central bank (the Bundesbank), withdraw its reserves from the ECB, print its own currency and then re-denominate the country's assets and liabilities in deutschmarks. While it would not necessarily be a smooth or easy process, Germany could reintroduce its national currency with far more ease than other eurozone members could. The deutschmark had a well-established reputation for being a store of value, as the renowned Bundesbank directed Germany's monetary policy. If Germany were to reintroduce its national currency, it is highly unlikely that Europeans would believe that Germany had forgotten how to run a central bank - Germany's institutional memory would return quickly, re-establishing the credibility of both the Bundesbank and, by extension, the deutschmark. As Germany would be replacing a weaker and weakening currency with a stronger and more stable one, if market participants did not simply welcome the exchange, they would be substantially less resistant to the change than what could be expected in other eurozone countries. Germany would therefore not necessarily have to resort to militant crackdowns on capital flows to halt capital trying to escape conversion. Germany would probably also be able to re-denominate all its debts in the deutschmark via bond swaps. Market participants would accept this exchange because they would probably have far more faith in a deutschmark backed by Germany than in a euro backed by the remaining eurozone member states. Reinstituting the deutschmark would still be an imperfect process, however, and there would likely be some collateral damage, particularly to Germany's financial sector. German banks own much of the debt issued by Club Med, which would likely default on repayment in the event Germany parted with the euro. If it reached the point that Germany was going to break with the eurozone, those losses would likely pale in comparison to the costs - be they economic or political - of remaining within the eurozone and financially supporting its continued existence. Scenario 2: Greece Leaves the Euro If Athens were able to control its monetary policy, it would ostensibly be able to "solve" the two major problems currently plaguing the Greek economy. First, Athens could ease its financing problems substantially. The Greek central bank could print money and purchase government debt, bypassing the credit markets. Second, reintroducing its currency would allow Athens to then devalue it, which would stimulate external demand for Greek exports and spur economic growth. This would obviate the need to undergo painful "internal devaluation" via austerity measures that the Greeks have been forced to impose as a condition for their bailout by the International Monetary Fund (IMF) and the EU. If Athens were to reinstitute its national currency with the goal of being able to control monetary policy, however, the government would first have to get its national currency circulating (a necessary condition for devaluation). The first practical problem is that no one is going to want this new currency, principally because it would be clear that the government would only be reintroducing it to devalue it. Unlike during the Eurozone accession process - where participation was motivated by the actual and perceived benefits of adopting a strong/stable currency and receiving lower interest rates, new funds and the ability to transact in many more places - "de-euroizing" offers no such incentives for market participants: The drachma would not be a store of value, given that the objective in reintroducing it is to reduce its value. The drachma would likely only be accepted within Greece, and even there it would not be accepted everywhere - a condition likely to persist for some time. Reinstituting the drachma unilaterally would likely see Greece cast out of the eurozone, and therefore also the European Union as per rules explained above. The government would essentially be asking investors and its own population to sign a social contract that the government clearly intends to abrogate in the future, if not immediately once it is able to. Therefore, the only way to get the currency circulating would be by force. The goal would not be to convert every euro-denominated asset into drachmas but rather to get a sufficiently large chunk of the assets so that the government could jumpstart the drachma's circulation. To be done effectively, the government would want to minimize the amount of money that could escape conversion by either being withdrawn or transferred into asset classes easy to conceal from discovery and appropriation. This would require capital controls and shutting down banks and likely also physical force to prevent even more chaos on the streets of Athens than seen at present. Once the money was locked down, the government would then forcibly convert banks' holdings by literally replacing banks' holdings with a similar amount in the national currency. Greeks could then only withdraw their funds in newly issued drachmas that the government gave the banks to service those requests. At the same time, all government spending/payments would be made in the national currency, boosting circulation. The government also would have to show willingness to prosecute anyone using euros on the black market, lest the newly instituted drachma become completely worthless. Since nobody save the government would want to do this, at the first hint that the government would be moving in this direction, the first thing the Greeks will want to do is withdraw all funds from any institution where their wealth would be at risk. Similarly, the first thing that investors would do - and remember that Greece is as capital-poor as Germany is capital-rich - is cut all exposure. This would require that the forcible conversion be coordinated and definitive, and most important, it would need to be as unexpected as possible. Realistically, the only way to make this transition without completely unhinging the Greek economy and shredding Greece's social fabric would be to coordinate with organizations that could provide assistance and oversight. If the IMF, ECB or eurozone member states were to coordinate the transition period and perhaps provide some backing for the national currency's value during that transition period, the chances of a less-than-completely-disruptive transition would increase. It is difficult to imagine circumstances under which such support would not dwarf the 110 billion euro bailout already on the table. For if Europe's populations are so resistant to the Greek bailout now, what would they think about their governments assuming even more risk by propping up a former eurozone country's entire financial system so that the country could escape its debt responsibilities to the rest of the eurozone? The European Dilemma Europe therefore finds itself being tied in a Gordian knot. On one hand, the Continent's geography presents a number of incongruities that cannot be overcome without a Herculean (and politically unpalatable) effort on the part of Southern Europe and (equally unpopular) accommodation on the part of Northern Europe. On the other hand, the cost of exit from the eurozone - particularly at a time of global financial calamity, when the move would be in danger of precipitating an even greater crisis - is daunting to say the least. The resulting conundrum is one in which reconstitution of the eurozone may make sense at some point down the line. But the interlinked web of economic, political, legal and institutional relationships makes this nearly impossible. The cost of exit is prohibitively high, regardless of whether it makes sense. John F. Mauldin johnmauldin@investorsinsight.com You are currently subscribed as jmiller2000@gmail.com. To unsubscribe, go here. Reproductions. If you would like to reproduce any of John Mauldin's E-Letters or commentary, you must include the source of your quote and the following email address: JohnMauldin@InvestorsInsight.com. Please write to Reproductions@InvestorsInsight.com and inform us of any reproductions including where and when the copy will be reproduced. Note: John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. 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