In the last quarter we saw the market move 200 points or more 18 times. We saw it move over 400 points four days in a row. What is causing such gyrations? Surely the U.S, economy is not that volatile. While the economy is struggling, it is not careening as wildly as the equity markets.

The reason for the volatility can be summarized in one word: Europe. For over a year Europe has been dealing with a mounting sovereign debt crisis. The focus has been on Greece, but Italy, Spain and Portugal are also under scrutiny and France may not be far behind. The problem is that these countries, particularly Greece, will have difficulty paying their bills as they come due. Since many banks in Europe hold bonds issued by these countries, the fate of the banks is in doubt as well. This is what is being referred to as the contagion effect.

There are several obvious solutions to the problem, but none are very satisfactory. For instance Greece could default on their debt. But, because of the contagion effect, no one is quite sure where that would lead, and furthermore, it would set a precedent for bad behavior in the European Union, and many countries don’t like that prospect, particularly the Northern European countries.

Greece could be excused from the EU. Even that does not avoid default, and in addition it would be very difficult to do.

The likely outcome will be that the EU collectively will have to guarantee every bank in Europe and every country from insolvency, but that is unpopular too as it would be like you being asked to guarantee your neighbors, or partners, or fellow board members debts. Furthermore, the longer this crisis has gone on the more countries are being swallowed in the vortex, which means fewer countries to guarantee more debt.

The difficulty with reaching a conclusion is that any path requires all 27 members of the EU to agree. That is why you see the earth standing still as little Slovakia decides whether or not to along with any plan that the EU might come up with. Slovakia has the smallest GDP of any member of the EU, and only joined in recent years. But their vote counts the same as Germany. Slovakians wonder why they should bail out Greece.

The current plan is to set up an emergency fund which would have from 100 Billion to 400 Billion in capital, but after that it gets murky. Christian Lagarde, head of the World Bank says that is not enough. Most seem to agree that more is needed, and that in any event the Stabilization Fund will have to borrow a lot more, maybe two trillion Euros to have enough capital to do the job. Even that may not be enough. Still it sounds a lot like doubling down on a bad debt, and so it is unpalatable to many countries. But what is the alternative?

What we are looking at is the potential break up of the European Union and the failure of the Euro. We leave the arena of economics and enter the arena of Politics when we contemplate a future without the Euro and European Union.

There were many reasons for the advent of the European Union which grew out of the European Steel and Coal community, a core group of six countries. Later a core group of European nations agreed to carry on trade without tariffs or trade barriers, and have a common customs union. This made a lot of economic sense; it also led to the Euro as it made trade lot simpler, more efficient, and with less friction.

The EU is composed of about 500 million inhabitants and about 20% of the world GDP. It is big even by American standards, and an important trading partner for the U.S..

The political objective was to bind Germany so tightly with the rest of Europe that there would be no more unfortunate German eruptions such as we had seen in the past. The idea was to bury Germany so thoroughly in Europe that they would never go to war again. Even the Germans supported this idea. The French particularly liked the idea. Germany could continue to be the economic engine of Europe and France the diplomatic voice. Since the Germans were still dealing with their war guilt, they were generally not outspoken on diplomatic matters, at least until they broke with the U.S. over Iraq. All this worked pretty well. Germany suffered a setback when the Berlin wall came down, and it was necessary to absorb East Germany. However, as Germany has recovered its footing, it is the clearly the dominant voice and economic power in Europe. This is not thrilling to the rest of Europe, but as long as there is a European Union, history may still be written peacefully.

France and Germany have continued to be the strongest champions of the Union, the common currency and a solution. (Although the Financial Times of Germany last Friday published their newspaper priced in Deutsche Marks, and isolated instances of businesses conducting business in local currencies have arisen.). However, European leaders have not been able to agree on the solution, nor is it clear that the leaders can bring their countries along with them. Many countries, EG, the Baltic States, and some of the newer entrants to the EU are skeptical. Switzerland although not a member of the EU has seen the rise of a nationalistic right wing party that is unsettling. Britain has a big stake but no voice. The U.S. wants a solution, but is consigned to the role of spectator and cheerleader. Even France’s role is shaky as their economy has weakened and their credit rating reduced. President Nicolas Sakorzy’s political future is in doubt, as is the political future of Angela Merkel, the Chancellor of Germany.

So, if a solution is not found, the whole future of Europe, not just its economy will be rewritten. Since that alternative is too threatening to be contemplated, goes the reasoning, a solution will be found. However, that solution may not be found until the markets throw another tantrum. And that brings us back to the beginning. How doe we invest in such circumstances? Each day there is optimism over a European settlement, the markets rally. Each day of pessimism the markets falter. Sometimes in the same day the market rises or falls dramatically. Sometimes within the same hour. Investing becomes treacherous.

We have continued to believe that the U.S. markets are reacting to the headlines, and not to the economic fundamentals in the U.S. The U.S. economy is struggling to achieve growth and while growth is slowing both here and internationally, U.S. companies are still reporting solid earnings. So we have been cautiously invested in the U.S. and Asia, with an allocation to cash, bonds, and solid U.S. companies. But that does not isolate us from all risk. For one thing if Europe fails, U.S. companies still sell many goods and services abroad. Furthermore, if a solution is found, I think the markets are spring loaded (in both directions) and will rocket up, but portfolios with above average cash allocations will suffer relative to the markets. They will rise, but not as much.

The risk of Europe failing is a risk to capital. The risk if they find a solution is the likelihood of not fully participating in a market rally. Then you have to ask how likely is it that Europe will fail? I think it will not fail, even if that means the U.S. will have to step in. (Tea party are you listening?) But to be fully invested means you will be subject to extreme volatility. Can you take it?

Originally posted in the Daily Journal of Commerce, Portland OR