The euro zone is coming apart at the seams now

You can read it on Reuters:

The top German official at the European Central Bank is to quit early in disagreement with the bank’s policy of buying euro zone government bonds to combat the currency bloc’s debt crisis.

Clearly, Stark sees the monetisation path the ECB is on as not at all compatible with the ECB’s mandate.

Separately, the noises coming out of the German governing coalition show exasperation with the progress in Greece. Edward Hugh writes that “a Greek euro exit is no longer the unthinkable taboo topic”. This is especially true after the beating Angela Merkel’s party took in elections in her home state of Mecklenburg-Vorpommern this past weekend.

Fiscal consolidation is not expansionary. Moreover, it increases deficits due to the increase in spending on fiscal stabilisers and the decrease in tax receipts – that is unless the cuts are extremely large. There is zero chance that Greece will make its targets. I don’t expect Portugal, Italy, Ireland or Spain to meet their targets either, especially given the incipient double dip we are witnessing.

As the Germans are likely to see their fiscal trajectory deteriorate markedly in this environment due to the anaemic domestic demand and dependence on exports, their willingness to fund bailouts will evaporate. The political calculus may turn to topping up capital at underfunded German banks. Greece, at a minimum, will default. Indeed, without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression. Stark’s resignation increases the chances that just this will occur.

The euro zone is coming apart at the seams. Right now the economic outlook looks bleak. If you are a euro zone investor, the policy outlook is extremely volatile. That means avoiding the periphery and piling into German and Dutch bonds and/or gold because we are about to see how limited the ECB’s bond purchases are.

P.S. – Economics is not a morality play. Hopefully, you will have noticed that I don’t write about this in moralistic tones (using language that conveys undertones about ‘evil’ Germans, ‘lazy’ Greeks and so on). Anyone who does has an axe to grind and you should be very wary of the biases this creates for their analysis.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

29 Comments

  1. Dave Holden says:

    “Economics is not a moality play.”

    I agree with this and appreciate your approach. I would add however that neither is it a science and that analysis also has to take into account that it is political and that much of that politic for good or bad is moralistic.

  2. Bernd says:

    “The euro zone is coming apart at the seams now”, I think you are reading the situation wrong, it´s probably correct that the euro zone will come apart, I do doubt however, that this will happen in a disorderly fashion.
    The whole situation is widely discussed in Germany(i.e.: http://www.zdf.de/ZDFmediathek/beitrag/video/1434224/Europa-ist%2C-wenn-Deutschland-zahlt%3F ), the interesting aspect is though, that whilst policy presctiptions do differ, the same can´t really be said about the analysis of the situation. Whilst the head of the main opposition party and one of the leading opponents in this clip do disagree about whether more aid for the periphery or “cutting losses” is the better policy, they do agree on the general analysis and respect each others positions(agree to disagree)on what the correct way ahead is.
    Apart from that there´s three basic issues:
    1. Germany cannot be seen to dominate Europe and impose it´s will. (It´s politically impossible, especially due to french fears of precisely that outcome plus the german people doesn´t wan´t to be in that position(most would prefer to be a larger version of Switzerland)).
    2. Transfer payments from Germany to the periphery, will not be made without signficant austerity measures being implemented(due to domestic issues). The periphery can´t possibly implement measures on the scale demanded without completely crashing their economies and loosing any domestic support.
    3. Germany cannot be seen to be abandoning Europe, if anything it will have to be asked to leave the Eurozone in order to enable more transfers and crucially a QE like program of the ECB.(Whilst leaving the Euro(especially for the good of the EU), when asked would be an extremely popular solution in Germany).

    Quite frankly what I would expect to see going forward is Germany complaining more and more about the purchase of gvnt bonds by the ECB, Greece and possibly other peripheral nations not being able to stick to their consoldidation programs, some controlled turmoil and Germany being asked to temporarily leave the Euro, with the ECB implementing Fed-like programs subsequently.
    The first indicator for this analysis will/would probably be the selection of a french chief economist for the ECB instead of a german one.

    • Nothing I wrote is at odds with that. Where is the disagreement?

      Everyone wants an orderly dissolution if that’s what is to happen. The question is whether the markets force a timetable that politicians cannot abide either in Germany or elsewhere.

    • Detlef says:

      Should your scenario happen I don´t believe it would be only Germany leaving. In an “orderly fashion”.

      Add the Netherlands too. Their Prime Minister just wrote an article in the FT a few days ago.
      Gideon Rachman in his FT blog characterized the article so:

      “I thought that Wolfgang Schauble, the German finance minister, was a bit of a headbanger on the need for austerity in the euro-zone, until I read this morning’s piece by Mark Rutte, the Dutch prime minister. He makes Schauble sound like an indulgent uncle.”

      And what about Luxembourg and Austria? Or Finland with its “True Finns”? Slovakia?

      You really believe they all will stay in the Euro zone if Germany is “being asked to temporarily leave the Euro”?
      That is difficult to imagine.

    • Coldcall says:

      I think the neatest solution is for Germany and perhaps some other northern eurozone members to leave the euro. This allows an extreme devaluation of the currency which would go a long way helping the GIIPS become more competitive. In places like Spain the cost of just about everything has exploded since they joined the euro, and wages have not kept pace. So the idea that wages in Spain need to come down is quite ridiculous. What needs to come down is the value of everyday items which were far more affordable during the days of the peseta.

      However i disagree that Germany will be asked to leave. I think she will be a driver in organising her withdrawal, no doubt somehow pegging the new German mark to the euro at a rate advantageous for German manufacturer’s sales to the GIIPS consumers.

      Remember this was the main motive for Germany’s involvement in emu; she got a pegged currency with practically third world economies at a moment of tremendous consumer and credit growth.

  3. Bernd says:

    The only disagreement that I see is, that you seem to assume that it will be “coming apart at the seams”. As Juncker rightly said: sometimes you have to lie.
    I would presume you didn´t take the statement about a “european economic government” by Merkel and Sarkozy seriously, any initiative óf that kind would take 2-5 years to implement, involving a change of european treaties… Whilst I definetely don´t hold our european leaders in the highest esteem, there definetely has been a learning curve over the past 2 years.
    The insteresting question is: what was the real issue they discussed? From what I hear it´s more along the lines of my first comment.

    • I am not assuming anything. I am just pointing out what has already occurred, namely that major policy makers are openly talking of how to break up the Euro. The Prime Minister of the Netherlands has done as has Schaeuble. To me that is evidence that the euro zone is coming apart at the seams i.e. political cohesion is all but gone. In no way does that mean the EZ is about to dissolve right now but I do believe it will eventually because the political will to support it is gone.

      • Coldcall says:

        Agreed. It’s more like a train crash in slow motion :-)

        The large political solution of fiscal union is clearly not possible after the German consitutional court said any further bailouts must be voted on in the Bundestag. So no eurobonds and no fiscal union.

        Problem is if Greece goes out then the precendent is set and i think the whole Eurozone will come apart.

  4. Don Davis says:

    When German and Dutch officials talk openly about things they CAN do, such as their countries leaving the euro, as opposed to things they cannot do, such as “kicking out” Greece, Portugal, etc. I will tend more to believe them. Right now Germany appears to be preparing to prop up its own banks in case Greece defaults. All else is posturing for domestic consumption. If they leave the Euro, I would expect them to work it out amongst those who they know will go with them and announce it as a fiat accomplis. Stark’s departure may be an indication that the ECB is preparing to cover the losses from a Greek default. Germany may see that as an unacceptable dilution of the value of their own euros. But they better figure out how to deal with a sharply appreciated currency for their own economies if they leave, and with a greatly reduced trade with the remaining euro-zone countries.

  5. Don Davis says:

    And don’t any of these geniuses understand three sector national accounting? If they are going to be export surplus countries, other countries have to be export deficit countries. All cannot simultaneously run an external trade surplus. At some point they are going to have to deal with the fact that the situation is much more complicated than their simple morality play narrative that casts the surplus countries as the heroes and the deficit countries as the villains. If they insist on substituting their morality play for double entry book keeping it will not end well for anyone.

  6. Jim says:

    Edward,

    Can you clarify one thing for us “ignorant Americans” regarding the Eurozone. When you say the Eurozone is coming apart at the seams, do you mean that the currency union is coming apart at the seams, or do you also mean that the entire Eurozone structure (free trade among members, no border crossing problems, free movement of people among countries to work, etc…) is likely to collapse as well?

    In short, is Europe in danger of falling back to what it once was?

    As you’ve pointed out for a while, the currency union of Europe is a mess and was likely doomed to fail without some sort of fiscal union or “super government,” none of which was really possible (in my opinion) considering culture, history and the general unworkable nature of such a system. While the unwinding of the currency union will be ugly and have significant short-term and perhaps medium-term economic fallout, I don’t see it as the end of the world either.

    However, the concept of the Eurozone (free movement of goods and people among members, etc…) is wonderful and is a huge plus for all members.

    Do you really foresee the entire structure of the Eurozone completely falling apart, not just the currency union?

    Sorry if this question doesn’t make a lot of sense, but I’m far from a scholar on the Euro, the Eurozone and all the treaties/constitutions that are part of it. But hopefully you get the “gist” of what I’m asking.

    • Jim

      Right now the likely policy outcomes are pretty volatile. So thinking about free trade, open borders, and free movement introduces a lot of moving parts.

      I would say this though: Europe is going to become more conservative, more nationalistic and more xenophobic. The same is true in the US. That means that the European experiment will be under great stress. The Spanish and the Portuguese or the Irish and the British or the Germans and the Dutch would then feel an affinity for each other that the Greeks and the Germans or the Finnish and the Spanish might not.

      What does that mean for policy? It means unilateralism. You see the Danes putting up restrictions on the Schengen agreement. You see the Dutch PM talking about tossing out member countries from the euro zone. And you see lots of western Europeans talking about the ‘coming wave’ of immigration from Bulgaria and Romania with dread.

      In a deep downturn, these tensions will boil over and the cohesion cannot last.

      The basic problem with the eurozone and with the EU is that they are too large. I wrote an article about this in 2008.

      http://pro.creditwritedowns.com/2008/07/did-joining-eurozone-bust-ireland.html

      It’s pure speculation how far the EU/EZ breakup will proceed but the minimum I expect is at least 1 or 2 members leaving the eurozone, restrictions on Romanian and Bulgarian workers and a few more dissenters to Schengen.

      • David Lazarus says:

        I suspect that Greeks will be migrating to Germany as well. Eventually Germany will suffer higher unemployment as migrants from the periphery move to the core. Romania and Bulgaria are just a symptom of the problem with the economics. There are insufficient jobs in the EU so people will move to where the jobs are.

  7. PBlacque says:

    Ed,

    Your analysis has been dead on, in large measure –I think– because you apply no overlays…

    That being said, what are your thoughts are on the potential success of a fiscal union or U.S.E.? As I’ve said here before, I remain skeptical simply because the deep cultural chasms in Europe prevent the necessary labor mobility and social connectedness to make such a construct work efficiently (e.g. USA and Canada)… any thoughts?

    Oh… where do you see the EUR/USD near term?

    Cheers

    • @PBlacque,

      As I was saying to Jim, there is so much volatility in the politics in Europe now, it makes investing difficult. I don’t see a fiscal union frankly. That’s the sort of thing you would see when times are good. Now times are bad. Many in Germany or Holland or Finland don’t want that now. Soon, they will be thinking about their own budget deficits and their own economic travails if a double dip comes – as I expect it to.

      As for the Euro, it is overvalued. Investing-wise, I will leave the currencies to the BBH guys. But I would say the only reason it goes up from here is because of a safe haven status. If people expect Greece and others to leave, there will be upward pressure. However, Germany or the Netherlands could leave and so there could be downward pressure. Lots of volatility. The best call is to be long volatility.

      • David Lazarus says:

        Add in political incompetence to boost volatility as well. The value of the Euro is probably fair on a EU wide basis but still not low enough for the periphery. For Germany to leave they need to expect a much higher Deutschmark and subsequent fall in exports. That might be enough to make bailing out German banks very expensive. Don’t forget that bad German loans to the periphery are at the centre of this.

  8. Pith Helmet says:

    “Economics is not a morality play. Hopefully, you will have noticed that I don’t write about this in moralistic tones (using language that conveys undertones about ‘evil’ Germans, ‘lazy’ Greeks and so on). Anyone who does has an axe to grind and you should be very wary of the biases this creates for their analysis.”

    Even if you do not make a choice, you still have made a choice. People who claim economics do not have a moral dimension are ignoring reality. You can accept the moral dimensions of economic decisions without using “moralistic tones” that suggest improper motivations.

  9. David Lazarus says:

    “Fiscal consolidation is not expansionary. Moreover, it increases deficits due to the increase in spending on fiscal stabilisers and the decrease in tax receipts – that is unless the cuts are extremely large.”
    That cannot be right. If cuts make things worse how can even bigger cuts make everything better? No what bigger cuts do is drive a population out. Like in Ireland and the Baltic states. These areas are economic wastelands for decades now because the higher debt burden will sap them for decades even though they may fiscally be in balance. Add in a new recession and where do you think they will go? They cannot maintain balance when exports slump when everyone is in austerity.
    The Germans might be getting sovereign bailout fatigue but why should they now feel happy about more bank bailouts even if they are German banks? People will realise that all the sovereign bailouts have failed to bail out the banks and even more bailouts will help how?
    The issue for years has been excessive debt and this will take time to clear unless it is simply written off.

    • That is right. It is exactly what we saw on Latvia and Ireland. In Latvia the cuts were so severe that the budget deficit did go down. In Ireland they were also dramatic but niot enough to overcome the impact of recession.

      The direct budgetary impact from lost tax revenue and increased fiscal stabilizers is LESS than the budget cut. The increase in deficit comes from the multiplier impact of recession which diminishes the larger the cuts are.

      • David Lazarus says:

        Yes but both countries benefited from the fact that so many people actually voted with their feet and left. If not unemployment payments would have been a lot higher, and the deficit still big.

        • I understand that you want to argue your point. But the fact is the revenue impact of any budget cut is ALWAYS positive except via multiplier effects, even with increased transfer payments.

          It is ALWAYS ONLY a multiplier effect which causes the deficit to increase. And this multiplier effect diminishes the larger the budget cut. Hence the difference in outcome in Ireland and the Baltics.

          The point is that a country willing to go to extremes of austerity will be able to cut the deficit, emigration or not. Whether they are or should be willing to do so is another matter.

          • David Lazarus says:

            They only managed the austerity because of emigration. The end result is that these two countries now have a potential GDP substantially lower than it would have been. They might be balancing the budget but their per capita debt burden is higher, their ability to grow out of this crisis is substantially lower. If there had not been mass migration then these two countries would be looking at significantly higher unemployment payments. Then the anger within the country would be significant and the countries would have revolted. Even Iceland has had significant emigration. That could be a problem in the future but at least they are financially in a better position that they might actually have those emigres return. That might not happen for Ireland and the Baltics. Just lumping the pain on the workers creates the conditions for revolt and when that happens the rich lose everything. Austerity is incompatible with social stability. It might suit neoliberal economists but the real world does not tolerate it for long.

          • That’s just not right, David. There has also been emigration from Ireland by Irish and non-Irish immigrants alike. You yourself said “what bigger cuts do is drive a population out. Like in Ireland and the Baltic states”. The difference from Ireland to the Baltics is that internal devaluation policies have been more draconian. The Baltics have been prepared to make deeper cuts to wages and budgets.

            While Michael Hudson derides the social impact of the austerity and resultant emigration in Latvia, he also accurately depicts the draconian cuts:

            “Analysts have viewed Latvia’s October election results as vindication of the efficacy of austerity for solving the economic crisis. The standard narrative is that Latvia’s Prime Minister won re-election even after imposing the harshest tax and austerity policies ever imposed during peacetime, because voters realized that this was necessary.

            […]

            But Latvia’s model is not replicable. Latvia has no labor movement to speak of, and little tradition of activism based on anything other than ethnicity. Contrary to most press coverage, its austerity policies are not popular.

            […]

            While the economic crisis was deep enough to drive even Latvia’s depoliticized population into the streets in the winter of 2009, most Latvians soon after found the path of least resistance to be simply to emigrate. Neoliberal austerity has created demographic losses exceeding Stalin’s deportations back in the 1940s (although without the latter’s loss of life). As government cutbacks in education, health care and other basic social infrastructure threaten to undercut long-term development, young people are emigrating to better their life rather than to suffer in an economy without jobs. Over 12% of the overall population (and a much larger percentage of its labor force) now works abroad.”

            http://creditwritedowns.com/2010/11/latvia-calls-for-european-fiscal-discipline.html

            It’s not jut about emigration. It is primarily about draconian cuts, ones that few countries in the west are willing to make. That is the correct story on the difference between the Baltics and Ireland.

          • David Lazarus says:

            You also forget that Latvia and the other baltic states had only had a decade of independence from the Soviet Union. That might also be a factor in why they did not protest more. An interesting survey will identify if ethnic Russians or Latvians left? They may have been more willing to accept the pain as the price of independence. Though austerity has not worked in all the Baltic countries. Even allowing for higher productivity these nations with lower populations will not be able to sustain an economy like before. They simply do not have the people any more.

            Ireland has had a mass emigration on a scale not seen since the potato famine. Yet it had to have repeated emergency budgets because as they cut the deficit simply did not fall. They are not in any better situation. Default is certain, even if the majority of people think that is unlikely now it will happen eventually. The only issue is how big the losses will be. Enron was doomed years before it actually collapsed as is Ireland now. Add a new recession and events change again. Governments everywhere not doing enough to help unemployment.

            The fact that Sinn Fein are likely to field a candidate for the Irish Presidency is a sign that the austerity has failed in Ireland, politically at least.

          • That newness to social democracy is exactly the reason austerity in the Baltics was accepted somewhat more and that is also what Michael Hudson was saying in the article I quoted and also what I meant when I said western European countries would not accept cuts of that magnitude.

          • David Lazarus says:

            I will agree with that. Just because it worked to an extent in one of the Baltics, I think the other two are still struggling, does not mean it is a universal solution.

            Greece will revolt unless the austerity is abandoned and the debts are wiped clean. Having a civil war in southern Europe will panic the markets like nothing else.

  10. Don Davis says:

    “Don’t forget that bad German loans to the periphery are at the centre of this.” – David Lazarus. Do you suppose that the fact that this is so little discussed in Germany might have something to do with the effect that a popular understanding of this might have on the popularity of German politicians needing to bail out the German owners of those banks – the ones who made the loans?

    • David Lazarus says:

      I am not following what is said in Germany, but I think that it was the Germans who said that the Greeks were feckless and lazy even though they work longer hours than Germans. The lack of greek productivity might be down to poor investment rather than anything else. It is always easier to scapegoat a nation than accept problems at home. It was always easier for politicians to blame the greeks rather than face the reality that their national banking regulations were either ignored or the regulator was captured.