More on what I think will happen in Europe

About a month ago, as the crisis in Italy became acute, I wrote that I believed the path was clear; the euro area countries would move to tighter fiscal integration, which may or may not eventually include Eurobonds. The alternative, an implosion in Italy, would mean economic Depression.

Since that time, despite the impression that some serious policy makers believed letting Italy default is a justifiable policy choice, the prevailing view amongst euro area policy makers seems to be that saving Italy from default is necessary and that the only politically justifiable way to effect this rescue is to move to fiscal integration. All of the statements by leading euro area politicians now point in this direction.

What I said a month ago bears repeating here:

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Does the ECB want to lose its trump card in dealing with Italy? No. That’s why they aren’t offering an explicit backstop. But if they don’t backstop Italy, Italian yields will remain elevated, Italy will default, all of the German and French banks with those bonds will be insolvent, and we will have a Depression. Italy is too big to fail.

If the ECB does backstop Italy credibly and fully, then yields will fall and investors will pile in again. However, this is nothing more than a temporary patch, a medium-term liquidity solution only. Clearly, the issue for the Dutch and the Germans is that Italy would have no reason under this arrangement to make reforms or move to fiscal consolidation. They fear Italy (and Portugal and Greece) would become permanent ‘free riders’, mooching off of Germany and the Netherlands’ fiscal probity, making the euro a weak currency. The right way to deal with that fear is to choose between greater fiscal integration or breaking the eurozone up at some point in the medium-term (say 2-5 years).

My conclusion: the ECB will eventually move to a lender of last resort role. The question is how much damage will be done before they do so.

Europe is already in a double dip recession and the sovereign debt crisis has already moved from Greece to Portugal to Ireland to Spain and now to Italy. Belgium, with its lack of a permanent government and 100% sovereign debt to GDP is next on this list. They would be followed by France and its implicit guarantee for a poorly capitalised banking system and Austria and its implicit guarantee for a banking system highly leveraged to central and eastern European debtors. Eventually, every country will feel the impact because a fixed exchange rate system with no lender of last resort is inherently unstable unless you have fiscal integration and/or compatibility.

The ECB’s backstopping Italy and Spain for fear of German and Dutch banks’ insolvency is like the Fed’s backstopping California and New York for fear of Bank of America, Wells Fargo, Citigroup and JPMorgan Chase’s insolvency. It is not a very palatable solution longer-term. Therefore, in the medium-term, the euro area will move to tighter fiscal integration. This may or may not include Eurobonds.

However, not all members will come along for the ride. Angela Merkel, admitting that leaving the euro zone is politically and legally possible during her commentary addressing the Greek referendum in Cannes, has already broken the taboo. Now everyone knows that it is possible to default, leave the euro zone and re-gain competitiveness in a move to a devalued currency. Given the lack of economic harmonisation in the euro area, some euro members will be forced to leave and choose this path. I predict that when Europe moves to change its constitution to include greater fiscal integration, it will also include explicit mechanisms for countries to leave the euro area.

Why questioning Italy’s solvency leads inevitably to monetisation

This has turned out to be the correct analysis. I would like to build on this briefly, reflecting what I think the latest information we have means for policy choices going forward.

At this point, the double dip in Europe is clear based both on industrial activity and money supply data. The periphery is getting crushed by internal devaluation and austerity. Greek bank deposits are leaving the country en masse. Unemployment in Spain is well above 20%. Even in France youth unemployment is near 25% (link in German). And the fiscal cuts are coming everywhere: France, Belgium, Spain, Austria, Italy, Portugal, Ireland, and Greece. This is a deflationary policy response.

Yet, for the euro to survive, politically fiscal consolidation is a must. It is the only quid pro quo that German and Dutch voters will accept for what they perceive as yet another bailout for the periphery. Now clearly, these bailouts are about protecting creditor country banks too but the bottom line is that there is zero political appetite for any sort of union that doesn’t have serious penalties for so-called free riders and their fiscal profligacy. I don’t see the situation in those terms, but I think that’s the messaging driving the political discussion in places like Germany and the Netherlands.

What this means, therefore, is that Merkel’s push for treaty changes is going to be about transforming the stability and growth pact into something that has teeth, something that allows for euro area oversight, penalises fiscal profligacy and even creates a path for expulsion. In some ways the mechanics are less relevant because they are in flux. For example, Merkel is pushing to avoid the Schengen route to agreement as an intermediate step because it would mean a two-tier euro zone. Let’s see what happens here.

What is really relevant is the vision; and that vision is a for a bailout followed by a hard currency United Europe which practices fiscal discipline.

Getting from here to there is going to be a struggle given what we already know about the economic situation in the periphery. More than that, Nicolas Sarkozy is talking about balanced budgets in the euro area by 2016. And we know that an adjustment to balanced budgets throughout the euro zone would require either an exactly equivalent offset in private sector savings down and/or in the export sector up. This is never going to happen in countries like Greece. Sarkozy also promises no eurozone member will default too.

What does that mean for policy choices?:

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  1. It means ECB intervention to bring down rates.
  2. It means moving to the hard currency United Europe which practices fiscal discipline that I have outlined.
  3. It means severe adjustments in the periphery toward fiscal consolidation and internal devaluation aka wage and price cuts.
  4. It means an implicit desire for offsetting adjustment in the euro currency down to create export competitiveness and/or equivalent private sector dissaving.

My conclusion: this is completely unworkable.

A hedge fund friend wrote me using the same language:

They can certainly agree to all sorts of budget cuts and tax hikes, but a) the governments won’t have the consent of the governed, b) the austerity measures won’t work, because economic growth will fall, and all the debt/GDP sort of ratios will consequently worsen, and c) the Germans really cannot go into an Italy or a Greece to “enforce” things.  It’s all completely unworkable.

Quite.

Marshall Auerback notes that under austerity imports go down even though exports do not necessarily go up. So there will be some automatic external sector adjustment. However, Marshall also says:

But exports don’t fall and may go up as imports fall even faster, as the euro zone is pretty well a closed economy and much more mercantilist than the US…

Add to that what the Fed is doing with these dollar swaps. This is theoretically unlimited uncollateralised lending from the Fed.

As of today, the 1 Euro = 1.33 U.S. dollars. So just purchasing the PIIGS debt to fund their 2010 deficits would have required the US Federal Reserve sell around $350b, which is about 5.8 per cent of the US GDP over the last four quarters.

You therefore have a potential (albeit a limited one) for a huge injection of US dollars into the world foreign exchange markets.

That should have an impact! So, it’s not at all clear the euro countries can get anything out of the external sector. The adjustment therefore would fall on private sector dissaving.

Most likely, the cuts in the public sector will lead to a deflationary spiral in the periphery (and maybe even the core) via defaults, debt distress and bank balance sheet deleveraging. There is zero chance countries like Greece will make the grade then.

Euro zone breakup is inevitable. As I wrote last month, convergence has not come to pass. It is becoming increasingly clear that convergence will never come to pass. The euro zone is unworkable. It needs tighter fiscal integration to succeed and it can’t have that unless it gets convergence. The Europeans are starting to recognize this and so breakup is now inevitable.

I don’t think the breakup would happen straight away because we are in a crisis and a breakup now would also lead to a significant economic Depression. But the panic button to eject countries will soon be enshrined into law and the euro will no longer be a roach motel where countries check in but they can’t check out. Once the situation is stabilised, thoughts will turn to these issues.

And, yes I do think the situation will stabilise because policy makers are willing to socialise as many of the losses as it takes. They will go to any length and have their people bear any cost to prevent this thing from collapsing and triggering Depression. This was not evident before this past week. But it is certainly evident now.

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11 Comments
  1. John Sanford Newman says

    Of course it’s hard to see how they can socialize too much more loss without setting off that depression also. As “austerity” is being targeted at the poor in post dictatorship democracies, Portugal, Spain, Greece and Italy where the wealth of entrenched aristocracies was insulated from taxation as a de facto condition of the transfer to democratic government, further steps in this direction will exhaust the poor’s ability to support them quickly. This will bring the perpetrators of what appears to be an accidental financial coup de etat of the European executive at the ECB into direct conflict with the entrenched aristocracies sooner rather than latter. 

  2. John Sanford Newman says

    Of course it’s hard to see how they can socialize too much more loss without setting off that depression also. As “austerity” is being targeted at the poor in post dictatorship democracies, Portugal, Spain, Greece and Italy where the wealth of entrenched aristocracies was insulated from taxation as a de facto condition of the transfer to democratic government, further steps in this direction will exhaust the poor’s ability to support them quickly. This will bring the perpetrators of what appears to be an accidental financial coup de etat of the European executive at the ECB into direct conflict with the entrenched aristocracies sooner rather than latter. 

  3. Oz says

    Ed, I think you’re right about treaty changes incorporating a mechanism for ejecting those who break the rules.  The problem I see with this is that it will make a fairly swift exit of Greece inevitable. 

    Individuals will look at the “rules”for staying a member and realise Greece (and perhaps others) can never possibly meet them.  They will then act in their own best interests – expediating the flight of capital from Greece until the government has no choice but to freeze remaining bank deposits and enacting an exit from the Euro.

    If they do decide to change the treaties in the ways discussed, Greece could be out of the Euro by Christmas.

  4. Oz says

    Ed, I think you’re right about treaty changes incorporating a mechanism for ejecting those who break the rules.  The problem I see with this is that it will make a fairly swift exit of Greece inevitable. 

    Individuals will look at the “rules”for staying a member and realise Greece (and perhaps others) can never possibly meet them.  They will then act in their own best interests – expediating the flight of capital from Greece until the government has no choice but to freeze remaining bank deposits and enacting an exit from the Euro.

    If they do decide to change the treaties in the ways discussed, Greece could be out of the Euro by Christmas.

  5. EDP says

    Great insights, always so enjoy your posts:
     
        I believe you are saying the Euro zone is unworkable but a disorderedly break up now would cause a depression in Europe. So it seems you are saying that even if Merkel and Sarkozy believed as you believe that ultimately it would not work, they would still have to go through the theatrics of attempting greater fiscal integration, as no plan is totally unacceptable. To me it seems further economic contraction in the EU is unavoidable.  If you were running the ECB, and believed as you believe, would it not make sense to be a little “slower” on monetizing EU sovereign debt as another CB ( I understand different currency)  would be a “liquidity” backstop and might “blink” first?

  6. EDP says

    Great insights, always so enjoy your posts:
     
        I believe you are saying the Euro zone is unworkable but a disorderedly break up now would cause a depression in Europe. So it seems you are saying that even if Merkel and Sarkozy believed as you believe that ultimately it would not work, they would still have to go through the theatrics of attempting greater fiscal integration, as no plan is totally unacceptable. To me it seems further economic contraction in the EU is unavoidable.  If you were running the ECB, and believed as you believe, would it not make sense to be a little “slower” on monetizing EU sovereign debt as another CB ( I understand different currency)  would be a “liquidity” backstop and might “blink” first?

  7. Anonymous says

    I agree with you on break up but how do you allow 17 countries to leave orderly without it causing problems? Once it starts then markets will sense blood and there will be runs on the next country likely to leave. That will cause problems. Speculators will be able to concentrate on one country at a time to maximise their gains, compounding the problems for the country ejected. Maybe a better solution is an overnight breakup with all the nations announcing exit?

  8. Anonymous says

    I agree with you on break up but how do you allow 17 countries to leave orderly without it causing problems? Once it starts then markets will sense blood and there will be runs on the next country likely to leave. That will cause problems. Speculators will be able to concentrate on one country at a time to maximise their gains, compounding the problems for the country ejected. Maybe a better solution is an overnight breakup with all the nations announcing exit?

  9. Dave Holden says

    “this is completely unworkable.”

    The basic fact is, there is no democratic legitimacy to fiscal union.

    “Acting Man” shows what European democracy looks like at the moment

    http://www.acting-man.com/?p=12155

    If the eurocracy have any sense they will be coordinating behind the scenes to expedite as orderly a break up as possible, my guess would be a core nation breakaway.  I will add I don’t think the eurocracy have any sense..

  10. Dave Holden says

    “this is completely unworkable.”

    The basic fact is, there is no democratic legitimacy to fiscal union.

    “Acting Man” shows what European democracy looks like at the moment

    http://www.acting-man.com/?p=12155

    If the eurocracy have any sense they will be coordinating behind the scenes to expedite as orderly a break up as possible, my guess would be a core nation breakaway.  I will add I don’t think the eurocracy have any sense..

  11. frank c says

    The alternatives for the over indebted countries are to be monitored/budgeted/governed by the proposed new treaty under the ECB or under the thumb of the IMF. The IMF is not a benevolent lender of last resort and will extort just as much, if not more austerity and asset sales. Either way it is austerity and recession.

    Merkel understands there will be much opposition. Listen carefully when she speaks of a “two speed euro”.
     
    If Italy & Spain gets to haircut its debt the quid pro quo is a balanced budget going forward.

    Don’t be surprised if PIIGS countries sign up for the treaties and get financial aid and further down the road repudiate the treaties and then exit. The balanced budgets are allegedly for 2016. Like all good budgets they are prone to revisions. In addition the Maastrict Treaty currently has a 60% Debt to GDP maximum that has been overlooked for years.

    My conclusion is that like all good politicians they will make the easy decision and never venture over the abyss. Borrow more money, print more money, create the bad bank or have the ECB/IMF hold the haircutted debt, promise, lie and not deliver. Kick the can down the road again  and again to the next administration.

    Merkel will eventually cave. She would love a financial tax but the Brits won’t budge. She wants the IMF to put in more if not all of it. But at the end of the day her country has made the most of the the euro and now stands the most to lose.

    The european bond markets reaction this week are indicative of deal that appears to be done with the typical back room wink and the nod. And the Italians (Draghi/Monti) are in on it

    The biggest problem this weekend is that wonderboy geithner is flying in to europe. If anyone can screw something up it is him.

    1. Anonymous says

      If Spain and Italy get decent haircuts on their debt then I agree that they will recover quickly. The problem is that haircuts are only considered when they have been screwed around so much that the country becomes a basket case as with Greece.

      Everyone probably appreciates that Greece will have to default but when, and will they stay in the Eurozone if the debts are cleared? The tax collection problem will have to be dealt with. A financial Tobin tax is a good idea, but the UK will not accept it unless it becomes a global tax. Though maybe the option of a huge taxes on tourist visas and money transfers to and from countries that do not sign up could be so draconian that they are supported, and with powers to eject EU members that do not sign up. The problem is that at the moment the UK will not sign up unless the Americans sign up. That is why the banks are smiling. Too much self interest from any nation to go it alone. 

      The problem with an IMF bailout is that the terms are painful and amount to outright theft when national treasures are involved. Privatising and selling of such treasures are very shortsighted. The UK government decided to do sale and leasebacks on many properties thinking that they could still gain by taxing the rents. Only problem was that these very rapidly were sold again and ended up in the ownership of companies in tax havens so the government do not even gain from that. Very short sighted and ultimately very costly as they will probably have to pay way over the odds to get control of them again. Imagine if the IMF decided to seize the treasures of the Louvre as part of the payments or forcing them to be sold. Yet that is what Germany is demanding from Greece. 

      As for Geithner, his only job is to stop any write-offs so that the US banks do not have to take any losses. He has a serious conflict of interest. 

  12. Anonymous says

    I agree that we’ll likely see theatrics, summits, meetings and joint press releases to busy our minds for the next few months. 

    But as is illustrated above, none of the greater fiscal integrations necessary are possible to implement.  That doesn’t mean they won’t be announced, and perhaps even disastrously attempted.  But we know they will fail.  Perverse incentive structures cannot be avoided in such a union.  Enforcement is impossible without reviving nationalistic resentment.  And popular sentiment is vehemently against it. 

    The only question that remains is whether the EMU and Eurozone breakup will be orderly or disorderly.  It seems incredible to me that leaders of each of these countries are not preparing themselves for this eventuality.  But seeing how ideologically opposed they are to the idea, I suppose they could be that foolish.  And this is where I see the real risks. 

    Forget debt default wiping out essentially all major financial institutions, asset deflation destroying public and private pension funds, depositors losing some of their savings (or having it converted to a currency of lesser value).  Those are minor problems and generally involve greater pain for those that took the greatest risk.  The pain can be justified politically. 

    I’m worried about last hour realizations that the EMU has failed and what these reactionary governments will do in the hours that follow.  If the eurozone crumbles, does the free movement of people and goods necessary follow?  And where does the infrastructure come from to monitor this?  Do countries start stationing troops on their borders to act as customs officers until enough can be retrained?  How does this not eventually revive the nationalistic resentment that integration has helped defuse? 

    If return to national currencies is taken at the last minute – because all else has failed, are our service industries ready and able to handle the changeover?  Or do people starve because grocery stores can’t buy goods from their suppliers in francs or lira? 

    The time for Europe’s leaders to prevent these sorts of things is now.  If they wait until the 11th hour, chaos will be the result.  And the blood will be on their hands if they allow their stubbornness to get in the way of what is in the best interests of their respective electorates. 

    1. Anonymous says

      Hopefully our leaders are preparing for the worst. Though when the UK leadership was questioned about Plan B they feared that even thinking about Plan B would be like admitting that Plan A has failed. So I expect that the rest of Europe will be just as blasé bout such an event. 

      1. Anonymous says

        Reminds me of Nov ’08.  Every day trying to decide whether bank A or bank B would be next, while the only official position was that neither could be allowed to fail. 

        As it turned out, the official position was correct.  They just altered the law to legalize accounting fraud.  And even with that fraudulent accounting, we’re right back in the same position. 

        1. Anonymous says

          And it is why we are now having worries about sovereign defaults. These same banks are still insolvent but the central banks behind them are now unable to bail out the banks. If we had refused to bail out the banks there would be less concerned about sovereign defaults now. The issue would be deficits but of a much lower order than we have now. Eventually we might have to charge the central bankers with accessory to fraud and clear the whole financial markets of such people. 

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