Eurozone slowdown coming; can the Euro survive?

The news out of Spain that the government is taking drastic action to avoid debt revulsion is a clear indication that the Eurozone is entering a new phase of economic weakness. All across Europe from the UK to Greece to Spain to Germany, governments are now cutting spending. And while these moves are necessary in the face of crisis, they will be a negative for growth in 2010 and 2011. Ultimately, all of this creates a market sentiment which weakens the Euro, and as I said on BNN yesterday, this is exactly what Europe wants (see video here; the second part on the global economy is here).

Obviously the Eurozone is not an optimal single currency area. It serves more to deepen political union than as an economic union given the lack of harmonisation between countries and the absence of a federal treasury. Nevertheless, many countries still want to get in. For example, Estonia has been granted permission for inclusion starting in January 2011.

But, a lot of people are asking whether the Euro can survive this crisis. Despite my euroscepticism, I have been optimistic for the simple fact that the political costs of dissolution are so great. But, starting in March I began to second-guess that optimism (see Anticipating Eurozone collapse). The domestic politics in places like Greece and Spain are really going to be put to the test as austerity takes hold. And hopefully, austerity won’t trigger a debt deflation scenario because then all bets would be off.

What if austerity doesn’t work then – what then?  I still believe a default within the Eurozone is more likely than a break-up of the Eurozone. But, obviously a lot of this hinges on the Germans.

First, I see the argument for bifurcation of the Eurozone into a Northern European and a Southern European block as a non-starter. Any hard currency block would have to include the Benelux region and Belgium has an enormous debt burden approaching 100% of GDP. So even under that scenario, you still get the debt problem weakening the Northern block.  Moreover, as it stands today, the Germans and the French both fail each Maastricht test on Debt to GDP and deficits. Therefore, the benefits of breaking up the Euro to form a northern European currency block are far outweighed by the political costs of breakup.

Second, the Germans could always go it alone. Things would have to get significantly worse for the Eurozone for this to become reality. The Germans still want European cohesion at all costs. That Europe breaks apart because of the Germans would be a national trauma. I could only imagine such a breakdown in a Great Depression II scenario.

For me, that leaves Greek default or restructuring within the Eurozone as the preferred and most likely outcome. The key test for the Eurozone, however, is Spain.  If Spain runs into trouble rolling over its debt, the Eurozone is in real difficulty because of the bank exposure to Spain (see the NYTimes Info graphic "Europe’s Web of Debt" below). The sovereign debt crisis is less about Greece and more about preventing contagion – especially to Spain. Italy is a red herring. Portugal is small. And Ireland is small too, although its outsized financial sector makes its indebtedness rather large on the chart below.



Spain is where the action is here. The Spanish are the key to keeping this crisis from spiralling out of control.

For Spanish-speaking readers, also see Obama llama a Zapatero para pedirle reformas que eviten que siga el contagio which talks about Barack Obama’s call to the Spanish Premier that precipitated Zapatero’s call for further austerity in Spain.

I will be talking about the crisis in the Eurozone in greater detail tonight at 7PM ET on Fox Business.

Update 2240 ET: I should also use this as an opportunity for a mea culpa. I hate doing these but if I am to be 100% honest with you readers I have to – and it helps make me mindful to not overstate my case. 

I have said a few times in the past that the Germans will not bail out Greece.  Of course, I have an out. For example:

I see it as unlikely that any deal – bailout via the EU, IMF bailout or backdoor help via quasi-fiscal measures from the ECB – can be reached unless Greece agrees to austerity measures.

But I don’t want to weasel out of this one. I was wrong. The Greeks got their bailout. And there are other instances when I implied they were not going to get one:

Moreover, as with Greece, they cannot rely on the next level of government for support.  There will be no aid forthcoming for states anymore than there will be for Greece (see Europe puts the loaded gun on the table but no bailout for the fig leaf of support Greece is now receiving).

Are munis the next shoe to drop?

It was re-reading this quote which prompted me to write this mea culpa. So, how does this change my thinking?  It certainly reinforces my belief that the Germans are politically committed to the Euro as i said earlier in this post. But it also does give me some doubts as to exactly how much the German political class is willing to do against the will of their citizens. Time will tell, but it bears noting that the bailout of Greece debt and the German and French banks is as unpopular amongst ordinary Germans as it is amongst ordinary Greeks.

  1. John Haskell says

    I think “Italy is a red herring” you borrowed from the Bloomberg interview of Janjuah? Or did he borrow it from you? Further on that topic you recently posted that Sicily is now in the top 10 CDS spread entities (along with California) so maybe it is not a red herring at all.

    Also I think you should offer an analysis of how Greek debt restructuring within the Eurozone would work, given the overwhelming evidence that it will not work. With their current effective exchange rate Greece cannot plausibly generate a primary surplus. So the only plausible source for repayment of bailout funds is more bailout funds.

    1. Edward Harrison says

      John, I did get that unconsciously from Janjuah probably. Just talking to Marshall about this restructuring issue. See his comments which mirror yours here (same video linked below for Stevie B.):

      I’ll get back to you with more on the restructuring later. But, it is going to have to happen. Greece cannot repay all its debts given the austerity now being imposed.

    2. Edward Harrison says

      Having spoken to Marshall, we both agree this is about the over-leveraged and capital constrained Eurozone banks. If Greece defaults, there is collateral damage in the CDS and in the underlying. There could be contagion. But why not eventually force banks to take a haircut? So I would say: work out a 30% haircut in Greek debt and a simultaneous nationalization/liquidation/bailout of worst affected banks. This would stop contagion cold and reduce the need for austerity.

      1. Marshall Auerback says

        The only caveat being that nationalisation is going to add to the Greek government’s debt burden. And nobody has yet been able to explain to me how a default impacts Greece’s ability to operate on a “smaller scale”. I’m not sure the Chapter 11 analogy holds. What is Greece going to do? Get rid of its armed forces? The state pension scheme? You could see how this could work more effectively if Greece were to leave the EMU and go back to Drachmas (as they could devalue and export their way out of this mess as Argentina did in 2001), but it’s a tougher process when one stays within the EMU. “Internal devaluation” is a very costly approach, as Latvia demonstrates. You now have the Latvian Prime Minister extolling a mere 6% contraction in GDP as “progress” _ (…)

        1. Edward Harrison says

          Of course leaving EMU would be better for Greece but the question is how can EMU survive. Austerity and paying back 100 cents on the dollar won’t work. What I am saying is as good as it’s going to get. That’s the kind of plan the Europeans need to be thinking about.

          I know you are worried about Portugal, Ireland and Spain in that scenario but if the EU can isolate Greece as a lone free rider perhaps we won’t get as much contagion.

        2. John Haskell says

          Recapitalizing exposed Eurozone banks would be cheaper than carrying Greece because (1) the banks (supposedly) have equity and reserves against bad loans; (2) the banks (supposedly) have earnings power to re-establish reserves even without a taxpayer bailout; (3) the Greek government is running a primary deficit of approx EUR 20 billion a year which someone not in Greece is going to have to pick up.

          1. Marshall Auerback says

            Well, as long as the recapitalising comes from the ECB. It’s the only
            verticle money circuit out there.

            In a message dated 5/14/2010 12:05:12 Mountain Daylight Time,

            johnhaskell wrote, in response to Marshall Auerback:

            Recapitalizing exposed Eurozone banks would be cheaper than carrying
            Greece because (1) the banks (supposedly) have equity and reserves against bad
            loans; (2) the banks (supposedly) have earnings power to re-establish
            reserves even without a taxpayer bailout; (3) the Greek government is running a
            primary deficit of approx EUR 20 billion a year which someone not in Greece
            is going to have to pick up.

            Link to comment:

            Options: Respond in the body to post a reply comment.

            To turn off notifications, go to:

      2. Olivier Travers says

        It’s not like Trichet could ever fall asleep at the wheel while undercapitalized banks show fake profits while making disastrous bets. Oh wait, Crédit Lyonnais. It’s really French taxpayers who took a haircut back then. It’s funny how somehow states never seem to go after the personal assets of banksters. Where’s the restitution to defrauded taxpayers?

        Until people responsible for these massive mess-ups personally give back the money they made and go to jail, the net incentives are too strong and banks will continue to find ways to make money ultimately at the taxpayer’s expense. Same deal with government officials. France being France, Trichet got away free and promoted.

        This is what you get with fiat money leveraged through private banks – privatized gains, socialized losses. Why would bankers show any sign of self-restraint and sound risk management? They have all of the upside and none of the downside. And then we have politicians and the populace happily confusing crony capitalism with the free market. The writing was on the wall for Greece for at least a decade, and spreads/ratings have been recognizing these fundamental problems only in the past 18 months? Of course a market awash in free money is going to send the wrong signals. All this government intervention (and expectations of more to come) prevents the market from doing its job with realistic price discovery.

        There’s no political will to do the right thing. Are you really thinking banks are going to be confronted with a 30% haircut? It’s a “buy my sovereign debt I’ll backstop your private losses” world.

        1. Edward Harrison says

          Exactly. It’s all bailouts, all the time. The thing is you can only socialize the losses so far and for so long. We are seeing the sovereign debt revulsion right now. Eventually, the jig is up and that’s when the pitchforks come out.

  2. Stevie b. says

    Ed – my whole career was built on mea culpas/meae culpae. IMHO you should not hate doing it – it’s cathartic and honest. No-one expects anyone to be anywhere near always right. You pat yourself on the back when your right and should readily and with equal gusto admit your failings and try and learn from them when you’re wrong.

    1. Edward Harrison says

      It is cathartic Stevie, but no one wants to be wrong! By April, I did change tack as it was increasingly obvious that the crisis was spinning out of control and that we were either going to get a post-Lehman-like collapse or a bailout.

      My most recent thinking is summed up well in the post on competitive currency devaluations:

      And Marshall goes into some of this in a recent interview on BNN here:

      1. John Haskell says

        foreseeing that the Eurozone was going to come up with a $1 trillion bailout fund was about like foreseeing that Nebraska would be up 12-10, the scoreboard would show 0:00 and the ref would put a second back on the clock to allow Texas to kick the winning field goal.

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