Why a breakup of the euro zone is likely
How should I begin this post? Let me start out with my former default position:
I have always seen a sovereign default and restructuring within the euro zone as more likely than a break-up of the euro zone. I would say I considered the dissolution of the euro zone as an outlier. See my thoughts from "Anticipating Eurozone Collapse" in March. Increasingly, this possibility is being raised. Granted, the chances are increasing but it still cannot be the baseline case.
–Three options for the euro zone: monetisation, default, or break-up
This is no longer my view. Breakup is my default case now. Let me tell you why.
The German Constitutional Court decision is critical
In June, I wrote that the chances of a euro zone breakup are now increasing, giving background for the current political turmoil surrounding Greece. My conclusion was “the policy decisions that governments and the EU are making cannot be maintained politically in the periphery or in the core”. A few days later, Nouriel Roubini wrote a very good note explaining then why the Eurozone could break up over a five-year horizon. We both stated that the key to maintaining the euro zone at all was the potential for closer integration of the member states. But the German Constitutional Court decision makes this nearly impossible:
"The Bundestag’s budget responsibilities may not be transferred through open-ended appropriations to other actors. In particular, no financial mechanisms can lead to meaningful fiscal burdens without prior approval," said the opinion.
"No permanent treaty mechanisms shall be established that leads to liability for the decisions of other states, especially if they entail incalculable consequences," it said.
The ruling is "a clear rejection of eurobonds", said Otto Fricke, finance spokesman for the Free Democrats (FDP) in the governing coalition.
Above all, the court ruled that the Bundestag’s fiscal sovereignty is the foundation of German democracy and that Article 38 of the Basic Law prohibits transfer of these prerogatives to "supra-national bodies".
By stating that there can be no further bail-outs for the eurozone without the prior approval of the Bundestag’s budget committee, the court has thrown a spanner in the works and rendered the EFSF almost unworkable.
It restricts the ability of Chancellor Angela Merkel to strike rescue deals at EU summits, leaving it unclear how she or any future Chancellor could respond to the sort of crisis that blew up in late July of this year when Italian and Spanish bond yields reached danger levels above 6pc. Moreover, Finland, the Netherlands and Slovakia are all eyeing variants of this legislative veto.
This ruling by the German Constitutional Court does allow the EFSF to operate as planned. Most commentators have focused on this. However, the language of the decision means there can be no eurobonds and no “supra-national” fiscal agent because these are in violation of the German constitution.
As I indicated when the sovereign debt crisis began, the Eurozone is unworkable in its present state.
This whole problem points back to my thesis that a Depressionary bust in Ireland is echoed in California, meaning that the individual sovereign states in the Eurozone are akin to U.S. states because the single currency gives them neither monetary control nor wide latitude on the fiscal front. More correctly put, I would now say "a depressionary bust in Spain is echoed in California" because the challenges facing the Eurozone are most evident in Spain. As in Ireland and California, Spain had a massive property bubble that has burst. The result in all three is high unemployment and a severe fiscal crisis.
In my view, the fiscal crisis in California demonstrates that a federal treasury is no panacea. After all, the U.S. has a federal treasury and California contributes more in transfer payments to that treasury than it receives. Yet, it too must cut spending like mad and raise revenue in order to pay its bills. Having a treasury would not have ended the economic pressures for Spain, Greece or Ireland – and I am dubious about a United States of Europe because of the greater fundamental differences within the EU.
Nevertheless, I anticipate some type of change is coming to eurozone treaties. The present setup is unworkable – and if maintained will force a breakup.
The European Harmonisation Fund is the only option
Yes, I am a eurosceptic and have always been. But we are here now. The euro exists. And that does change things.
It would easy for me to say something like, “see I told you so. The euro is an abomination and the peripherals should simply leave or be tossed out of the euro zone.”
[…]
But, again, we are here now. The political imperatives for closer European ties that created the single currency are still with us. And the negatives of abandoning it are many, both politically and economically – in the periphery and the core. I recognize this.
In my view, eurobonds and a “supra-national” fiscal agent are almost the only mechanisms which make the euro zone viable. Therefore, with these options now excluded, the euro zone is almost doomed to failure. The euro zone double dip is almost here and I think that spells bailout fatigue, austerity fatigue, default, and political unrest which will break the euro zone apart.
Internal devaluation and austerity is not a solution. They are politically unsustainable. It is obvious to most that defaults are coming. For Greece, sovereign default is a foregone conclusion. For Ireland, by dint of its socialisation of bank losses onto taxpayers, sovereign default is a real possibility. In Spain, bank losses have not been socialised and so the sovereign remains relatively healthy. However, Spanish banks have been slow to recognize losses and that means many contingent liabilities keep the market for Spanish government bonds in a state of stress. Portugal is well above the Maastricht 3/60 hurdles and contagion has spread to Belgium, Italy and France. Meanwhile, the public in countries like Slovakia and Finland want no part of future bailouts, while the public in countries like Greece and Spain are fed up with double digit unemployment and the prospect of a decade more.
I say the euro zone is “almost” at the point of collapse only because there is one other option, what I dubbed a European Harmonisation Fund when I recommended it in as the sovereign debt crisis began in March 2010. I envision this as a pre-funded emergency fund designed to distribute funds based solely on changes in economic outlook.
All euro states would fund the mechanism during cyclical upturns. However, in downturns, the euro zone would disburse funds based on changes in levels of economic data which indicate recession: disposable personal income, retail sales, industrial production, unemployment, and GDP growth. Originally, I had said these funds should be loans but given the pre-funded nature of the fund, it is better as disbursements.
At the same time, the EHF would only disburse funds if the states in need forced through pro-cyclical policy via budgetary discipline to comply with the Maastricht Treaty. If any member state refused to make the necessary changes or repeatedly failed to meet targets, the EHF would not disburse the funds.
Finally, the ECB would have to support the EHF by promising to supply unlimited liquidity in the event f a liquidity crisis by buying member state sovereign debt.
The EHF would therefore be beneficial in at least the following political or economic ways:
- The EHF would give states policy space via counter-cyclical disbursements while still moving them toward the Maastricht criteria.
- The EHF would not balloon the debt to GDP trajectory of the countries receiving the funds by saddling them with loans that could prove unpayable
- Via the ECB’s promise to backstop euro states as the Fed backstops the US government, the EHF would eliminate liquidity crises which worsen debt to GDP trajectories by increasing borrowing costs
- The EHF would be politically more acceptable than bailouts as the disbursements would be pre-funded by all member states and the budgetary discipline would be enforced via a previously recognized mechanism
- The EHF would enforce the budget discipline of the Maastricht Treaty and therefore asssuage fears of moral hazard that bailouts entail
- The EHF would allow defaults within the euro zone without contagion
This could constitute an effective ‘transfer union’ without moral hazard. I see it as the last hope for the euro zone. And hope we should – at least over the medium term; the global economy and financial system is still so weak that a euro zone breakup would be financial Armageddon, that much is assured.
i can’t imagine a breakup. it may be costly politically and economically for germany to change its constitution (or interpretation thereof) and accept a supranational fiscal agent/transfer union/eurobonds. but that is only if germans look only at the expense side of the ledger.
what about the income side? who do germans think they export to, exactly? the health of germany in the eurozone has been built in large part on the backs of the peripheral countries whose domestic industries it exploited. now they’re being asked to pay that piper, and if they refuse they’ll find the price is the remorseless collapse of their vaunted german export machine into a pit of depression.
if the germans want to find themselves in the world of scheisse that michael lewis intimated they secretly desire, they should allow schauble to continue to insist on the periphery devaluing internally while trying to close national deficits that cannot as a matter of mathematics be closed short of regional poverty. what idiocy this is!
Politics is not driven by economics, especially during deep downturns. Economic nationalism becomes ever more a factor for politics the deeper the downturn gets. In the event of a second downturn, we should expect nationalism to favour default and breakup irrespective of the economic consequences. The goal is to rid a country of the euro’s yoke once and for all, come what may.
Look no further than the debt ceiling debate to see the kind of extremism that becomes commonplace. Threatening default was seen as a necessary political choice to rid the country of the ‘big government’ yoke once and for all. This is the kind of politics that we will see more.
i can’t argue that you’re wrong, edward, much as i would like to. reflective pragmatism too often dies just when it’s needed most.
Yes Edward…Politicians….
The scene that comes to my mind is the one in Kill Bill 2 when one chick pulls the other chick’s eye out.
I see the politicians acting something like the chick sans eyes.
(not pretty)
Mystic, hi, good to hear from you! Politics is ever more important now because the advanced economies would be in a deep depression right now were it not for the policy response. But the whole affair has a dithering quality to it as they have protected vested interests (banks principally). People are getting fed up with this and sooner or later the politics will get so volatile somewhere a politician will make a fatal mistake. We have played extend and pretend long enough. If we get a second dip in GDP, that’s when the chick sans eyes will appear to vent her spleen.
Very well written. One of the very few articles which makes distinguishes a true supranational fiscal authority from Special Purpose Entities such as EFSF – even though the latter is termed “supranational”
A clear analysis. This has been lacking almost everywhere else. It explains gold’s (no longer inverse to the dollar) movements perfectly.
I do see Greece leaving first. Then, maybe a few months later Portugal. Ireland will hold on for dear life because much of their foreign direct investment is totally dependant on being within the eurozone. Though if Greece starts to recover quickly then I see Ireland leaving as well, especially as its recovery is very sluggish. It might even fall into depression as the rest of the Eurozone slumps into recession. Spain and Italy might survive but Italy looks weaker than Spain right now. The politicians will probably fight this outcome because their reputations rest on it.
Great post as always Edward. I don’t understand where the initial money for the Harmonsation fund would come from, since it would be commencing in a cyclical downturn. would they print it or would the Germans pony up?
Ah, you are onto the real problem. Getting from here to there is tough. The only way to do it right is to have sovereign defaults, debt writedowns and bank recapitalisations. That would give the euro zone a reset.
The peripherals reduce the value of the Euro. Without them or Germany on its own the resulting currency would be at least 40% higher and German exports no longer competitive. Germany and its export economy benefits tremendously from the inclusive Euro. Now it wants to punish or expel the very countries whose participation in the Euro makes the German economy thrive. It can’t afford a breakup. Politics being what they are may still drive Germany in this path.
Default and exit from the Euro may, however, benefit the peripherals. Especially if they adopt EuroII or if Germany et al exit the Euro
Greece and Portugal will benefit from a weaker currency enabling them to become more competitive. It will also get a tourism boost. Inflation will increase as a result of the weaker currency, but the issue will be how the pain is distributed.
Douglas, when you talk about the euro’s value, you are probably talking about the value of a strong euro vis-a-vis a new Greek, Italian or Spanish currency. Right now the euro is already overvalued with respect to the dollar, so it wouldn’t rise 40% against the dollar from here without the periphery. Remember it was introduced at 1.17 and traded to as low as 0.83.
I took the 40% figure and the rational re German exports from the 21 page FT article your site linked to yesterday.
But a Eurozone without the periphery will have a much stronger euro. Will they be able to maintain exports at such a rate with a stronger currency? The smaller Eurozone countries will suffer maybe even be considered a sovereign risk themselves. Germany might be the last to feel the effects, but outside the euro with a new Deutschmark, they might have the same problems as the Swiss.
I double checked. The article is UBS: Euro break-up – the consequences. Here’s an excerpt:
So what is the cost of a “stronger” country leaving? The same problems with modelling apply to a strong country departing as a weak country – this is such an abnormal event as to be all but impossible to simulate with any great certainty. However, we can make some assumptions about the basic costs. The seceding strong currency is likely to have an appreciation of 40%.
——
Further, the exit causes a growth shock to the rump Euro, which undermines the export potential. We have
assumed a 20% reduction in trade. This is very conservative, but it needs to be seen in the context of the 40% appreciation of the NNC, which will create an
obvious additional drag on trade.
Those numbers are too high in my view. What UBS is saying is like what David Lazarus is saying, that there will be a speculative move into Rump-euro and it would end up trading like the Swiss Franc (or the yen).
We might see a moonshot like that just after the EZ broke up but eventually the currencies would fall in line closer to purchasing power parity (which is below where the euro is now). But clearly this is all just speculation because the fundamentals don’t support this since purchasing power parity is quite a bit lower.
From my point of view, living in rural Portugal, leaving the euro zone would be the best thing for this country. Portugal would return to a familiar lifestyle of self sufficiency and, although stifling, economic independence. The only way to meet the debt crisis is through radical political strategy, and this country, just like Greece, does not have the stomach for radicalism. The only difference with Greece is that there will never be riots here, and the escudo may even be welcomed back.
I think that Portugal will protest and even riot if that is the only alternative. It also depends on how the government react. If they ignore the public then anger will grow, if they send the police in against protestors then watch the fall of the government. Much will depend on the electoral timetable. If the next elections are years away expect protests. Especially if the government ignore the people. Greece is very vulnerable. I suspect that the governments of the periphery will fall. Default is the only option and with an escudo the tourists will return.
With oil prices high, it tends to cause recession (especially among oil importers). Governments attempt stimulus and bail outs, but it only gets them deeper in debt. These issues add a whole new dimension. Means that there is little chance that over the long term the problems can be worked out, regardless of what will happen. Some US states are in financial trouble. Over the long term, the US government is likely to be also, IMO.
If the US had ignored the lobbying from the Automakers and Big Oil it would probably have a lower trade deficit and that would have meant a lower fiscal deficit. The US needs a green energy program to cut oil usage so that its trade deficit falls considerably. This would take a lot of the pressure off the fiscal deficit.