Europe’s Three No’s in Two Parts: Part II
The ECB, as illustrated by the Fitch comments, is seen to be the key protagonist and the pressure is more acute on it to act. Yet it steadfastly refuses, though since the resumption of its bond purchase program, it has acquired almost the same amount of bonds as Spain and Italy have sold in the primary market.
The other solution that has been advocated is a joint European bond. Even the EU Commission has called for “stability” bonds. These are essentially joint liability obligations. Every one becomes responsible for every one’s debt, which is to say that the strong credits become responsibility for the weak.
It is not going to be forthcoming any time soon. It cannot. In addition to treaty changes that would be required, creditor countries, like Germany and the Netherlands, cannot agree, unless they have some mechanism that offsets the moral hazard that is implicit when one is not wholly responsible for one’s own actions.
Everything we know about politics and economics says that Germany will not sanction joint bonds as a solution to the current debt crisis. Such bonds are not seeds but fruits of a fiscal union (which is fundamentally different than an austerity pact).
European bonds also pose another risk that few observers recognize. Most seem to focus on the idea that a European bond would in effect allow Greece to draw on Germany’s creditworthiness and balance sheet. The risks of it defaulting are less.
However, the cost of reducing the risk of a single sovereign default would be to increase the risk of collective defaults. A European bond would expose Germany, as the chief creditor nation, its own Triffin Dilemma.
Recall that the original Triffin Dilemma was a national currency also being a reserve asset. To provide the reserve asset the supply of the national currency must increase (through running balance of payment deficits) which over time would undermine the currency’s credibility as a reserve assert.
Under conditions of a European bond, Germany would take on such contingent risk that it would jeopardize its own solvency. Germany’s debt to GDP is now near 80%. It already faces contingent liabilities from the EFSF and ESM and well as the EU. Germany’s banks have also been cited by the EBA as in need of more capital. The economy itself appears to be slowing considerably as the destination of 40% of its exports, which themselves are almost 40% of GDP, namely the EU, appears to be contracting.
Surveys suggest a little over half the market expects a country to no longer be in the euro zone by the end of 2012. The obvious candidate is Greece. There is little thought given to the mechanics. There are, after all, two different types of exit—to be pushed out and to drop out. There is no mechanism for the former, but if it were to come to pass, it would unlikely to have a stabilizing influence as investors would quickly handicap the next candidate.
Contrary to what some noted economists have argued, a Greek decision to drop out would be a tremendous policy blunder. It would tend to magnify all of its problems, without offering a lasting solution to any. The economic contraction would be considerably deeper than it is currently experiencing. Inflation would rise considerably as debt is monetized and the currency devalued. Moreover, large parts of the economy would remain euro-ized—as the new currency could not fulfill a key function of money, a store of value.
The new currency could be introduced at a level that could represent a 50% or greater devaluation, extrapolating from others’ experiences. Bank deposits, pensions, wages and other such domestic obligations would be immediately redenominated in the new currency. Household wealth would be destroyed. The banking system would be wiped out.
Contracts under the jurisdiction of foreign governments would likely remain euro-denominated. In the private sector this means widespread failures and bankruptcy. On the sovereign level it means that there could be a large residual of debt, such as the borrowings from the EU and the IMF, for example, which would remain payable in euros.
The competitive gains accrued through the depreciation are unlikely to be sufficient to substantively alter the cost-benefit analysis of leaving the monetary union. Greek industry has numerous challenges well beyond an over-valued currency, including industrial capacity.
Moreover, whatever competitive advantage is gained would likely prove temporary in the face of high domestic inflation that would ensure. Greece would likely feel compelled to introduce capital and foreign exchange controls, which would run afoul of EU Treaties, forcing it likely exit the EU as well as the EMU.
It is conceivable that were Greece to drop out of the monetary union, the political class would be destroyed and the ensuing economic crisis could lead to a breakdown of social order, shortages of food, bread riots and in a word, chaos.
Gaming out scenarios, to include more countries, or a creditor country, like Germany, drives home the point that there can be no orderly exit. As Socrates bid his friends farewell after drinking the hemlock, he noted that it was not clear who would be going to the better place. A country leaving the EMU would not solve any one’s problems and would likely serve as an accelerant of the crisis, not the end of it, even for the departing country.
Many economists and investors see a binary outcome of the European debt crisis: either the ECB backstops the sovereign/there is a European bond, or the euro zone breaks up. Instead, we think that the continuation of what can be called “muddling through” is the most likely scenario for the period ahead.
It is the absence of a comprehensive solution that will shape the investment climate. It means that the crisis continues. The risks are asymmetrically distributed to the downside, yet the ECB’s massive provision of liquidity would seem to contain the extreme tail risks.
The investment climate will be punctuated disequilibrium—episodic of spikes in market volatility and disruptions. There will be more European sovereign credit down grades. The rating agencies have numerous countries on negative watch and many will be resolved in Q1 and some countries appear to be vulnerable to cuts of more than one notch.
Moody’s two notch cut of Belgium’s rating on December 16th and keeping the negative outlook is suggestive of things to come. Given the linkages, sovereign downgrades will likely start another round of bank downgrades.
Several countries are cutting growth forecasts and it appears to be largely a foregone conclusion that many countries are going to contract in the first part of next year. The risk is for weaker rather than stronger growth, which in turn will jeopardize fiscal targets and require more austerity.
The strikes and demonstrations in Europe over the past year lend credence to the arguments that austerity is terribly unpopular and that it is producing a political backlash. This appears to be both an exaggeration and a simplification.
Spain, the most recent euro zone country to go to the polls, gave overwhelming support to the Popular Party which promised greater austerity than the outgoing Socialists. Polls indicate in that the government’s austerity in the UK is supported by a majority of voters. In Ireland and Portugal, the governments that have been elected since the crisis erupted are imposing more austerity than the governments that were voted out.
The governments that replace the technocratic governments in Greece and Italy are more likely to consolidate and extend the austerity programs that they will inherit than reverse it. Recent polls suggest an increased likelihood that Sarkozy is re-elected as France’s president in the spring. Support for Merkel’s has also risen recently, despite having lost nearly every state election this year, the self-immolation of the junior coalition partner, the FDP, and a financial scandal surrounding the President.
The European debt crisis is the single biggest risk facing the global economic and financial system. Investors should prepare for the continuation of the crisis, whose intensity ebbs and flows. We suggest three no’s in Europe capture the key elements of the investment climate. There will be no ECB sovereign backstop. There will be no European bond. There will be no euro zone break up. Such a climate is not supportive for the euro.