Europe edges closer to the endgame
Later this week, I plan to write a more comprehensive post on the European sovereign debt crisis to incorporate what we have learned since the French and Greek elections. Here’s a short preview of what I will have to say.
For me the details and the minutiae can be distracting. When analysing situations like the European sovereign debt crisis that have the potential to cause seismic shifts in the economic landscape, one must develop a macro framework that produces discernable outcomes and then re-analyse the details as they come to light to understand whether that framework fits and how the details change the picture. I have argued for 18 months now that there are only three options for the euro zone: monetisation, default, or break-up. And while a lot of analysts have not shared this macro view, I believe they are coming to my way of thinking because all of the events since I developed this frame are bearing this view out.
The euro zone is unworkable in its present form because it is predicated on harmonised national fiscal and economic policies that are supposed to obviate the flexibility that a sovereign national currency affords. That harmonisation has never existed for the euro member states nor do I believe it ever will. And that means that the euro zone will always be beset by crises during economic downturns. Why?
Member states within the euro zone cannot run independent monetary policy. They cannot depreciate a national currency. They cannot depend on a central bank backstop. Nor can they run sufficiently countercyclical fiscal policy to deal with a large downturn. These are the policy tools that euro zone members have given up to benefit from the single currency due to a perceived free rider problem when the Maastricht Treaty was formulated. Without some kind of a countervailing supranational fiscal agent or sovereign risk pooling, this arrangement invariably means some sort of crisis will arise when the unharmonised economies of the euro zone result in large enough current account imbalances. Put simply, the euro zone is made for crisis. It is designed to fail.
Some of the designers knew this. They wanted the euro for political reasons and were willing to allow it to come to form in its present incomplete form. Their contention at the time was that the euro zone would develop the necessary institutions to prevent crisis before any crisis occurred – or at least before any crisis became existential. This contention has proved false as we are now in that existential crisis.
My belief all along has been that each nation in the euro zone is committed to its success. The European body politic has grown to support it as indispensible. Moreover, unravelling the euro is a very difficult task. And so, I believe political inertia alone will help see the euro through for most countries unless we see a catastrophic banking system collapse.
When looking at the French and Greek elections, the questions one has to ask are two fold:
- Do these election results change the commitment to membership in the euro? If so, by whom and of whom?
- Do these election results change the commitment to the institutional framework and the specific economic policy guidelines used to support the euro? If so, by whom?
My answer to the first question is no. The commitment to the euro by leading political figures in Europe is still strong. Only in Greece is there any potential for change at the moment.
My answer to the second question is yes. France, a leading and driving force of euro zone institutional arrangements and economic policy, is now less committed to those arrangements and that policy.
The question analysts need to be asking is what these small changes mean for future of the euro zone.
Here’s what I think should be known already.
- Greece can’t make it. Last summer I wrote why Greece will be cut loose, predicting that Greece would default. But, it was soon apparent that Germany may also be preparing for Greece’s exit from the euro zone. While reports on this were just hearsay about contingency planning, Angela Merkel, Germany’s Chancellor has made clear repeatedly since that Greece is expendable and that her goal is to ring fence it by insulating the rest of the periphery from what happens there.
- Greece will exit the euro zone. I wrote a trilogy of posts on this in February. See Running through unilateral Greek exit scenarios, How and why Greece will leave the euro zone, and The political economy of a Greek default (and euro zone exit). The key here are these two paragraphs:
- France has a mandate to redesign the institutional framework to include growth. The election in France does not mean that austerity is over. Again, Europe has not voted no on austerity. The election will shift policy but the shift will be less than the media frenzy suggests. What will happen is that a "growth compact" will be bolted onto the stability and growth pact, ending in a temporary relaxation of the 3/60 Maastricht deficit/debt hurdles. Nowhere is there any evidence that a seismic shift in policy is about to occur. Baby steps.
For the time being, European policy makers must continue down the present path of austerity/non-default defaults because they are deathly afraid of committing policy mistakes given the weak financial sector and high private sector indebtedness. Most importantly, if things go pear-shaped, they know they will be blamed because they have no mandate to break up the euro zone (yet).
Eventually, however, the populace will grant this mandate to break up the euro zone. In the core, bailout fatigue will set in and Greece will come to be seen as expendable even if it means significant costs to prevent contagion and to recapitalise the European financial sector. In the periphery, the deflating economy that accompanies austerity will cause such social unrest that nationalist and extremist politicians will take prominence, giving a green light for a euro zone exit as well. Their mandate will be to throw off the ‘German yoke’ by any means necessary and that means default and/or exit to stop the debt deflationary spiral. Finally, it is clear by now that private sector participation will not be near unanimous. And so the likelihood of ECB participation in writedowns and a credit default swap triggering default will increase over time. To me that means default and exit – come what may.
This is what has happened with the Greek election. Greek politicians now have a mandate to throw off the austerity yoke. If this results in loans being withheld, the political mandate for a Greek exit is likely.
I am going to leave it there. For those of you who are Credit Writedowns Pro members, I will have more on how this will affect markets, the European and global economy as well as an analysis of what next steps will be in the weekly. For those of you who are not, the sign up is here.