More Thoughts on the European Endgame

Today’s commentary

My view remains that Europe is in an incipient but unstable recovery vulnerable to exogenous shocks. However, I do not believe this recovery means that crisis is over. Rather, this is a lull before continued stagnation forces Europe to make hard policy choices about who actually remains in the euro over the long-term.

Let me lead here with three stories in the news regarding the eurozone. First, there is the banking union story. The way that Wolfgang Munchau tells it, this is not a very good story. He calls it “An exercise in prolonging a banking credit crunch”.

The agreement on a eurozone banking union is neither a glass half full, nor half empty. As many commentators are saying, last week’s deal is hideously complex, and a common resolution mechanism without a fiscal backstop for failed banks is pointless.

Those technical deficiencies apart, the agreement raises two broader, more important questions: why do countries keep on accepting such lousy deals in the first place? (Or to use a seasonal metaphor, why do turkeys keep on voting for Christmas?) And what are the long-term consequences of their actions?


…The banking union that was agreed was the banking union Mr Schäuble always wanted. He does not want German taxpayers to pay for the restructuring of banks in other countries…

So why did the others accept it?…The periphery countries accepted austerity but failed to secure Berlin’s commitment to debt mutualisation as a quid pro quo. Berlin got an all-for-nothing deal: more eurozone fiscal discipline, at no cost to Germany.

One explanation is that Mr Schäuble is a formidable lawyer and better prepared than his negotiating counterparts. The fundamental reason is that the periphery countries were never able or willing to form an effective coalition against Germany, let alone willing to make a credible threat that they would leave the eurozone without such guarantees.


The European Central Bank, in its role as supervisor, has started a comprehensive assessment of the banking sector. As part of this exercise, it assesses financial risks, takes an in-depth look at balance sheets, and subjects banks to stress tests. This exercise is going to end with a demand that some banks raise their capital.

But without a common fiscal backstop, it lacks credibility. The ECB will be in no position to demand that banks raise capital if there is no backstop.

I am going to leave the quote there. You can read the full thing at the FT. But I agree here. The so-called European banking union is  nothing like the FDIC system in the United States. Munchau believes we are seeing something akin to 1990s Japan in the making, with the European banks unable to provide enough credit to fund economic growth due to the banks’ collective undercapitalization. And when they run into trouble there will be chaos because of the lack of a robust regulatory regime.

Then, there is the whole United States of Europe meme. If you recall, the economic impetus for Maastricht pre-dated the Greeks and the Portuguese and the Spanish as parts of the European Union. It pre-dated the inclusion of Scandinavia in the European Union and of the eastern European states as well. The eurozone, as originally conceived , was really all about core Europe – and that includes Germany, France, the Benelux countries, and Italy. That’s what the eurozone is about. The other countries – like Denmark, Ireland and the UK which came on board in 1973 – are really a bolt-on – and two of them rejected the euro. So the eurozone is really all about the United States of Europe, both in terms of political and economic cohesion and as a counterweight to the United States of America.

Hans-Werner Sinn gets this right when he writes that the “Euro needs ground-up reform before any United States of Europe”.

The European Union has earned its place as an instrument for peace in Europe. Free trade has brought prosperity to its peoples, and the freedom to choose a place of residence guards against the resurgence of totalitarian regimes…

The paradox is that the same enthusiasm and benefits do not apply when it comes to Europe’s common currency. On the contrary, the euro has plunged southern Europe and France into a deep economic crisis that is fraying the nerves of all involved. I have never seen so many swastikas and hateful slogans directed at Germany. The ex-head of the Eurogroup, Luxembourg’s long-time prime minister, Jean-Claude Juncker, has said that 2013 makes him think of 1913, when no one could imagine what would happen a year later. That may be stretching things a bit, but a statement like this by such a distinguished politician is chilling.

Unfortunately, the crisis is far from over…


Europe should now use the calm between the storm fronts to rethink the European currency union from the ground up…

Sinn sees four things that must happen. First, he sees the need for debt forgiveness and credit writedowns in the periphery. Second, Sinn believes that a eurozone expulsion/exit clause needs to be written into the euro treaties – to allow for temporary departure from the euro, and external devaluation if necessary. Third, within the euro, Sinn says members could then plough ahead with a ‘hard’ euro dictated by fiscal discipline and low inflation. And finally, sovereign bankruptcy laws need to be formulated in order to prevent investors from treating riskier sovereign debts as safe assets and precipitating crisis.

I like where Sinn is coming from. When I last wrote about the euro comprehensively in November, I mentioned that many in Germany wanted an expulsion clause. And I have said previously we will eventually get this for reasons I will go into below. But Sinn’s thinking is good because it is flexible. Basically what he is saying is that he wants a hard euro, one that is predicated on fiscal discipline and price stability. This would naturally mean a strong currency, one that would force manufacturers in Europe up the product curve into high value-added exports predicated on productivity gains instead of lower value-adds predicated on a weak currency and so-called external competitiveness. This is the route the Swiss, the Germans and the Japanese took during the 1970s and 1980s in contrast to the route the Italians took, which Sinn is explicitly toiling against.

What Sinn wants then is that eurozone members that want to take the Italian route be forced to pay the price for doing so – not a harsh price, but one dictated by flexibility in terms of eurozone exit, credit writedowns or restructuring, and sovereign bankruptcy. Think of this as a Bretton Woods system in which the British pound sterling was devalued repeatedly because of Britain’s need to go this route in order to work down its sovereign debt burden while keeping a high level of nominal GDP growth. At the same time, those within the euro would be like the US and remain anchored at the fixed exchange rate, using low inflation and fiscal discipline to avoid devaluation, balance of payments problems or high sovereign interest rates.

Only after this framework is set up should Europe move to a United States of Europe. This framing makes sense to me. I see Sinn’s view as the endgame for Europe, the real question being whether eurozone exit is setup as Sinn prefers or thrust upon the eurozone by a political and financial crisis. In May of 2012, I wrote that the European Endgame was within sight and enumerated what I saw as likely outcomes over the longer-term, all of which fit into Sinn’s framework:

  • Grexit as the euro zone will lose Greece as a member. It could happen over the medium-term too if the European situation is not stabilised. Portugal could also exit.
  • But the rest will become more integrated as the Lisbon treaty is amended to add greater fiscal integration and penalties. The big question marks are Italy and Spain.
  • Defaults in Greece and elsewhere. Portugal seems most likely, followed by Ireland.
  • Eurobonds will eventually have to occur in order to keep sovereign debt from being a problem. Clearly, the fiscal compact and the penalties will have to have teeth for Eurobonds to be palatable. In practice, you could have sovereigns conduct a ‘sovereign debt swap’ whereby the ECB buys an agreed-upon portion of the existing debt from the sovereigns and then uses these funds to back the supranational debt.

The real question is how we get from here to there, which leads me to the third story in today’s headlines. SYRIZA has a clear lead over New Democracy in the latest polling. As the depression in Greece continues, the only reprieve that I see on the horizon from internal devaluation is a sort of stagnation, with sovereign debt and unemployment still at stratospheric levels. SYRIZA is a party which, unlike what Munchau points to about the periphery leaders to date, will push the envelop. Their mandate, if elected, will be to throw off the austerity yoke by whatever means necessary including debt default, forgiveness, and eurozone exit. In my view, SYRIZA’s coming to power will set the chain in motion because Greece is where the political and economic conditions are most unsustainable.

Next year, Greece will need to see a debt restructuring. German finance minister Schäuble has said he wants an extend and pretend type of restructuring rather than actual credit writedowns. However, it is clear that the debt burden is unsustainable and that given the high costs of borrowing for Greece, the debt is actively adding to the intolerable economic conditions. Greece has a primary budget surplus. What it needs now in order to end austerity is a lower interest bill. And this can only occur via the debt restructuring that Hans-Werner Sinn advocates, one that includes public sector involvement – and that means losses at the ECB.

Will we get this? Probably not if New Democracy are in power. But it is clear that we need it. It is also clear that an ECB debt writedown would be an historic step necessitating a recapitalization of the institution because operating at a theoretical negative equity position reduces credibility. There is no political will for this. And so I believe it can only happen via crisis – one forced upon the EU by periphery governments.

In sum then, we are eventually headed for a different Europe, one that allows for expulsion from the eurozone. Eurozone expulsion is critical in removing the suffocating policy of internal devaluation from countries like Greece where it has no chance of success. Even Portugal could benefit from a eurozone exclusion and perhaps Spain and Italy would as well. Getting there will be difficult because there is no political will for making the kinds of hard decisions we need to make in order to get there.

Policy is geared toward the present framework of eurozone cohesion via austerity and internal devaluation. This will not work. Eventually, the economic depression in the periphery will force a change in policy and the question will be whether Europe can react by integrating the necessary flexibility into its structure or whether we will see a disorderly exit. It is not clear which outcome is more likely at this point. I don’t expect this endgame to come to a head in 2014. But if it does, it would be in Greece with its sovereign debt restructuring. My expectation is recovery in Europe, low interest rates, and improving equity markets that allow the EU to paper over these cracks. And major policy shifts almost never occur unless crisis dictates it. Therefore, it will be easy sailing in Europe as long as the economy is on the upswing as it seems to be now. However, when the eurozone falls back into recession, crisis will return and these issues will have to be dealt with.

Happy investing until then

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