Three options for the euro zone: monetisation, default, or break-up

Judging from rising sovereign borrowing costs and euro weakness, market participants are not impressed by the Irish bailout. Marc Chandler’s group at Brown Brothers Harriman is right when they write the market is clearly disappointed with the rescue package of Ireland.

This period in Europe reminds me very much of the period after the Indy Mac failure in the U.S.  Before Indy Mac, after each credit crisis trigger event, there was a restoration of calm. The TED spread was consistently the best bellwether for crisis sentiment. We saw spreads spike when BNP Paribas froze funds and Northern Rock failed in August and September of 2007 only to drop again. There was another spike in December 2007 over difficulties at bank structured investment vehicles and bond insurers. Again, massive liquidity and lower interest rates helped to bring things under control.

When Bear Stearns failed in March 2008, the TED spread did not rise to even the levels it did in September and December of the preceding year.  Especially after Bear’s failure, there was plenty of time for pressured financial institutions like HBOS, Bradford & Bingley, Barclays, RBS, WaMu and Lehman to raise capital from sovereign wealth funds and other investors (see my credit crisis timeline – that I will be restarting). But the Indy Mac failure changed sentiment. The taps were shut and no more capital was available for illiquid or insolvent financial institutions. It was Indy Mac which was the point of no return. Afterwards, the nationalisation of Fannie and Freddie, the failure of Lehman, the seizure of WaMu, the takeover of Wachovia and the bailout of AIG were pretty much inevitable.

Analogously, the Europeans have had an opportunity to deal with the fundamental problems of its financial sector’s undercapitalisation and the sovereign indebtedness at the euro zone’s periphery. They have dithered, choosing superficial and phony approaches like stress tests instead of addressing fundamental issues. The first warning shot of so-called "sovereign debt delusion" in Europe was the Dubai crisis last November. The immediate crisis eventually faded but the contagion persisted in terms of stress on Greek sovereign debt. Here too, much time was wasted as Greece was eventually bailed out – not before contagion to Ireland, Spain and Portugal increased significantly. By June, some contagion had reached France and Belgium. And eventually, Ireland came under attack and has now been forced into a bailout as well. But the fundamental problems remain: the Europeans’ financial sector’s undercapitalisation and the sovereign indebtedness.

Now, the day of reckoning is at hand. Ireland is the Indy Mac moment in this European crisis. Superficial fixes will no longer work. Markets will not be calmed until a fundamental solution is found. I think Pippa Malmgren put it well:

1. On kicking the can: "If you’re going to make a bet on the European banking system which is purely based on the idea that policy makers will consistently bail them out, then you have to ask questions about the capacity of policy makers to deliver on that promise."
2. On markets as a pack of wolves: "That is fine as long as the market doesn’t call their bluff… Do I think the markets are going to call their bluff? The answer is yeah, because that’s what markets do."
3. On the psychology of change: "The thing is, in markets and politics, you have to have a crisis to get a solution. That’s the way it works. It always works this way."

–A few thoughts about the euro crisis and the psychology of change

So what’s next? Here are three options: monetisation, default, or break-up.

Monetisation

This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.

The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.

Now that the credit crisis has moved on to sovereign debt, the central bank can play this role with sovereign debt as well. The best way to accomplish this task would be to start buying enormous quantities of sovereign debt, inducing a huge shift in the price/interest rate of those assets. Only afterwards, the ECB would announce that it was prepared to supply unlimited liquidity to stand behind these assets at specific target interest rates and would do so at the most inconvenient moments for speculators wishing to make a quick euro. (Update: see comments of a similar nature after this was written from Willem Buiter at the bottom.)

The point would be twofold:

1. Market participants would understand that the ECB had unlimited means to back up threats with action, the stress clearly on the word unlimited.
2. Market participants would understand that the ECB intended to penalise speculators by targeting them with its unlimited liquidity.

As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout. On the other hand, it could be a possibility for Spain because Spain is simply too large to bail out in the way that Greece and Ireland were bailed out.

The immediate impact of this kind of action would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation, if you will. Clearly, countries like the UK and the US will choose inflation and exchange rate depreciation instead of default as a way of dealing with the sovereign debt problem. That is certainly part of what QE2 is about.  If forced, the ECB could go this route as well.

Just as central banks target short-term interest rates via the Fed Funds market with threats of an unlimited supply of liquidity, central banks could in theory do the same for longer-term rates. During our discussion about quantitative easing in the US, Scott Fullwiler pointed out to me that offering a credible commitment to defend a specific target rate with unlimited liquidity could require less liquidity in practice. That is the Fed’s experience from the Fed Funds market.

I see this as only a fix for the liquidity issues – and not as a fundamental solution in that sense. For this to work as a longer-term solution, this carrot would need to be offset by some sort of stick regarding budget deficits and bank capital. Otherwise, the moral hazard this invites will make one unsuccessful in solving the fundamental issues.

Default

The second path is more tricky and therefore not likely in the near-term unless it is forced upon the Europeans. As Edward Hugh pointed out yesterday, Greece is not headed in the right direction.  Default is inevitable. I don’t think the default issue is controversial anymore. The question now is who defaults and under what conditions.  What Europe should strive for is a default by the ‘right’ players under the most benign conditions.  And so that means this option is not mutually exclusive with the first. You could have a monetisation-default scenario whereby the monetisation leads to the ‘right’ players defaulting i.e. the insolvent as opposed to the illiquid.

As I mentioned, Greece is clearly not making the grade and will be unable to lower its debt to GDP through internal devaluation and austerity without serious growth via exports and currency depreciation. There are almost no circumstances in which all of these positive factors can come together.  Ireland, on the other hand, despite having socialised its banks losses like Iceland, is in a fundamentally better position than Greece. Its debt-to-GDP is lower, it’s structural deficit is also lower, and it has good export competitiveness. It is the banks in Ireland which are insolvent – and these losses, having been socialised, are threatening the sovereign with insolvency too. The right thing to do would be to de-couple the bank/sovereign issue by rescinding the senior and junior bank debt guarantees. And politically, this would also be favourable with the Irish people as well.  Instead, with the bailout, we are seeing the government raid pension funds i.e. the ‘people’s money’ to pay off the debts of the banks, ‘the foreigners’ money.’  That is a solution built for social and political upheaval.

This sociological factor is a crucial element at this stage of the process. Recent research demonstrates this.

[H]igher per capita GDP growth is significantly negatively linked to the support for extreme political positions. While estimates vary between specifications, we find that roughly a one percentage point decline in growth translates into a one percentage point higher vote share of right-wing or nationalist parties. Moreover, we find that the amount of income inequality in a country affects the role that growth plays. Highly unequal countries display a lower growth effect than more equal countries. For countries with a more equal distribution of income, a one percentage point drop in the growth rate may increase the vote share of far right parties by up to two percentage points.

Our results therefore make clear that countries should not expect right-wing parties to get majorities unless growth declines quite as much as in the 1920s. Nevertheless, even with a less significant fall in economic growth rates, a rise in support for extreme parties is likely to change political outcomes – for example through their impact on incumbent parties’ political platforms.

Our more recent research on the vote shares of other groups of political parties points out that smaller growth rates mostly benefit right wing and nationalist parties – and not so much the communist parties. One explanation for this asymmetry may be that voters perceive right wing parties as generating more individual income uncertainty.

Conclusion

Our results lend support to Benjamin Friedman’s view that economic growth determines the direction in which a democracy develops. This also implies that solving Europe’s growth problem may have important consequences that lie outside the purely economic sphere.

–The OECD’s growth prospects and political extremism

I got into some of the political positioning that occurs in a depression in my post pointing to less policy advocacy and more policy forecasting at Credit Writedowns.

Again here, defaults are not the end-all solution. Certainly, having investors in failed private enterprises bear the losses of their investment decisions instead of taxpayers is the right thing. However, just allowing bankrupt sovereigns to default and restructure doesn’t address flaws in the euro zone’s make-up.

This is a trade issue, first and foremost. The reason the Eurozone exists from an economic standpoint has to do with European interdependence from business trade. The eurozone functions as an internal market much the way the United States does, with the majority of trade occurring inside the region as opposed to externally with non-Eurozone countries.

When the Euro was formed, exchange rates were fixed and a common monetary policy came into being – much as we see for states in the US or provinces in Canada. Of course, monetary policy is not run for specific regions within the zone, but for the zone overall. And this invariably means that the European Central Bank’s monetary policy is geared more to the slow-growth core of Europe than the periphery.

During any business cycle then, current account imbalances build up within any diverse economic group living under one monetary policy as some regions overheat and others languish. This is true in Canada, the UK, and the US as well as in Euroland.

For example, slow growth in Germany has led to an export model which not only makes Germany a huge exporter world-wide but also within the Eurozone (see The Soft Depression in Germany and the Rise of Euro Populism). Because there is no built-in adjustment mechanism to prevent large trade imbalances from building up in the Eurozone, the result has been extreme and unsustainable current account imbalances within the Eurozone.

When recession comes, the regions which overheated and suffered the largest capital inflows and largest current account deficits (like Florida in the US or Spain in the Eurozone) suffer the most. Unemployment skyrockets and budget gaps open up.

However, there is no devaluation escape hatch in a currency union. In the US, Canada or the UK, severe regional economic downturns are attenuated by levels of fiscal transfers, automatic stabilizers and labour mobility that are even greater than in the Eurozone. Moreover, recrimination across regions for huge trade imbalances are more muted in Canada, the US or the UK because of an integrated national identity. This is not true in Europe.

I certainly believe California is effectively bankrupt – and has been since 2008; an eventual  liquidity crisis will bring this issue to the fore. But, I do not anticipate Californians rioting in the streets because of the austerity imposed on them by Washington and budget zealots in Nebraska, Montana or South Dakota (see Chart of the Day: State Budget Gaps 2010). California is not going to secede from the United States and form its own currency even if does run out of money and defaults. However, this is what you hear people talking about in Europe. That’s the difference.

–The mindset will not change; a depressionary relapse may be coming – European version

What you probably need is some sort of pre-funded fiscal transfer mechanism as you see within Canada, the US or the UK: A European Harmonisation Fund.

Break-up

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. A recent BBC article frames the issues well, determining that the most likely scenario is that the relatively stronger sovereigns would have to leave the union.  Here are some of the issues.

1. If Greece or Ireland were to defect now, we would see serious capital flight out of those countries. We have already seen capital flight from each country during the crises leading up to the bailouts. And remember, Greece or Ireland would not be leaving the euro zone to revalue, now would they? So it is reasonable to assume that even more capital flight would occur if people get wind of an imminent euro zone dissolution that would depreciate their bank currency holdings. A previous example from Argentina in which the government mandatorily converted even foreign currency deposits into domestic currency during the two-thirds devaluation is instructive.
2. Access to international capital markets would be limited. No international investor would want to buy Greek sovereign bonds denominated in foreign currency if one feared default. Greece would therefore have to issue debt in the local currency. International investors would fear currency depreciation for debt denominated in local currency. And since Greece has been especially dependent on foreign capital to fund its deficits, leaving the euro zone would require a dramatic increase of domestic purchases of Greek debt.

Read "Leaving the euro: how would it work?" for more from the original BBC article. My takeaway here is that any sort of dissolution is problematic. For example, in my German-framed post "How Belgian debt, Italian anarchy and Greek profligacy lead to economic chaos in Europe" I commented on how Belgium and Italy, founding members of the EU, were also major debtors. Wouldn’t any currency union with Germany have to have one of these countries in it? From a political perspective, it would be disastrous not to, as it would be seen as an act of German economic aggression against the rest of Europe.

We are now seeing euro zone divergence as investors are becoming increasingly aware of the different risk profiles within the euro zone core. But even France and Austria have worsened here. Finland, Austria, France, Germany, and the Netherlands are probably the core of the less indebted nations (see More Charts on Debt in Europe, Germany and the Periphery). Could we see a union of these nations along with Luxembourg, Cyprus, Slovenia and Slovakia (and maybe Estonia) but leaving out two of the founding members of the EU? I doubt it seriously. So, either the euro zone dissolves entirely or it remains intact and creates more mechanisms that bind it together. I still think it will be the latter.

My view is that some combination of monetisation and default is the most likely scenario for Europe.

Update 2300 ET: Apparently Willem Buiter has made similar comments regarding monetisation. From Bloomberg:

Buiter argued that the ECB must be prepared to wield its power as the euro region’s most powerful financial body and “take on more of the burden of supporting ailing banks and sovereigns.”

“As the sole source of unlimited liquidity and as an institution that can take decisions without the need for political or popular approval, it is the only institution that can take actions of sufficient size and with sufficient speed to stave off major financial instability,” Buiter said.

Full story here.