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
I would like to re-iterate this view now. However, I do so with much more hesitation. The possibility of a euro zone dissolution are much more pronounced now. The recent BBC article “Greece crisis: Commissioners ‘fear future of eurozone’” by Joe Lyman demonstrates how far we are from a proper resolution to Europe’s sovereign debt crisis. More alarming was the subtext that:
EU commissioners have a "profound sense of foreboding" about Greece and the future of the eurozone, a leaked account of a meeting has suggested.
I highly recommend this article as background for the current political turmoil surrounding Greece. Here are the main political issues now at stake:
- Dithering on restructuring and default: “The ECB is not in favour or restructuring and haircuts” and “excludes all concepts that are not purely voluntary”, according to Mario Draghi the presumptive incoming ECB head. This stance is completely at odds with the reality of the markets where a Greek default is a foregone conclusion. Bond yields and CDS are soaring and downgrades are coming fast and furious.
- Opposition to bailouts outside the periphery: Moreover, right across euro land we are seeing governments signal opposition to the bailouts of the periphery. The head of the True Finn party in Finland wrote a scathing article in the Wall Street Journal decrying the bailouts. In Germany, the constitutional court may even rule the bailouts are unconstitutional. If we don’t see restructuring and bailouts are resisted, how are these countries going to survive without an involuntary default?
- Resistance to austerity: The austerity plans now in place in Greece and elsewhere are not sustainable without debt relief. Austerity is not a good way to solve unsustainable fiscal trajectories because fiscal contraction reduces output and tax revenue, and therefore increases budget deficits. You need a Herculean level of budget cuts and asset sales to overcome this effect. And even then, the lower level of output and the permanently diminished tax base from asset sales will make any debt burden that is constant or increasing in nominal terms that much harder to finance. This is why default is seen as inevitable in Greece where debt to GDP already approaches 160%. The Greek Prime Minister is now seeing defections in his party from MPs who are opposed to his austerity budget. Reports are out that he has therefore offered to resign and form a unity government in order to see through the plans.
- Likelihood of more political unrest in the periphery: Meanwhile, massive protests are rocking Athens. Strikers protesting austerity come from a wide cross-section of Greek society, union members, older women, doctors, civil servants. Greeks will not accept the wage and price cuts of austerity’s ‘internal devaluation’ in order to prevent a default. That much is clear. The BBC reporter covering this said “These are not professional protesters” and phoned in with a simple message: “This is not sustainable.” Indeed, Hurriyet, a major Turkish newspaper ran a story in late May that the CIA believes a military coup in Greece is possible. While Hurriyet is a well-respected newspaper and a leading daily in Turkey, it does have a nationalist slant which make one sceptical. Nevertheless, I take notice.
- Potential for contagion: Yields on Portuguese and Irish bonds are at record spread to German bunds. As more and more time passes, the negative sentiment surrounding Greece is making the likelihood of an eventual Portuguese and Irish default that much greater. Spain and Italy have also seen the negative effects of financial contagion cause their bonds to sell off and CDS to rise. The only reason we have not had a cataclysmic crisis is because Spain and Italy have decoupled from the periphery. However, market observers like Felix Zulauf fear a rumoured bank run in Italy and additional property loses in Spain. If Spain or Italy were to recouple, a major financial crisis and economic downturn would ensue.
I am going to be talking about these issues today on the BBC at 8PM British time (3PM Eastern). And I will have to admit that the chorus of voices questioning the Eurozone’s future is growing ever louder. For example, Marshall Auerback wrote “To Save the Euro, Germany Must Quit the Euro Zone” in late May. Nouriel Roubini wrote “Could the Eurozone Break Up? Possible Over a Five-Year Horizon” earlier this week. These are cogent analyses from serious people. That they are talking about the euro zone’s collapse tells you that this crisis is well out of hand.
The EMU has never satisfied the optimal pre-conditions for a currency union: harmonised and synchronised economic activity, capital and labour mobility, political union and fiscal federalism (aka transfer union like the UK or the US). The hope had been that convergence would cause the periphery to become more like the core. That has never happened and now the EMU is in an existential crisis.
I said that the Eurozone is unworkable in its present state in March of last year and I still believe that some type of change is coming to euro zone treaties. Moreover, the euro zone will have to have more ‘fiscal union’. Last march I proposed a European Harmonisation Fund instead of a European Monetary Fund as a mechanism to create that union. However, within the euro zone, the political resistance to a ‘transfer union’ is large.
I still believe the political price for a breakup is large but the chances of one are increasing because the policy decisions that governments and the EU are making cannot be maintained politically in the periphery or in the core. Unless we see a change in the EU’s structure toward greater integration, a breakup is likely.