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Anticipating Eurozone collapse

The Germans are pressing a hard line on all fronts of the sovereign debt crisis in Europe – not only with austerity measures for Greece but for a planned European Monetary Fund (EMF) as well. The most critical part of the German negotiating stance, however, is now Eurozone exclusion, something that started when Finance Minister Wolfgang Schäuble publicized plans for the EMF.

But now German Chancellor Angela Merkel is also pushing this line. I saw her as rather dovish earlier in the crisis. But, the domestic politics have changed this I was wrong (see this Spiegel article for why). She calls for more severe sanctions including Euro exclusion for persistent free riders. In fact, Merkel wants to change eurozone rules in order to kick out any repeat offender of the stability and growth pact. The rhetoric is the toughest stance yet by German officials and makes the chances of a systemic crisis that much greater.

An article just released in today’s German weekly WirtschaftsWoche (Business Week) puts together the salient points quite well. My translation is below.

The Chancellor stands firm and refuses to help the Greeks. She wants new rules for the euro.

The Greeks are creating pressure. When European leaders meet in Brussels on Thursday and Friday, Prime Minister Jorgo Papandreou expects to finally have a concrete pledge for the ailing Mediterranean state. "It is important to make a decision at the summit," said the Greek. "We have to put the loaded gun on the table to ensure that the markets react properly." Previously, a senior Greek official had announced that Greece would apply to the International Monetary Fund no later than the Easter weekend in order to extricate itself from its financial plight. Papandreou denied [that Greece has made] the request to the IMF. But the message itself weakened the euro and made it clear to the political leadership in Europe, that it can not remain idle.

The Greek pressure generated counter-pressure. Chancellor Angela Merkel, who so far has steadfastly refused to support the Greeks lightly, wants to avoid future dilemmas like the current one. Her conclusion from the Greek crisis: she wants new rules for the euro.

So, you have Greek politicians threatening to go cap in hand to the IMF, involving the Americans and humiliating the EU, if the EU doesn’t bail the Greeks out. Then you have the Greek Prime Minister denying this and telling the other Europeans they must put the loaded gun on the table this week or the debt markets will implode. Meanwhile, the response from the Germans is ‘Nein.’  In fact, Angela Merkel wants to retroactively change the eurozone criteria so that the Greeks can be excluded from the eurozone if they continue to deficit spend. This doesn’t sound like a lovefest of Friede, Freude Eierkuchen to me. More likely, we have the makings of a more severe crisis.

This is a far cry from last March when it was widely reported that The EU promised to bail out eurozone members and might have even made assistance available in Eastern Europe as well. But, today, the Dutch are also onboard with the ‘no bailout’ approach of the Germans. Elections in June in the Netherlands are top of mind for Dutch Prime Minister Balkenende. He has consulted with Merkel to take a united stance on the issue. Others see the German stance as ‘absurd.’

WirtschaftsWoche again:

After a visit with the Dutch Prime Minister Jan Peter Balkenende last Thursday, for example, she stressed: "We need sharper tools in order to force compliance with the European Stability and Growth Pact." Last week she went one further and asked to "improve" European treaties so that countries could be thrown out of the euro zone, if they did not comply. The President of the European Central Bank, Jean-Claude Trichet, described the suggestion as "absurd". But now it is out there and the debate will not end so quickly.

Exactly. This thing is spiralling out of control and lines are being drawn in the sand. I am not in favour of a bailout. But, the issue here is negotiating tactics. Some tactics bring resolution; others bring escalation. When I lamented the politicization of economic problems, this kind of rhetoric is what I was referring to. At some point, there will be no backing down.

The hardness with which aid to Greece was rejected by Merkel in recent months has brought her a reputation as a Neinsagerin [lady that is not for turning]. In the coming EU summit, Merkel will again argue against premature support for Greece with the argument that the Greeks have not even asked for help. But now their attitude takes on a new quality: it aims to reform the monetary system.

This is a risky course which far from all countries wish to follow. France and Belgium would like to put together a rescue package for the Greeks. Collisions at the meeting of 27 Heads of State and Government are therefore very likely.

I am now going to have to reverse myself here. Ambrose Evans-Pritchard has been pushing the inevitability of the breakup of the eurozone. As recently as January 2009, I said that I didn’t foresee a breakup of the Eurozone, although I did see banking crises – in Ireland in particular – and the prospect of sovereign default within the Eurozone.

My take on events is that a number of countries within the Eurozone will face banking crises, starting with Ireland.  At that point, leaving the Eurozone will make no sense because the damage has already been done.

Evans-Pritchard’s calculus is more to the point: Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

-The Eurozone and the spectre of banking collapse, Jan 2009

The Germans, apparently, will not go along with this. But even before then, back in August 2008 – before the Lehman panic, before the Greek crisis – I asked "Will the global recession end the Euro?" My answer was no and laid out my case.

Ambrose Evans-Pritchard of the Telegraph in London is one of the more interesting reporters on the business scene. In today’s Telegraph, he chronicles the depth and breadth of the global slowdown now taking form.

However, the crux of his article revolves around Spain and the sharp downturn they have experienced. While his article suggests Spain’s slowdown will test the Eurozone’s cohesion, I believe the Euro will pass this test. The global recession will not end the Euro…

I don’t see Eurozone disintegration as very likely. The political pressure to remain in the Euro is too great. Moreover, the costs of leaving the Euro would be prohibitive.

The most likely scenario is some sort of relaxation of the stability and growth pact along with political pressure on the ECB to provide monetary easing — pressure we have already heard from France’s Sarkozy…

given the large current account deficit the recession is likely to be deep and protracted. And then there is the question of Spanish banks and likely writedowns from property losses.

All of this speaks to Evans-Pritchard’s main theme of strains in European cohesion as Spain suffers a sharp and deep recession with no monetary stimulus to offset it. The first outgrowth of this has been a divergence of Eurozone interest rates. Spreads of Spanish sovereign debt have been widening over German Bunds. But, I don’t see this going any further than that.

Whilst Europe may be going through a difficult period, and a severe recession for Spain is a foregone conclusion, the political and economic costs of breaking up the Eurozone are too large to bear. For now, the Euro remains safe.

That was then. Now, all bets are off. The Euro is not safe. The eurozone is looking very weak indeed. And with Merkel pushing the Eurozone exclusion angle, you can almost see the writing on the wall.

Source

Merkel fordert neue Regeln für den Euro – WirtschaftsWoche

Update 800EDT: when I say ‘collapse’ I mean economic collapse rather than break up. If I had to bet on likely outcomes (as many, undoubtedly, are via the CDS market), I would:

  1. still bet on a sovereign default within the Eurozone as the most likely outcome; that’s the writing on the wall, Eurozone economic collapse – particularly in Greece, Spain and Ireland. But a double dip of some sort would hit Germany as well (see posts here and here).
  2. Second would be some sort of bailout mechanism. I see this as a second choice option because my understanding is that we need a unanimous backing of any bailout mechanism. The Dutch and the Germans are the most negative here in this regard. But what about Sweden, the Baltics and Ireland? None of these nations want to see a bailout either. Some European politicians are already trying to position specific types of support as ‘support’ rather than bailout. Maybe they can pull it off, especially given intra-EU bank exposure to Greek sovereign debt and the Greek banking system.
  3. A Eurozone breakup, something I dismissed as the eventuality proffered only by Eurosceptics, is now possible in my view. I don’t see it as the most likely possibility, but it is no longer a non-negligible possibility. And that’s what this article is trying to say.

Update 810 EDT: Clearly the downside risk in all of this is the weak global economy and political pressure that would result from an economic collapse.  Moreover, the intra-EU exposure to the Greek banking system is probably dwarfed by the exposure in Spain.  In my view, the economy in Spain is the real question mark in all of this.  If contagion were to spread to Spain – even in the event of a bailout, downside risk increases.

Also the parenthetical "lady that is not for turning" is a reference to Margaret Thatcher which I inserted. It’s not in the original text, hence the parentheses.

Sources

Speech to Conservative Party Conference (‘the lady’s not for turning’), 10 Oct 1980 – Margaret Thatcher Foundation

1980: Thatcher ‘not for turning’ – BBC News

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

22 Comments

  1. Anonymous says:

    Bah, humbug. In order to throw out Greece, you need to change the treaties. In order to change the treaties, everybody must agree. Greece will not agree to being thrown out. Thus they will stay. QED.

    My bet: There will be lots of huffing and puffing in the coming two months (state elections in NRW in May). How, I don’t know, but in the end, Greece WILL be bailed out in return for serious promises for long term change (esp re: pensions and inflated public sector). Germany simply cannot afford to let the Euro go down the drain.
    The sinners will be given a second chance to clean up their act, with a dire threat that, if they don’t, next time they will be be on their own.
    The politicians will explain to the public that by lending to Greece at higher rates than Germany pays, Germany will make a profit, so it shouldn’t count as a “bailout” …

    My personal opinion of what should be done:

    1) Inflation in 2008-2010 was/is well below the 2% inflation target. Have the ECB calculate how much EUR the difference makes. “Print” this money (electronically of course). Distribute it to the memberstates of Euroland on a per capita basis. To the extent the Members are indebted above the Maastricht 60% / 3% PIB targets, require the Members to apply the new money directly to debts. In the other member states, distribute the money directly to consumers.

    2) Coordinate with the US to slap slowly (!) growing tarifs on China, unless they revalue the yuan. This allows to grow income levels esp. in Germany which in turn helps Greece etc to become more competitive.

    3) Start a desertec – light initiative to built lots (!) of solar power plants in southern Europe. Effect:
    - reduces the trade deficit of Spain and Italy
    - helps their construction industry
    - helps the German manufacturing industry

    • positroll,

      your plan seems reasonable. The ‘money drop’ is something that Marshall Auerback had been mentioning as a solution. Politically speaking, I don’t see that part of the plan as viable.

      you are also right when you say that changing treaties requires everyone to agree. The parts of the article i did not quote mentions this – and uses Ireland’s Lisbon Treaty rejection as an example of how difficult changing treaties would be.

      If I had to bet on it (as many, undoubtedly are via the CDS market), I would still bet on a sovereign default WITHIN the Eurozone as the most likely outcome – that’s the writing on the wall, Eurozone economic collapse.

      Second would be some sort of bailout mechanism. You say “explain to the public that by lending to Greece at higher rates than Germany pays, Germany will make a profit, so it shouldn’t count as a “bailout.”” That sounds reasonable.

      But, a Eurozone breakup, something I dismissed as Eurosceptic bias earlier, is now possible in my view. I don’t see it as the most likely possibility, but it is no longer a non-negligible possibility.

      • I agree, Ed. The idea of break-up has moved from the realm of arch eurosceptic wet dream to one of real possibility. The less accommodating are the Germans, the more likely this becomes because the Germans have yet to appreciate that today’s problems are the product of flawed institutional arrangements, not Greek corruption or “PIIGS” profligacy.

  2. Anonymous says:

    Is euro overvalued? probably compared to historical series , as stated by societe general could be 1 or 1,20 as claimed by others. there is too much noise, to be frank i feel safer having euros than dollars, of course in the range of 1,20/1.30, us solution is to print money creating inflation in the future, ecb will not print . Greece, ireland, spain are bankrupt? so is california paying with IOUs and not cheques to suppliers, new jersey, texas unbeliveably and so on. And by the way i have german bonds , if germany leaves the eurozone , well i think the deutche mark will increase its value.

    • Amazingly the Euro IS overvalued at 1.35. It was introduced at 1.17 and was a s low as 0.83 if I recall correctly. The point is – The Euro can go lower and a lot of people think the ECB wants this.

      Now, you have Martin Taylor, the former head of Barclays, writing Op-Eds in the FT about splitting the Euro in two:

      http://www.ft.com/cms/s/0/5d191800-3510-11df-9cfb-00144feabdc0,dwp_uuid=86be4e0c-53d0-11db-8a2a-0000779e2340.html

      Carmelo, you’re right. There is a lot of volatility here and anything is possible at this point. Unfortunately, the key is the politics of the matter. Merkel seems to be taking a stance that will prove hard to back away from. I don’t see a lot of good options here. The IMF or Greek bankruptcy seem more likely than an EU bailout right now.

  3. Daniel says:

    I think the most likely outcome will be a mixture of IMF involvement and bilateral credits

    http://www.ftd.de/politik/europa/:streit-ueber-finanzpaket-eu-steht-vor-durchbruch-fuer-griechenland-hilfe/50091997.html

    The “problem”: They can finance themselves on the market, the only problem is that they (greece) think that 6% yield is too high. Does anybody know how much a country has to pay when they go to the IMF?

    Second problem, according to the Bundesbank

    Die Bundesbank äußerte erhebliche Bedenken, ob Hilfen des IWF für Problemländer wie Griechenland überhaupt legitim sind. Ein finanzieller Beitrag des Fonds zur Lösung struktureller Probleme wie Budgetdefizite sei “mit seinem monetären Mandat nicht zu vereinbaren”, so der neue Monatsbericht. Das Kapital des IWF bestehe vor allem aus den Währungsreserven seiner Mitgliedsländer, das schränke seine Kreditmöglichkeiten ein, so das Urteil der Notenbanker. “Mandatsgerecht” dürfe der Fonds nur helfen, kurzfristige Zahlungsbilanzprobleme zu überwinden und einen temporären Fremdwährungsbedarf zu decken.

    http://www.ftd.de/politik/international/:euro-krise-trichet-schuetzt-griechen-vor-merkel/50091864.html

    and obviously, the german government doesn’t believe that the export model is dead

    Brüderle startet Export-Offensive

    http://www.handelsblatt.com/politik/deutschland/trotz-frankreichs-kritik-bruederle-startet-export-offensive;2550800

  4. linus says:

    Ed, you are missing the underlying phenomenon here. the battle isn’t on economic grounds anymore. it has shifted. geopolitics has now taken center stage. Germany is trying to carve out EU to its advantage, thereby trying to achieve what two world wars couldn’t: Europe comes under the economic leadership of Germany and Germany affectively holds the purse strings of Europa…

  5. karl deeter says:

    Ambrose-Pritchard is a dyed in the wool eurosceptic, he takes a shot at all things EU at every turn, he is to the EU what Rush Limbaugh is to the Democrats, and so biased that you have to discount what he says when it comes to the Eurozone in many cases. Ireland never said that we would leave the Euro or anything like that, instead we worked with the ECB and while things are hard, the country is still operating, we have had austerity budgets that have passed, we are going through the motions required for recovery and did so within the parameters of the EU, if the Greeks have an ounce of sense they’d have the balls for austerity rather than co-opting the IMF to do it for them.

    • Karl, I have reason to believe that AEP is keeping his euroscepticism under
      wraps for political reasons. This is a sensitive time – and with Germany
      making aggressive statements about kicking members out of the union, I
      imagine no UK journalist wants to stoke the fire, lest it reverberate back.

      But, as for the Greeks, they really are in a different category to Spain or
      Ireland. Throughout the last decade, they have had problems on the budgetary
      side knowing full well that they can’t just devalue. The fact that they are
      still talking about the IMF shows that they are still viewing this as a
      political issue more than a budgetary one as you rightly infer. However, i
      imagine their domestic politics is driving this as the PM doesn’t want to be
      seen as the bad guy. he would prefer the IMF, the Germans or the EU take the
      heat.

  6. Hinjew says:

    I think you are missing the point. A sovereign default at the periphery would essentially force the country out. Capital would flee the country, forcing a massive correction in the current account deficit. In short, none of the peripheral countries are able to finance both CA and budget deficits so the result would be economic chaos. The public would question the optimality of keeping the Euro and the politics would very quickly become unsustainable. History is very clear on this; international monetary unions do not work. See Bordo paper here: http://ideas.repec.org/p/nbr/nberwo/7365.html for an excellent historical overview.

    • History may be clear that currency unions don’t wok but it is not clear at
      all that a default would force Greece out of the Euro zone. Once default has
      occurred there is no incentive over the medium term to leave the union.