Tuesday, June 21, 2011

Euro futures

The European sovereign debt crisis has its roots in a variety of long term mistakes. The biggest of which is not the creation of the common currency, but the failure of states to maintain solid public finances. Whether the crisis is the result of a policy mistake- the Irish decision to offer an unlimited guarantee to its banking system- or long term corruption,-the fraudulent Greek public debt numbers- the impact amounts to the same. No matter what, all European states now have no option but to bring their runaway government budgets under control. That is as true for countries outside the Euro zone- such as the UK- as it is for the Euro member states.

However, the structural problem of Euro sovereign debt is now putting the entire mechanism of the Euro under intolerable strain. The European Central Bank, through its large scale purchases of the sovereign debt of the weaker Euro zone members, is placing its own balance sheet at risk, and even now, it is straining its own leverage ratios to a level- estimated at 23 times its capital base- that can not be considered prudent. Any default will force a significant recapitalization onto other Euro zone members

Yet in the last few days, it is becoming increasingly clear that the Greek government is under growing pressure, both domestically and from its Euro-zone partners, to consider the option of a default on debt and a withdrawal from the Euro. The fact is though, that there is no evidence that the the process can be done in an orderly way. The need to create new drachma notes and coins alone is a logistical problem that could take months to solve- and for the plan to work, this must be carried out in secret. Meanwhile the pressure on Athens grows more severe every day. A disorderly default is also a nightmare for the rest of the Eurozone too: not least, as I have written before, for Germany.

Yet, before the anti-EU brigade starts to crow, the next question is: what next?
The fundamental question, however, still remains: how to maintain a common currency without a common treasury? That may yet prove so intractable that the very idea of a common currency evaporates. On the other hand, there is growing talk of new and stronger mechanisms that can be applied across economies that are more alike, and which do not have major debt issues in the first place.

The fact is that the common currency drove interest rates substantially lower and gave far greater access to capital. The complete fall of the Euro would raise rates and reduce liquidity at a time when growth is already under attack from the dramatic retrenchment in government debt that the years of excess have racked up. The Euro has done an awful lot of the good that it promised.

The complete fall of the Euro could take Europe back to the 1930s. That is why the Greek crisis is rapidly becoming a pan-European crisis. In the face of the abyss, some of the politicians are beginning to panic.

Yet, there is also the conundrum of what would happen if Greek withdrawal were actually to take place in an orderly fashion, and that this helped to stabilize the Greek economy? In fact such a stabilization is likely to be many years away, no matter what happens: such is the scale of the crisis today, but let us make an assumption that Greece manages an orderly exit. In such circumstances, would not the pressure on other ill-fitting members lead to the complete breakdown of the currency bloc? I think the answer is that the peripheral states, such as Portugal and Spain may well follow suit, but for Italy and Ireland the message is far less clear. To a great degree the Irish are more likely to be able to complete the policy prescription. In Italy, despite the growing crisis of competitiveness, coupled with the death throes of the Berlusconi (should that be Burlesque-oni?) era, the country remains fundamentally much stronger than its club-Med peers.

The fact remains that a Euro is likely to survive.

That may be a Euro pared back to its core: Germany, Austria, BeNeLux, Finland, Estonia, Slovakia and Slovenia say: a Greater D-Mark; or with the continued participation of France, Italy and Ireland, it may remain something quite like the Euro we know today.

In the face of what is happening, some very cool heads indeed are now needed, yet the transfer of authority in the IMF with the exit of DSK and the ECB itself with the forthcoming exit of Jean-Claude Trichet makes the question of leadership in the crisis itself a tricky question ("who voted for Mario Draghi?" is a question already being posed by journalists).

However, even a default and Euro exit of Greece or indeed the gamut of the PIIGS states, would most likely still leave the Euro in existence: shorn of its more prickly weaker members, it may even face an new situation: the problem of too much strength.

Hold on to your hat, it is going to be a very bumpy ride in the next few weeks.

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