Europe – Into the Abyss

Cover photo from the Economist about a year ago — now all too true.

As we watch the ongoing train wreck in the European Union, we can’t help wondering where it will all end up.  I search in vain on the internet for a discussion about the logical conclusion to this catastrophe, but few venture to put forth a picture of what’s to come.  Here is my best guess.

The fear of a Euro breakup has finally reached the point where Europe has isolated itself from the rest of the world.  No longer are non-European investors willing to risk their assets with any EU bank or sovereign debt.  The EU has become a financial island unto itself.  Outsiders would rather divest themselves of any European assets than take on more of them. We have a run on the bank, and the bank is Europe.

European investors are desperate for a safe haven, so US treasuries remain in demand.  European demand for non-European assets will act to diminish the value of the Euro.  This effect could boost exports of European goods and help at least the industrial core EU countries weather the storm, but this does nothing for the short term.

Within the EU, with foreign funding cut off, the resolution of the imbalances must be dealt with internally.  Greece is looking for loans from the ECB (European Central Bank) by December 9 in order to be able to roll its debt and avoid outright default.  However, after the recent political turmoil in Greece, the original agreement that called for more austerity measures in exchange for a 50% “voluntary” write-down on the current debt is now in doubt.  The Greeks now want to pay only 25% of their outstanding debt if they are to accept the rest of the deal.  This makes the “voluntary” nature of this credit event much more dubious, and suggests that CDS (credit default swap) insurance on these loans will eventually be triggered one way or another.  This could start the unraveling of banks on both sides of the Atlantic that have exposure.  No matter how you look at it, most of the Greek debt is held by German and French banks and investors, and they will take the biggest hit.

The demands of the core countries (Germany and France) reflect their self-interest in getting their money back.  But the bleeding of the PIGS (Portugal, Italy, Greece & Spain) is a slow death for these countries and they are no longer willing or able to put up with it.  It’s been said that the best approach when in fiscal trouble is to default early but not often.   If you compare the trajectories of Iceland and Greece following the 2008 financial crisis, you can see why this is a good rule.  Iceland refused to put the sins of their bankers on the backs of their people, and have since begun a modest recovery from a desperate position.  Greece, saddled with the demands of membership in the EMU (European Monetary Union), could not easily make an early exit, and has suffered the consequences of a running five-year depression.

With Europe now cut off from outside funding given the present conditions,  either Germany accepts the position of lender of last resort by way of the ECB, or the rest of the periphery countries face the Greek fate.  It’s just a matter of time — perhaps just days, when one of the countries that can no longer afford ever-increasing demands from the EU core countries to fund their debt, will decide the value of continued membership in the EMU is no longer worth it. Then, brand new Lira , Pesos, or Drachmas will appear overnight.  The least pain will come to member states that don’t hesitate once the movement is underway.  This is very much like leaving the gold standard was 80 years ago.  Those who stuck it out (France) suffered the most while those who bailed first (Britain) quickly recovered because they finally had control over their own monetary policy.  With that in mind, it seems that once the exit starts it will unfold rapidly.  One can imagine that all of the PIGS bail out and declare their own Greek or Italian “Euro” that is initially pegged at the EMU Euro, but is destined for immediate devaluation as quantities of the new currency are printed to pay off the old debts and reduce domestic interest rates.

Germany and France are likely to come to bilateral agreements that maintain their union, as are other core countries.  The crisis will likely spark the necessary reforms so that what remains of the EMU will have the tools to deal with imbalances that are bound to develop.  Some of the ideas required for a fiscal union are floating around now, but the proposed legal treaties and reforms seem motivated by a German moral crusade rather than any credible path toward unwinding the present imbalances.   The puritanical legalese may be good enough to unite the core countries without big problems,  but the blame-the-victim tone almost guarantees that these measures will not be agreeable to the PIGS, and time is running out.

Once the first state leaves the EMU, world markets will be in free fall.  Italy or Spain’s departure will really stress the banks.  It seems likely that the process of rolling over Italy’s debt into a new currency with a questionable exchange rate would cause a “mark-to-market” evaluation of assets.  No bank would like to see anything like that happen when they are holding stressed assets that might be of dubious value in the first place.  Banks will not be in a position to trust each other to be solvent.  Credit will dry up.  This is the nightmare scenario that prompted Henry Paulson to demand a trillion dollar bail-out for the banks from President Bush after the Lehman Bros. default.  Who will come riding in this time?

What happens in a global economy when no one can exchange money?  I don’t know, but we might find out!