The Worst Case Scenario for the Eurozone

And so the nightmare continues. Are we heading for the worst case scenario? To answer this, we must first work out what that is.

Despite the ECB’s recent efforts, no ideas currently on any of the EU’s round tables seems capable of ending the euro’s unravelling. The reduction in spreads that followed the ECB’s desperate bid to buy Irish and Portuguese bonds the other day is more significant for its feebleness than as a sign of the ECB’s capacity to lead Europe out of its nightmare. There is simply no hiding the fact that, though EU debt as a whole is relatively small, the markets are betting that Spanish debt is as risky as that of Pakistan. How on earth did Europe dig itself into such a  hole?

Well, we know how (see here for my take). We even know what ought to be done to get us out (see our Modest Proposal): The trick is to attack, at once, the member-states’ debt and the banks’ potential losses through a centrally planned negotiation, before following that up with the issue of eurobonds for 60% of each member-state’s debt. But, no, the EU seems determined to continue with loans after loans after loans to bankrupt states to payoff bankrupt banks to whom they owe money that the banks do not expect back because they can see that the conditions for these loans (misanthropic degrees of austerity) only reduces the medium term capacity of the states to pay. And so the nightmare gets darker and longer.

Meanwhile, a sad conclusion is reached every time the most powerful of Europe’s politicians repeats that private investors must, after 2013, take a haircut if the states whose bonds they buy find themselves in trouble. What conclusion? That even she, the pretend Iron Lady of the EU, is not contemplating that Europe’s banks will have to be told by the ECB to take a negotiated hit for existing debt (which lies at the heart of the current crisis) as a condition for continued access to ECB-provided liquidity. Will someone please tell Mrs Merkel that if she really wants to be tough she better do so in relation to existing debt holders, rather than future ones? That there is nothing less impressive than someone who tries to frighten some fictitious future bogyman while the true villain is rampaging downstairs in the living room?

A reader (Mark, [email protected]) asked what I thought of “the ongoing brinkmanship being performed by policy makers from the core of the EMU?” That it is the desperate act of men (and few women) who know that their ammunition will not last the fire-fight but who feel they have no other alternative. That is what I think Mark. “Is this ‘madness’ a reflection of some larger strategy?  Could they be setting the stage for changes to the political structure of the EMU?” My answer is that I wish that some devilish plot were being weaved by our policy makers to change the political and institutional architecture of our European Monetary Union; of the eurozone. It would mean that at least someone is looking at the large picture. That someone will soon table proposals which, however divisive, can spark off a serious debate. Alas, I am not that optimistic.

Mark also raises a good point: “From a financial point of view, the EMU sovereign bond market seems to be changing from a spread market to a credit market.  Is this an accident or a deliberate strategy?” Accident, I am very much afraid. Once the spread market ceased up last May, following the Greek collapse, the EU responded with the well known €110 billion loan that then led to the establishment, along similar lines, of the EFSF. Then, as you rightly intimate, a game based on spreads evolved into a credit game in which the main players (the EU) lacks credibility. And there lies the awful rub.

On radio, TV, in newspaper interviews etc. journalists incessantly (and correctly) ask their guests: What is the worst case scenario for the eurozone.  I used to have an answer but now I am torn between two competing ones. One thing I do know is that the worst case scenario for the eurozone is not that we have a frank and feisty debate on how to restructure it. The worst case scenario is a toss-up between (a) a quick collapse of the eurozone and (b) a long period during which the ECB is winning small victories (like this week’s), which only prolong the agony without resolving anything, before the euro collapses in the medium term.

So, which is worse? The euro’s quick death (a) or a prolonged, agonising one, after a lengthy stagnation during which EU leaders fiddle? I am not sure. If the euro dies now (e.g. following the eruption of Spanish and Italian spreads that cause Germany to get out of the euro), the whole continent will be engulfed in a postmodern 1930s type of recession that may well have similar results globally. The new DM will appreciate hugely, exports will collapse, and Germany’s already squeezed working class will find itself in the throngs of mass unemployment. The repercussions for the rest of us, both economically and politically, are unfathomable.

But then again, the prolonged death is not a better scenario either. One thing that is certain is that, failing a world recovery that is not currently in sight, the ECB will not be able to avert the euro’s medium term collapse on current form. Put simply, the ECB will never be able to fight the bond markets to a successful conclusion while Germany is tying its hand behind its back, stopping it from buying a few trillion euros worth of distressed bonds. All the ECB can do, currently, is to buy a limited number of tranches of 100 million euros. Although it sounds like a great deal of money, it is grossly inadequate. To see this, just note that asset managers and hedge funds have a great deal more ammunition to play with. Pimco, for instance, can mobilise a sum greater than the GDP of Greece, Portugal and Ireland taken together (about a trillion euros’ worth). All that the ECB can do against such enemies, given its political constraints, is to buy some time. Time in which to do what? To prolong the current dead end which guarantees an investment drought in Europe’s real economy for the foreseeable future?

As the days go by with no visible sign of intellectual life among our leaders, I am drawn to the conclusion that the ECB’s time-purchasing efforts may well be part of the worst case scenario: A continuation of present inaction that diminishes both the productive capacity of Europe and its political appeal to the people of Europe so that, when the final crisis erupts, we shall be lacking both the economic dynamism and the political clout to prevent the euro’s collapse and the slide into a postmodern Hobbesian future. What maddens me is that the nightmare could be ended in a few weeks without any great losses for any of the major players.