14/02/2012 by

While Greece burnt, and the Parliament of the Hellenic Republic was insincerely accepting impossible conditions for implementing yet another unworkable fiscal adjustment plan, the buzz in Frankfurt’s financial district was an exciting, fresh German Plan A.[1] For the first time in two years, since the euro Crisis began, Germany’s captains of finance could be seen to have re-discovered a spring in their step. The new optimism stems from a new Plan which is predicated upon a long delayed recognition and two strategic choices:

Germany’s belated epiphany is that, without a major redesign of the euro architecture, a number (>1) of eurozone member states are irretrievably insolvent. As for the two strategic choices, the first is Berlin’s conclusion that German politics have no stomach for, or interest in, a structural redesign of the euro system.[2] The second choice involves a massive bet in attempting to save the eurozone by shrinking it forcefully while, at the same time, authorising the ECB to print trillions of euros to cauterise the stumps left when the states earmarked for the chop are severed.

The detail not yet ‘worked out’ concerns the identity of the countries to be shown the door. The consensus opinion in Frankfurt was that Greece and Portugal are certainties. Few expressed the view that Portugal is too close to Spain to cauterise effectively while others went against the grain of majority opinion suggesting that Ireland ought to be liberated too. My impression is that, current thinking, has settled on Greece and Portugal, with a questionmark over Ireland.

But let’s take matters one at a time:

The epiphany: It is the insolvency, stupid!

Granted that there is a grey zone separating an insolvency from an illiquidity problem, Europe’s denial that Greece has been insolvent for two years now will go down in history as the ultimate (though powerfully motivated) error. It did not have to be that way. Had Greece been given debt relief (of the sort that is now taken for granted) back in January 2010, and had Europe focused on the mess of its banking system (instead of putting all its eggs in the austerity-plus-loans basket), things might have turned out quite differently. But, it was not. Instead, Greece was forced to shed 15% of GDP while taking an additional 20% of debt on its weary shoulders. This sealed its fate once and for all. As for the much debated reforms, their fate was sealed at that time too: no reforms can be effected meaningfully in an imploding social economy.

Recall how, at first, Germany was insisting that there would be no bailout, no debt restructuring, no interest rate relief. One by one these holy cows were slaughtered. Then came the notion of interest rate reductions, the debt restructure (euphemistically named PSI), more loans. It was too little, too late. When this cascade of German ‘concessions’ failed to stem the inexorable movement to insolvency, a few days after the October 2011 Summit (where the latest PSI and Bailout Mk2 were agreed), Germany ceased to deny that Greece may be forced out of the euro. It was at that point that Germany also began making noises that Greece is a special case. Today this litany has ended too: Portugal is quietly put in the same ‘too hard’ basket. Perhaps Ireland too, even though this is a point of contention: many within the German elite insist that Ireland, though also insolvent, ought to be kept within the ranks as a reward for having ‘internalised’ the austerian ‘logic’ even before the powers that European be imposed it upon the Emerald Isle…

In effect, two years of the wrong, poisonous, medicine has forced the surplus countries into an impasse. Instead of reassessing the medicine that is causing the eurozone’s gangrene, they are now turning to their last resort treatment: Amputation of the worst affected limbs, followed by ECB-administered cauterisation. The only pending issue, as far as they are concerned, is how much of the eurozone to amputate.

Cauterisation and the Weimar trauma

My Frankfurt interlocutors, upon being challenged on the realism of containment following the traumatic events which will undoubtedly follow the severing of ‘gangrenous limbs’, admitted that cauterisation would cost trillions and would involve unremitting money-printing by the ECB. In their view, the ECB would have to attempt: (a) to keep afloat the banks of Italy, Spain, France, Belgium, Germany and Holland, and (b) to smooth the severed countries’ tortuous path to oblivion (by keeping at least some banks functional during the tumult that will surely follow).

The remarkable part of this new consensus is that it shows that Germany’s fear of inflation-inducing money-printing has vanished in the face of the euro Crisis. Or perhaps that it was always a mirage. That the supposed Weimar-trauma had nothing really to do as such with the money supply getting out of hand, with hyper-inflationary effect, and everything to do with a penchant to retain maximum control over the eurozone’s economic policy. For if it transpires that Berlin will indeed give the green light to the ECB to print trillions as a means of cauterising the eurozone stumps, as well as preserving in a state of suspended animation countries like Greece and Portugal, it is clear that the hitherto presumed German conviction that such an infusion of freshly minted money will prove disastrously inflationary was never genuinely entertained.

The key to this new Plan, and the optimism it has inspired within Germany’s financial community, is twofold: First, it shows that Germany is certainly unwilling to re-design the eurozone’s flawed architecture, in view of its revealed preference for, God forbid, inflation over the institution of a surplus recycling mechanism plus a unification of the eurozone’s banking system. Secondly, it suggests that Germany is not yet ready to ditch France.

This second point is crucial. My German sources acknowledged that France is not up to Germany’s strict standards as a monetary union partner. They consider France to be a chronic laggard, a fundamentally deficit-oriented economy, a state whose ambition constantly, and irritatingly, overreaches its potential. But they feel that there is a political need to give the eurozone, i.e. the Franco-German axis, one last chance. France is, therefore, still tolerated. And with it Spain and Italy will also be given another chance, courtesy of as many LTROs (i.e. oodles of ECB-printed money for Italo-Spanish banks) as it takes.

If they pull it off, they hope they will have managed to salvage the European political project (which they will try to argue is on track, with promises that the countries amputated are always welcome to rejoin once they have their houses in order) and to avert the massive drop in exports that would be  inevitable were Germany to cut loose all countries except similarly surplus countries.

Will it work? Three reasons it won’t

Any Greek or Portuguese or Irish government that serves its people’s interests would point-blank refuse to play ball. The idea that exiting the eurozone is a simple matter of devaluing is dead wrong. It confuses the correct view that Greece and Portugal and Ireland would have been better off outside the euro with the quite different, and catastrophically erroneous, view that exiting is the optimal strategy. In this sense, our governments have no reason to go along with Germany’s amputation strategy. But then again, the Greek government had no reason whatsoever to choose the Bailout Mk2 agreement, and the strings that it came attached with, over a simple default within the eurozone (which I was advocating; along with Wolfgang Munchau). And yet it did. Why? Because the politicians of the Periphery have neither the stomach nor the interest in disobeying orders issued from the North. Why that is is a matter for historians and psychologists. For now, we must take it for granted, unfortunately. Which leads me to the sad conclusion that, even though Germany has no way whatsoever to force certain countries out of the eurozone, the moment the Greek, Portuguese or Irish PMs get their marching orders, they will immediately start marching their way out of the eurozone.

But will it work out for Germany the way that Frankfurt financiers currently hope it will? That massive ECB-money printing can create circumstances which shield the rump eurozone from banking sector tumult, following two or three ‘exits’, there is little doubt. After all, the ‘markets’ held steady for 48 hours after Lehman’s was ‘amputated’. And then? Similarly, Germany’s new Plan A is doomed. Here are three reasons:

The first reason is that, in the short, run, just like in the case of Lehman’s, the Frankfurt optimists are assuming that they know the unknowable (just like, prior to 2008, they assumed they had created riskless risk). The interconnections between the Portuguese banks with those of Spain, and of the Greek banks with those of France and Germany, are of the sort that will only see the light of day when disaster strikes. And when they do appear in full Technicolor their sight will be terrifying.

The second reason is that the massive liquidity injection into the Italian and Spanish banks, not to mention the French and German ones, will operate like large cortisone doses injected into a cancer patient. They will cause temporary relief but, at the same time, they will give the underlying malignancies time to grow nastier, bigger and deadlier. In short, the remaining eurozone’s banking sector will turn into a monster version of Japan’s zombie banks of the 1990s, brewing en masse the next banking crisis and embedding the virus of recession everywhere, from Spain to Germany, from France to Italy.

The third reason is structural. The eurozone’s troubles stem from the lack of a pan-European system of supervising the banks, of managing public debt and of planning for aggregate investment. None of these three constituents of the Crisis will be dealt with if Greece, Portugal and possibly Ireland are amputated – even if the stumps are effectively cauterised. This means that on the Morning After, Italy will be the next Greece and Spain will be the new Portugal. The internal imbalances of the eurozone, after a brief lull, will start rearing their hideous heads again, and, in conjunction with the zombie banks and the recessionary environment, it will not be long before another round of amputations will become ‘inevitable’.


Clueless for so long, Germany now has a Plan. According to this New Plan, some deficit countries will be amputated in order to give the Franco-German axis a final chance. The price Germany is willing to pay for this is the ditching of its ‘psychological’ rejection of hyper-energetic money-printing on behalf of the ECB. Thus cauterised, the festering wounds of Greece et all will cease to threaten the eurozone or to give rise to suggestions for a fundamental re-design of monetary union.

When will this Plan come out of the shadows and be discussed in public? After Mr Sarkozy, on whom Mrs Merkel has invested much, wins the French Presidential election, was the answer I was given. Then, Germany will ‘suddenly’ realise that the impossible conditions the Greek government pretended to accept have not been met. And then the ball will start rolling. Tragically, it will keep rolling well past the point willed by Berlin and Frankfurt. Even if contagion is initially arrested by Super Mario, the deeper causes of the eurozone’s current troubles will continue to work unimpeded and, before too long, Germany will realise that the amputations must go on until all is left attached to its economy are the rest of the surplus countries. Then, just like it has now accepted inflation as the price to pay for implementing this New Plan A, Germany will accept the need for deep deflation, following the loss of export markets, that will come as part and parcel of the next-next Plan: of ditching France.

Why not do as I and Munchau suggested instead?  Because they prefer this to recapitalising their banks and  because deep down they know that without a SRM it is all hopeless. They hope against hope that Italy and Spain… They may even be willing to issue Eurobonds with them but not with the likes of Greece.

They err in a number of ways. First, cauterisation will not work. The gangrene will spread. Secondly, even if it works,  Italy and Spain will eventually   Evoke the new Greeces of the rump euro one. Thirdly, the LTRO is setting the euro one up for the next Crash.

The recent LTRO, and its forthcoming extension, is the blueprint.

Germany had done what it could for Greece. The time has come to cut losses. To identify the countries that are still potentially solvent, and act swiftly. How? First, by smoothing the path back to their own currencies of the chronically insolvent

[1] This post could be entitled ‘Letter from Frankfurt’. Over the past three days I was in Frankfurt, filming a documentary on the Crisis for Channel 4. This post’s contents reflect the impression I got from talking to people in the financial establishment.

[2] Such a major re-design would involve bank recapitalisations and the unification of the european banking sector; thoughts that fill the soul of German bankers and financiers with horror. Germany’s politicians, in view of the expected backlash, thus have no interest in re-designing anything…

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