Stephen King: Saving the euro gets more difficult by the week
Economic Outlook: The key thing is to persuade investors the euro really does have a future and that any political inconsistencies can be resolved
Monday 12 September 2011
In the financial markets, belief matters more than truth. At the moment, nowhere is this more obvious than in the eurozone. The accelerating crisis stems from inconsistent beliefs about the eurozone's future. The euro's destiny will ultimately be determined by which of these beliefs prevails.
One belief – held by those with a Germanic view of the world – is that the euro will happily survive so long as all countries in Europe behave a bit more like Germany: hard work, control over labour costs, low inflation, high savings, modest borrowings. Another belief – held by those with a "peripheral" view of the world – is that too much austerity will throw economies back into recession: to ease the pain of adjustment, support will have to be offered on an ongoing basis from the eurozone's creditor nations (in other words, from the Germans).
A third belief, and one that has considerable force within the investment community, is that the first two beliefs will never be reconciled. The euro will, thus, inevitably collapse, pulled apart by its internal political contradictions. If these inconsistencies cannot be resolved, we face financial chaos.
To see why, think about those who fear the euro will collapse. What sort of financial bets might they make? They cannot easily sell the euro against other currencies because, in the event of a break-up, the German bits of the euro would presumably rise in value while the peripheral bits would drop. On average, then, nothing very much would change.
But there are other bets to be made. Before the euro was created, interest rates in the peripheral nations were much higher than those in the "core", reflecting persistent fears of currency devaluation. So an investor today might take the view that, in the event of a euro break up, interest rate spreads would, once again, massively diverge. The natural conclusion is to sell Italian bonds and buy German bonds. That's exactly what has happened.
That means, however, that peripheral nations end up with higher interest rates not only because their fiscal positions are, in some cases, a touch shaky but also because they are penalised as a consequence of investors' doubts about the euro's future. The higher cost of borrowing forces even more austerity upon these countries, increasing the economic pain and, thus, raising even more questions over the euro.
Let us now imagine that this situation gets progressively worse: more austerity, weaker economic growth, more doubts about the euro's future, higher interest rates ... and yet more austerity. How might countries break out of this vicious circle? One way would simply be for the peripheral nations to leave the euro and devalue. Another might be to default to a country's foreign creditors. Both would be painful and, oddly enough, both would have similar effects.
Following the euro's formation, eurozone governments were able to sell their bonds more easily to investors from countries elsewhere within the eurozone. Before the euro, German and French investors were less than enthusiastic about buying, say, Italian bonds because they rightly feared that their savings would go up in smoke as a result of the occasional lira devaluation. Once in the euro, however, Italian bonds seemed a lot less risky for the simple reason that Italy no longer had a currency it could devalue. As a result, a lot of Italian bonds ended up being held by French and German financial institutions.
It follows, then, that both an Italian default and a break-up of the euro which led to a resurrected – but devalued – lira would leave French and German financial institutions nursing huge losses. So another way for investors to protect themselves against the risk of a euro collapse is to sell shares in French and German banks or simply to stop lending to those banks (which is exactly what many nervous US money market funds have decided to do). The result is that the credit taps are slowly being turned off, leaving the eurozone economy unable to recover.
With the German and French economies now vulnerable, too, Paris and Berlin are in danger of losing any last vestiges of sympathy for their southern neighbours. Might political unity now completely haemorrhage? If so, might we then see defaults taking place left, right and centre, the euro crumbling and Europe finding itself facing a financial crisis far worse than anything Lehman Brothers had to offer?
It doesn't have to be like this. My little story shows, however, what happens if destructive beliefs are allowed to fester. They can lead to the meltdown of financial systems. So the key thing is to persuade investors that the euro really does have a future and that the political inconsistencies can be resolved.
Monetary unions are only likely to offer stability if they can offer some sort of fiscal and political unity. Getting there is not going to be easy but already there are moves afoot. The Dutch talk about the need for a fiscal "czar", the French hope eventually that there will be "eurobonds" and even the Germans, keen for all nations to stick to fiscal rules, can imagine that, one day, eurozone countries would find themselves bound together in some kind of Teutonic fiscal arrangement.
Yet all of this will take time. Markets want answers now. So what can be done to bridge the gap between the eventual logic of a closer fiscal union and the crushing uncertainty of the inconsistent political positions now plaguing the eurozone? Fortunately, there is a stop-gap solution. If investors continue to sell Italian or Spanish bonds, then someone needs to buy those bonds. The obvious "purchaser of last resort" is the European Central Bank (ECB). Like the US Federal Reserve in 2009, which bought masses of bonds from Fannie Mae and Freddie Mac (the two government-sponsored financial firms whose purpose is to increase levels of home-ownership in America), the ECB has the opportunity to stabilise bond markets and, in the process, prevent financial Armageddon.
There is, however, one problem. If the Italians and Spanish know that the ECB will be the "purchaser of last resort", will they put much-needed structural reforms on ice? And, if they do, for how long can the ECB carry on buying bonds before it ends up being accused by the Germans of "monetising" government debt and placing Europe on the path towards hyperinflation?
The answer, as we discovered at the end of last week, is "not very long at all". Apparently fed up with the compromises forced upon Europe's central bank, Jürgen Stark, the senior German representative at the ECB, walked out. Trying to save the euro from its inconsistencies is a task that gets more difficult week by week.
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