By Jason Voss, CFA
Conventional wisdom holds that the lack of a legal framework for political and monetary union makes policy coordination within the EU and the eurozone impossible. Instead of solving crises, finance ministers race from one disaster to the next, with no real resolution. When such a lack of structure collides with excessive debt and negative economic growth, the thinking goes, there is only one endgame: economic doomsday.
With a capital-poor banking sector that is seven times as large as its economy, Cyprus is the latest eurozone fire hazard and - as conventional wisdom would have it - the most likely candidate to spark a conflagration of the euro. Adding to the inevitable sense of gloom is the fact that European negotiators forced depositors holding more than €100,000 to endure large losses. In so doing, policymakers have violated a social contract, in place since the Great Depression, which holds that depositor monies are sacrosanct. The inevitable result? Chaos, panic, disorder!
If the conventional scenario is an accurate model, then what evidence would you look for to confirm it? I would expect to see an appreciation in reserve currencies - the US dollar, Swiss franc, yen, and renminbi - relative to the euro, as flustered and angry businesses and individuals extracted their deposits from the system. But guess what? That just isn't happening.
I would also expect to see a big sell off in global financial markets, a widening of credit spreads, and many other such things. Yet these things have not come to pass either. And finally, I would expect Russia to deliver a strong response since so many of the country's nationals are affected by the rescue package. (Such an expectation is rooted in fact: You may recall that on 7 January 2009 the Russian government cut off natural gas supplies to Europe for several days in retaliation for support of the "Orange Revolution" in Ukraine.)
So what did Russia do this week? The government raided a handful of German non-governmental organizations. Even this response, tepid by any measure, was likely aimed at merely placating a domestic audience rather than truly punishing German support of the Cyprus plan.
Perhaps the conventional wisdom about the eurozone will eventually win the day. But, then again, predictions of a disintegration of the "European experiment" have yet to be fulfilled even though more than 1,000 days have passed since the crisis first began. I still hold out the conventional wisdom as a possible scenario. But the quality of any scenario must be evaluated based on its predictive value. And since the predictions haven't rung true, I believe that investors need to consider a new scenario, one based on the power of informal problem-solving mechanisms.
Many policy dilemmas are not solved formally. During the Cuban Missile Crisis, for example, formal mechanisms between the United States and the Soviet Union completely failed to avert an impending crisis. Instead, the informal structure of relationships among longtime US and Soviet diplomats saved the day. Similarly, when Chrysler needed financial assistance in 1980, it was an informal mechanism that saved the embattled car maker: Lee Iacocca's personal relationships both with US legislators and the president secured the financial lifeline.
When it comes to informal problem solving, interactions between people is what is important - not the interaction of different systems, such as political charters, national laws, or business contracts.
There is plenty of evidence that informal mechanisms are strongly in play in Europe. For starters, consider the ad hoc nature with which each new crisis is dealt: Ireland was asked to right its fiscal situation after receiving a bailout from the European Financial Stability Facility and the International Monetary Fund. Greece was asked to implement austerity measures in order to receive a bailout similar to the Irish lifeline. However, bondholders were asked to take a limited haircut. Then, in Italy, Prime Minister Silvio Berlusconi was replaced with an EU technocrat who worked to stave off the anxiety of markets. In Spain, meanwhile, the country's teetering banks were bailed out directly.
And now, in Cyprus, depositors are being asked to take a haircut.
The upshot? There are many eurozone crises, each with an ad hoc, unique solution.
Another piece of evidence that informal mechanisms are gaining traction: The increasing rapidity with which each new crisis is being dealt with. Greece took almost three years. Spain several months. Cyprus has taken just a few weeks.
To be sure, Cyprus is far smaller than Spain and maybe not directly comparable. But maybe, just maybe, the rapidity of the solution suggests that informal problem-solving mechanisms are crystallizing. With the passage of time and with each new crisis, there is a mapping out of the players' personalities. There is a growing understanding of who can do what in Europe, who can be relied upon to deliver this constituency and not that constituency, and a greater understanding of what the public will tolerate (and won't). France's president understands Germany's chancellor better. Germany knows where Finnish and British interests lie. European Central Bank Chairman Draghi knows Spanish Prime Minister Rajoy's personality - not to mention the name of his closest relatives. That's how informal channels develop.
An analogy: When we first tried to understand the night sky we used telescopes to look at the visible light emitted by stars. But some phenomena remained unexplained, so we eventually realized that there was an invisible story happening in the night sky, too, but happening at different wave lengths of light.
To those expecting a formal mechanism for resolving such problems - for those who subscribe to the conventional wisdom - Europe looks foolish and hopelessly inept. I am not saying that the conventional wisdom is necessarily wrong and should be abandoned. But I am arguing against an absolutist view of the crisis. In my view, an informal, evolutionary process is taking place in Europe. On the surface, the crisis looks like a classic zero-sum game. But the financial, political, business, and public responses to the crisis just are not what conventional wisdom would predict. Investors owe it to themselves to consider an alternate scenario. Whether it proves right or wrong, at the least it helps illuminate the overall picture.
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.