The news out of Spain that the government is taking drastic action to avoid debt revulsion is a clear indication that the eurozone is entering a new phase of economic weakness. All across Europe from the UK to Greece to Spain to Germany, governments are now cutting spending. And while these moves are necessary in the face of crisis, they will be a negative for growth in 2010 and 2011. Ultimately, all of this creates a market sentiment which weakens the Euro, and as I said on BNN Tuesday, this is exactly what Europe wants (see video here; the second part on the global economy is here).
Obviously the eurozone is not an optimal single currency area. It serves more to deepen political union than as an economic union given the lack of harmonisation between countries and the absence of a federal treasury. Nevertheless, many countries still want to get in. For example, Estonia has been granted permission for inclusion starting in January 2011.
But, a lot of people are asking whether the Euro can survive this crisis. Despite my euroscepticism, I have been optimistic for the simple fact that the political costs of dissolution are so great. But, starting in March I began to second-guess that optimism (see Anticipating Eurozone collapse). The domestic politics in places like Greece and Spain are really going to be put to the test as austerity takes hold. And hopefully, austerity won’t trigger a debt deflation scenario because then all bets would be off.
What if austerity doesn’t work then – what then? I still believe a default within the eurozone is more likely than a break-up of the eurozone. But, obviously a lot of this hinges on the Germans.
First, I see the argument for bifurcation of the eurozone into a Northern European and a Southern European block as a non-starter. Any hard currency block would have to include the Benelux region and Belgium has an enormous debt burden approaching 100% of GDP. So even under that scenario, you still get the debt problem weakening the Northern block. Moreover, as it stands today, the Germans and the French both fail each Maastricht test on Debt to GDP and deficits. Therefore, the benefits of breaking up the Euro to form a northern European currency block are far outweighed by the political costs of breakup.
Second, the Germans could always go it alone. Things would have to get significantly worse for the eurozone for this to become reality. The Germans still want European cohesion at all costs. That Europe breaks apart because of the Germans would be a national trauma. I could only imagine such a breakdown in a Great Depression II scenario.
For me, that leaves Greek default or restructuring within the eurozone as the preferred and most likely outcome. The key test for the eurozone, however, is Spain. If Spain runs into trouble rolling over its debt, the eurozone is in real difficulty because of the bank exposure to Spain (see the NYTimes Info graphic "Europe’s Web of Debt" below). The sovereign debt crisis is less about Greece and more about preventing contagion – especially to Spain. Italy is a red herring. Portugal is small. And Ireland is small too, although its outsized financial sector makes its indebtedness rather large on the chart below.
Spain is where the action is here. The Spanish are the key to keeping this crisis from spiralling out of control.
For Spanish-speaking readers, also see Obama llama a Zapatero para pedirle reformas que eviten que siga el contagio which talks about Barack Obama’s call to the Spanish Premier that precipitated Zapatero’s call for further austerity in Spain.
I talked about the crisis in the eurozone in greater detail Wednesday night on Fox Business.
Update 2240 ET: I should also use this as an opportunity for a mea culpa. I hate doing these but if I am to be 100% honest with you readers I have to – and it helps make me mindful to not overstate my case.
I have said a few times in the past that the Germans will not bail out Greece. Of course, I have an out. For example:
I see it as unlikely that any deal – bailout via the EU, IMF bailout or backdoor help via quasi-fiscal measures from the ECB – can be reached unless Greece agrees to austerity measures.
But I don’t want to weasel out of this one. I was wrong. The Greeks got their bailout. And there are other instances when I implied they were not going to get one:
Moreover, as with Greece, they cannot rely on the next level of government for support. There will be no aid forthcoming for states anymore than there will be for Greece (see Europe puts the loaded gun on the table but no bailout for the fig leaf of support Greece is now receiving).
It was re-reading this quote which prompted me to write this mea culpa. So, how does this change my thinking? It certainly reinforces my belief that the Germans are politically committed to the Euro as i said earlier in this post. But it also does give me some doubts as to exactly how much the German political class is willing to do against the will of their citizens. Time will tell, but it bears noting that the bailout of Greece debt and the German and French banks is as unpopular amongst ordinary Germans as it is amongst ordinary Greeks.