We looked with rising amazement at the Markets rallying strongly early last week on signs that finally the euro problem would meet a solution of sufficient force.
Yes, pressure (from the US and big emerging economies) was applied to European politicians. Yes, plans circulated. At least five different versions of some form of leveraging the European Financial Stability Facility (EFSF) from 440B euro to a cool 2 trillion, and a 50% 'haircut' to Greek bonds to boot, to placate the Germans.
How realistic are the prospects that they will become policy? There are those that have never really worried about the euro because a break-up would be so costly, politicians would, in the end, do what's necessary. They point to the high value of the euro for proof, but that's not necessarily a source of comfort (the market might just assume weak countries leaving, after which the euro would be much stronger).
Those costs of break-up are indeed scary, at least to a study by Stephane Deo at UBS. If Greece were to leave, it would cost 40-50% of GDP in its first year alone. Germany leaving (there are already rumors) would hardly fare better, it would face 20-25% of GDP in its first year and roughly half that subsequently, according to the same study.
Others look at the political statements coming out of German politicians when they are not cornered in international crisis meetings, and these are by no means reassuring. The rally resumed briefly when the German parliament voted with a surprisingly strong positive margin (523 yes to 85 no) on earlier plans to extend the scale and scope of the EFSF on Thursday, but when the dust settled, the euphoria quickly receded.
German public opinion is firmly against any "leveraging" of the European Financial Stability Facility and both Wolfgang Schäuble, the German finance minister, and Philipp Rösler, the economics minister, set their stalls out against any such extension as the Bundestag voted 523 to 85 to increase the EFSF's available funds to €440bn (£382bn). The vote approves the increase of Germany's guarantees from €123bn to €211bn. Schäuble said any further increase, mooted after last weekend's IMF meeting in Washington, was "out of the question". [The Guardian]
When you read that figure about the magnitude of German guarantees (€211bn), it becomes 'somewhat understandable' that they don't want any furter increases and indeed, when Schäuble was asked what he thought of this idea he said:
I don't understand how anyone in the European Commission can have such a stupid idea. The result would be to endanger the AAA sovereign debt ratings of other member states. It makes no sense. [The Telegraph]
That is pretty strong stuff and the question remains whether circumstance will force him to eat those words.
Crisis largely of its own making
However, one also has to understand that Germany, as the region's most successful exporter, has gained the most from the euro. Also, they have been most obstructive when it comes to solutions, which is at least partly the reason why we're at the edge of a precipice right now.
Not only are they against the introduction of eurobonds, or ECB buying up bonds, they are the ones most insisting on the counterproductive type of austerity now slash-burning the Greek economy into a depression where prospects of stabilizing its public debt/GDP ratio become ever more elusive.
'Private sector involvement'
Collectively, The euro-area public deficit and debt figures are actually better than either those of the US or Britain. Interest rates in many peripheral countries are much higher than those in Britain or the US. There are two reasons for that:
- No implicit central bank guarantee for public debt of members of the euro area
- The insistence on 'private sector involvement' (PSI) for Greek debt.
Let's start with the latter. Problems within the euro only really started to hit the market when, on Germany's explicit insistence, and against much opposition (most notable from ECB president Trichet), talks of a 'haircut' for Greek bondholders (mostly banks) became public. This spooked the markets and opened a new front in the euro crisis.
Plans for such 'public sector involvement' (PSI), as this was called, date back to a meeting on October 18 2010 in Deauville where Sarkozy and Merkel not only hatched the plan for a permanent emergency fund, but also the idea of PSI. Word has it that Jean-Claude Trichet, the president of the ECB, goes to every meeting armed with a graph displaying interest rate differentials, which began to diverge just after that day in October, which is marked by a little flag 'PSI' in Trichet's graph.
It culminated in the second bail-out for Greece (July 21st of this year) which introduced a 'PSI' in the form of a one-off 21% voluntary haircut. The cat (the possibility of default on public debt within the euro area) was out of the bag, despite insistance that this was a one-off, would not be repeated, and was entirely voluntary.
One has to realize that in a country which has its own currency, the central bank can always issue currency to pay back the bondholders. In other words, a country issuing its own currency can never go bankrupt, but the same is not the case for a country within a monetary union, there is no implicit central bank guarantee for its public debt, which was now all the more likely after the 'Greek haircut.'
This realization didn't take long to sink in for the markets. The very next day, a sell-off in sovereign debt of countries which might also default, like Spain and Italy, began in earnest, as is clearly visible in the figure below.
Almost from one day to another, sovereign debt changed from being one of the safest asset classes to something like a hot potato, at least for a considerable number of countries.
It can only have been national political expediency in Germany (and the Netherlands) why they insisted on a Greek 'haircut' that has now led to investors fleeing not only Italian and Spanish sovereign bonds, but also French, Italian banks (well actually, most banks in the EU and even beyond).
And in the end, the insistence on PSI is not saving the proverbial tax payer anything; quite the contrary. They had to guarantee tens of billions of euros to the ECB, because Trichet predicted what was coming, large scale bond purchases of southern countries and propping up banks with large bond portfolios. Worse, it has led to a crisis of potentially epic proportions, and trying to stem the tide now will cost much, much more.
PSI has been an unmitigated disaster. It led to a crash in Greek debt, with American hedgefunds buying it up for 30-40 cents to the dollar for a quick buck when they put it up for the official program at 79 cent for the dollar. Greatly embarrassed by these developments, the Germans (and Dutch) now want a much larger haircut for Greek debt. This could trigger banks falling over and ultimately a systemic crisis for which there won't be a solution because the Germans are against any.
They don't want eurobonds, they are against any ECB bond buying, and they made strong statements against expanding and/or leveraging the EFSF.
Basically, they are throwing oil on the fire and taking away the fire extinguishers. It's inexcusable. Whether the strong talk against any further expansion and leverage of the EFSF is just that, talk, aimed at placating a domestic electorate that is very wary about the whole bail-out, really remains to be seen.
It is still not entirely impossible to save the euro and the dire consequences of a break-up. Probably the best route is for direct ECB debt monetization, we really don't see any viable alternative.
But the truth remains, while being the biggest beneficiaries of the euro, Germany and the Netherlands have couched the whole eurocrisis in the wrong terms; those of profligacy and financial rectitude. In doing so, they have forced the wrong solutions and blocked better ones, all the while making a crisis of epic proportions ever more likely or the cost of avoiding one ever more expensive.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.