So many meetings have happened in the last months around the topic of the European crisis, and we still have this crisis well alive. Let's try to understand what this crisis is, and what possible outcomes it has.
Nature of the crisis
The reasons why we have this crisis can be summarized in a few key points:
- The eurozone area was created without political union. The euro was a logical continuation of the European free trade zone. But the hurry to collect the economical benefits from the euro has blinded the Europeans leaders about the fundamental instability behind a political-less euro. We can even call the euro an "integration bubble". Many pundits say that Europe needs a fiscal union. The reality is that any currency is a tool of economic war, and therefore has a high degree of political value.
- The bursting of the 2008 financial bubble in the US has hit hardly investor confidence, leading to a more aggressive stance on deficits as well as currency wars between central banks. There is clear war between the euro and the dollar for the status of the world’s main reserve currency.
- Many European nations have been living above their means. This is not something new, but this time, these countries have found themselves hog-tied by the euro. No monetary policy to rescue them. Just permanent bail-out discussions.
These reasons have led to a situation where many countries entered the euro, did not control their deficits and were hardly hit by the US housing crisis and a strong euro. Today, there is a lot of bad debt in the eurozone, and nobody wants to pay for it. The indecisiveness of the European leadership has been lasting for more than a year. And the longer it lasts the higher the bill. Spain and Italy are currently borrowing at a rate higher than 5%. This means that their debt to GDP ratio is sharply growing and that they are headed at great speed toward insolvency. What is currently happening? There are attempts to leverage the EFSF instead of simply increasing its nominal size. Why? Because parliaments will most likely reject an EFSF increase and ask indebted countries to default. The idea of leveraging the EFSF speaks by itself of the situation: nobody wants to take this bad debt.
Based on who is going to pay the bad debt, there are three main scenarios described below on how the euro crisis will evolve. Even though a great deal of pressure is put on Germany, we do exclude a scenario where Germany and other healthy economies of the eurozone would accept to fully pay the bad debt. Merkel has very clearly rejected Eurobonds.
1. Germans say "Basta!" and then money printing à la FED
From our point of view, this is the main scenario because we do not believe that the deficit reduction programs in place will be strong enough to stop the bleeding. When the heat and risk will start to be too high for Germany itself, we expect Germany to take decisive actions to cut the propagation of the deadly epidemic. Since it will not be able to throw out of the eurozone indebted countries (too many of them), it will have to step down from the euro. Rumors already circulate that fresh Deutsche marks are being printed “just in case.” The Dutch, the Fins, the Austrians will follow immediately.
This high risk moment for Germany will be when its own debt financing will start to become problematic and its own banks will be on the brink of collapse. The second condition is already true; however, the yields on the bunds have stayed so far low. Today the 10-year yield of the German bunds has started growing again from record lows. We will probably witness the German reaction when the yield will move sharply above 3%. Most economic actors will be startled by the German decision and a dramatic drop in the value of the euro will follow.
Germany will suffer from a very strong Deutsche mark, because many people will exchange their euros for marks. Plus the price of turning back to marks (change of all the system) will take away several percentage points from the German GDP. In this scenario, Germans will pay only for the losses incurred by their banks and their devalued EFSF money.
The countries that would stay in the euro, and France at their head, will launch euro bonds or give a banking license for the EFSF, and start printing money to solve all their problems. Such a currency devaluation could lead EUR/USD pair to go below 0.8. All the countries that would stay in the eurozone will become poorer as a whole.
2. Defaults are allowed and weak countries leave the euro
This is the scenario where the euro stays a currency of the north. Basically, in this scenario, we would see countries exiting the euro one by one: Greece first, then Portugal, Ireland, Spain, and maybe Italy and Belgium. Why is this scenario unlikely? Because it is already too late for that. There is also an element of pride here. One of the reasons this crisis is still alive is the inability of the top European leaders to recognize that the political consensus behind the euro has vanished. The main European leaders don't want to face the reality that Europe is too heterogeneous and that the European idea has lost a lot of its political momentum. Just remember how the European constitution was handled.
The main sign that we have entered this scenario is a "let go" of Greece. This could lead to a long term strengthening of the euro. EUR/USD could head again towards 1.6 and higher. Such a scenario would lead to fewer perturbations in the world economy. In this scenario, the indebted countries would pay the most. The bail-out of European banks would cost some money to the core as well.
3. Brutal government downsizing and massive social unrest
This is the least likely scenario. All the European governments would start cutting their budgets harshly to go back into deep budgetary surpluses. Major social programs would be stopped and armies of public employees fired. Such harsh savings would allow stopping the financial bleeding. And since no further bond emission will be necessary, yields will be falling. To reach a surplus, the budgetary cuts would need to take into account the loss of fiscal revenue from economic deflation. We are speaking of reducing government budgets by a third or a fourth. This would lead to social unrest and political instability. This in turn would damage the reputation of these European countries and prolong the period of economical recession. The euro would stay volatile in such a scenario.
In this scenario, the poor layers of society in the indebted countries would pay the most. Usually this leads to fascist style governments.
What to watch for investors
The next upcoming event is the rise of strong tensions at the heart of the eurozone between the Latins (France, Italy, Spain, etc., or "the money printers") and the Germanics (Germany, Netherlands, Austria, etc., or the "value keepers"). The rejection of the EFSF boost will be the key trigger of these tensions.