Reading the tea leaves on the future of the euro requires adherence to that old mantra: Forecast early and often. The moving parts are so many and so capriciously balanced that visibility is difficult. Nevertheless, if we are willing to look dispassionately, we can see some elements coming together. And I think they do not spell the end of the euro or the end of the EU, either or both of which many of my colleagues at Seeking Alpha and elsewhere are predicting (see, e.g, Felix Salmon’s analysis here). The fundamental document of the moment is the European Council Press Release dated December 9, 2011 (see here). A second excellent source is the ECB President’s press conference of December 8, 2011 (available here).
Though elements of fantasy remain, the steps being taken are not merely more “extend and pretend”. These current steps are beginning to address the fundamental problems of the euro architecture.
The resulting governmental structure may not be ideal. And it may violate the economic or social principles of many Americans and Brits. But it is not our government. The process now going on has reminded me of an experience 20 years ago as chief of staff of an governmental advisory committee on international banking: Many of the participants made a great deal of the idea of “harmonization” of rules. At the time, I thought this was euphemistic talk about doing nothing much. I now see the great difficulty of melding the rules and traditions of many cultures that have existed in conflict with each other for centuries. The process of bringing those cultures into closer cooperation for the greater benefit of the whole is extremely ambitious. It is political as well as idealistic, and involves power politics as well as softer versions. In some respects, the harmonization of rules and processes is more important than whether the rules and processes are optimal.
Here are my guesses as to where the euro and the EU are headed:
- First: Germany and France have made it clear that they are going to stick together in the euro. I believe them. Whoever wants to follow is welcome to stay. In practice, this is likely to mean that almost all the 17 nations of the eurozone will remain. Some of them may have to drop out because of internal politics that their leaders cannot overcome, but that is likely to be a small number. All 17 leaders have signed on to the communiqué, with some reserving commitment based on specific national requirements. If some nations do not approve, it seems they will be invited to leave, though by what mechanism I do not know.
- Second: The Treaty changes and related legislative actions that the leaders have committed to have substance, and they will change the way that the countries of the zone are governed. This will be a real cession of an important piece of sovereignty to the bureaucracy of Brussels and will tend to further politicize that bureaucracy. Although from earlier reports it appeared that the fiscal compact might be all stick and no collaboration, it now appears that collaboration will be required; to what extent it will take place remains to be seen.
- Third: Germany and France—and those nations that join them in this effort—will provide significant assistance to Italy in its efforts to regain the market’s confidence. But they will not do so in any way that jeopardizes their own economic standing, except to the extent of specifically approved amounts. If Italy nevertheless cannot regain the market’s confidence, then it will have to try to make an orderly restructuring of its debts, and as part of that process may or may not leave the single currency. Italy is important, but France and Germany will not allow Italy’s fate to determine their own continued participation in the single currency and single market. (Spain probably follows along with Italy, though not necessarily.) Can there be a euro without Italy and Spain? “Yes” probably is the answer. Though such a large participant leaving would be a logistical nightmare, it would be less of a nightmare than dissolving the whole concept. I believe that Germany and France will do everything they can to keep Italy and Spain in the euro, since low-cost competition for their products from within the single market would give them serious internal political problems.
- Fourth: It is possible that loans to the banking system will cause losses to the ECB. If there are losses, I believe the nations remaining in the euro will stand behind their central bank.
- Fifth: The UK and other EU countries that are not in the euro are likely to remain in the EU to take advantage of the single market. They are likely to demand some rearrangements of the various EU subsidy payments in light of the tightening of fiscal oversight in the eurozone, and, eventually, they are likely to get some concessions in that regard, since their presence in the single market is useful to all members of the EU.
- Sixth: To the extent that countries that are weaker financially drop out of the euro arrangements, the euro should appreciate, with the logical consequences of such appreciation.
- Seventh: The ECB will do its utmost to save the European banking system. The European banking system is—and for a long time has been—undercapitalized. How undercapitalized depends on the future of European sovereign debt, and therefore the degree to which central bank funding can make a real difference is limited. The European banks are now under an injunction to raise 115 billion euros of additional regulatory capital (see here). Although that is a substantial amount, it probably is at the low end of what is required. How they will raise that capital I do not know, unless they can reduce their exposure to European sovereign debt, which, obviously, means selling and bringing more pressure on its pricing. It appears that European banks already have sold a net 65 billion euros of sovereign debt over the last nine months. Some of them likely will continue that trend, although it is possible that some others will increase their holdings, as some German Landesbanks and some Spanish banks have done recently (see here).
Quel mess! Nevertheless, many European banks will survive. Some will be owned by the state and effectively guaranteed by the owner nations. Those that fail will, if they are large, pose grave questions for their national governments. Cf. Ireland and Iceland. But one way or another, I see the ECB and the national central banks funneling enough money to the surviving banks to prevent credit from seizing up entirely. Europe, unlike the U.S., relies almost completely on banks for business and real estate financing.
- Eighth: The ECB will not violate the spirit of the Treaty under which it operates. But it will play a strong role in effecting purchases of sovereign debt from time to time, and it will do whatever else it might take to maintain economic stability in the eurozone if there is a period of adjustment due to either the default or the transfer of a country out of the zone. We should note that European banks now will be able to borrow at a low rate for three years. They could invest in sovereign debt of their own country. As a consequence, the FT reported (see here) ,
Nicolas Sarkozy, French president, on Friday outlined what he expected would happen as a result of the central bank’s move.
‘Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.’
Thus, one can see a variety of near-term measures coming together to reduce pressure on Italian bond yields.
- Ninth: I wish I knew what it means to declare the Greek haircuts a one-off but maintain that the same language that permitted the Greek haircuts must remain in all eurozone sovereign debt documents. I guess this is a fudge, since an absolute commitment most likely cannot be maintained in an extreme case.
- Tenth: Whether Italy and Spain can get their fiscal houses in order is not likely to be determined in a week or a month. Their fiscal crises are likely to play out over many months, if not years.
In conclusion, I do not believe the eurozone is headed for Armageddon or collapse. Some nations may leave the euro because they cannot find any other way to get back into fiscal balance, but the zone will remain a vibrant economic unit. The EU also will remain, increasingly as a separate concept related to the single market. Most nations that remain outside the euro will not be hurt by these arrangements, since they will retain their flexibility. Nations that leave the euro and have to restructure their debts and their currencies probably will go through a few years of significant hardship, but they, too, eventually may flourish. All this will take quite a long time to play out, and, in the short run, the economies of the eurozone are likely to contract. For investors, there will, as usual, be ups and downs, but longer-term, I believe the adjustments, although now only faintly seen, will be beneficial to global business. Timing, as usual, will be everything.
Dr. Pangloss and I have a pact not to compete with each other.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.