The Euro zone crisis will remain the largest threat to economic stability and growth in 2012. The four options for the current situation have been thoroughly discussed at seekingalpha.com and elsewhere: complete (or at least fiscal) integration, complete breakup, weak members leave the Euro zone or strong members leave the Euro zone. In the following I'd like to discuss the fourth option and contradict the conventional wisdom which forecasts total disaster for Germany and the fiscally stronger countries if they should leave the Euro zone.
Why the first three options are not viable
1) Complete Integration
Even if the willpower were in place (anybody care to execute referendums?) the political process itself would take a decade. The European Union is a body of 27 members and the Euro zone a subset of 17 members all with strongly differing cultures and languages. They are neither ready nor willing to take this step. Especially not after the dishonest conduct of multiple members. There is no basis of mutual trust.
2) Complete Breakup
The sovereign bonds in question have been tendered in Euros. Any nation leaving the Euro zone would produce income in its own national currency but then be forced to buy Euros in order to service its debt obligations. Should all members leave the Euro it would render the Euro currency baseless since there would be no underlying national economy to define its function and value. The damages in this scenario would be especially felt outside of the Euro zone for those countries which have collected Euros into their currency reserves.
3) Weak members leave
A return of a weak member to its own national currency combined with a strong depreciation of its value would multiply the effect of its debt burden. Either the economy is strangled for years to come or substantial haircuts would endanger the existence of European banks, those banks which were instructed to use these pieces of paper as Tier 1 capital reserve. The effect of credit default swaps (CDS) would cause secondary waves of losses to the sellers. No one can bail out Italy. And even Spain with more than 700 bn Euros estimated public debt in 2011 would be a huge pill to swallow. The heavily indebted countries are stuck with the Euro and their Euro-denominated debt whether they like it or not.
4) Strong members leave
In contrast to the weaker members (let's define weak as >90% debt-to-GDP ratio, see chart below) a strong member, e.g. Germany, could leave the Euro zone and would have a different worry altogether, i.e. currency appreciation. (On a side note, I personally find it difficult to speak of a fiscally disciplined or strong Germany when its public debt-to-GDP ratio is above 80% and therefore well above Maastricht treaty limits.) But this scenario offers options with benefits for all parties involved. This is a scenario which offers hope for the future.
Why Germany, Austria, Netherlands and Finland (GANF) should leave the Euro zone
Imagine a group of stronger members DEU, NLD, AUT, FIN leave the Euro zone and the weaker members PRT, ITA, IRL, GRC, ESP, BEL remain. We will come back to France later. The following paragraphs list reasons and methods how this could pan out peacefully and beneficially for the countries involved.
a) The GANF countries can manage a strong currency
The main argument against scenario #4 is the expected appreciation of Germany's currency. Yes, it would be in strong demand by other nations who need to diversify away from the Euro and citizens from Euro zone countries. And yes, nominally a strong German currency would put its economy at a disadvantage. On the other hand having your own currency puts the fate of your country back into your own hands, something the PIIGS countries are desperately missing but currently cannot afford.
Germany has successfully managed its economy for many decades despite a continually strengthening currency. In the 1960's one USD could buy 4 German marks. By 1986 the exchange rate had dropped to 2.70 DEM. The Euro's zenith in April 2008 at 1.60 USD can be translated to 1 USD = 1.22 DEM. A return to its own currency would pose a challenge but not an existential threat to the German economy. Worst case the German Bundesbank could employ Swiss methods, i.e. peg the currency exchange rate.Assuming a role as currency reserve It also can afford to print more money than would effectively show up in its own national circulation, a benefit the USA has enjoyed for many decades.
The arguments apply for the other strong members as well. They have products and services that other economies need and they also thrived in the post-WW2 economic environment. Possibly they will agree with Germany to use the new German mark for the time-being. It may be less expensive than reactivating and operating their own currencies in the short term. Such countries could wait for more stable times and then revert back to their own money if necessary.
b) The North can pay its debts down
Since any indebted member of the Euro zone must repay its debts in Euros, the stronger members would enjoy an additional benefit from leaving the Euro. They can produce income with their new strong currencies and buy Euros "on the cheap" to pay off their old debts and therefore substantially reduce their nominal debt-to-GDP ratio. This historical twist of fate also offers these countries a rare chance to clean up their balance sheets. A fresh start just in time before pension obligations induced by the demographic curve come due in major proportions. (Side note: Why doesn't anybody learn anything from Australia's debt pay-down and retirement system reform in the 1990's? You never hear reports about this in mainstream media or elsewhere. Their success is so blatantly ignored by developed countries.)
c) Brighter future for the South
Once the stronger members have left the Euro zone the weaker members truly own the Euro. And they can finally do what is desperately needed and greatly depreciate its value so that the competitiveness of their economies is increased. This offers the potential of new growth for these suffering economies. A depreciation of the Euro currency would put labor costs in these countries into a healthier perspective. Manufacturing jobs might be relocated back from the Far East to Southern European countries, near-shoring could gain a whole new meaning. Not to forget these countries remain important trade partners for the rest of Europe and many other parts of the world. The Northern European countries have a vested interest in a healthy and stable Southern European environment.
There remains the off-chance that Ireland exits the Euro as well and tries to grow its way out of the issue. Its dedication to austerity and reform has been tremendous. Possibly a mild haircut can get them on their way with their own new currency.
d) France - Leader of the Pack?
The exit of strong members will create a pivotal decision point for France. Of course the French self-perception is one of strength and leadership; it remains a permanent member of the UN Security Council. Yet during the tenure of the Euro zone it has maneuvered itself into an extremely weak position. Its debt-to-GDP ratio is growing quickly towards the 90% level and its banks are dangerously exposed to the sovereign debt issues in the South. The generous social entitlements of its citizens are weighing down on public coffers. It could make a decision to leave the Euro zone and join either a strong Northern currency group or re-introduce its own currency. On the other hand it could remain in the Euro zone and by default increase its leadership role within the zone and therefore within the EU. By acting as a counter-balance to political leadership in Spain and Italy, more often than not it could speak for more than half of the EZ’s current GDP (which would amount to ca. 5.5 trillion Euros) compared to Germany’s 2.5 trillion. One might argue that France’s fiscal behavior in the last century consisting of “government-led” industrial policies might fit better into a system where the currency serves the purpose of the government (devaluing debt by inflation, manipulating the currency exchange rate) and not of the populace (price stability, wealth preservation). But in the end I assume that the French tendency towards independence will prevail and they too would leave the Euro zone. Italy and Spain would thereby assume the leadership roles in the downsized Euro zone.
e) What about the rest: LUX, EST, SVN, SVK, CYP, MLT?
Each country will have to make its own decision. Luxemburg and Estonia would be obvious candidates for an exit from the Euro zone, possibly adopting their own currencies or using a new German mark. Cyprus has its own special issues to take care of and would probably stay in the zone. Their vicinity to Greece might affect this decision. Malta, Slovania and Slovakia will need to decide if they want a stronger or weaker currency for their own futures. It’s another fork in the road for their economic future. Estonia, I really feel for Estonia. They went through all the preparation and tough reforms and arrived just in time for the end of the party. Now the hangover is starting to set in and they haven't had any drinks yet.
Politically speaking, the above described scenario may seem brutal and possibly not actionable. The Euro is a political currency after all. The overall impression would be that the strong economies improve their strength by leaving the Euro zone and nominally reducing their debt load; the weaker ones would feel left behind (and possibly stigmatized) with their mountains of debt and struggling economies. It wouldn't seem fair, now would it?
Yet one way or the other these countries must face the consequences of their own political decisions and lifestyles. Nobody forced these highly indebted governments to take money from the banks. On the contrary the secret currency swaps as performed by the Greeks were premeditated, it is populism to blame the bankers involved instead of laying responsibility on public officials who acted with deliberate intention. Fiscal discipline includes refusing short-term pleasure and sparing future generations long-term pain. Yet the scenario described above offers these countries a chance to grow out of the situation.
A desirable long-term effect could be the demonization of debt in general. Imagine a generation growing up with a frugal attitude and then marching through the institutions, quickly downsizing governments to lean and efficient organisms serving the people and promoting growth economies. Unfortunately the social systems in place and the entitlement mentality induced by the education in Europe will hinder such developments. But the thought is tantalizing.
Debt indulgence always leads to a day of reckoning and the one for the USA may be the theme of 2013 and beyond, especially after Europe has resolved its situation. If Europe should solve its problems with some sort of healthy perspective for its own future than the focus of financial markets will return to the steadily increasing position of government debt in the District of Columbia and the other 50 states. The solution options for this situation might be even more difficult than in Europe.
|General government gross debt as apercentage of GDP|
|Source: International Monetary Fund, World Economic Outlook Database, September 2011|
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.