1 Week To Save The Euro?

Includes: EU, FXE
by: Shareholders Unite

Here is Italian Prime Minister Mario Monti:

There's just one week left to save the euro - at least according to Mario Monti, the prime minister of Italy, who made the prediction ahead of the European summit that takes place on the 28/29th June.

Here is George Soros, agreeing:

Billionaire investor George Soros called on Europe to start a fund to buy Italian and Spanish bonds, warning that a failure by leaders meeting this week to produce drastic measures could spell the demise of the currency.

All very well but this sense of urgency isn't not shared by everyone. Here is European Central Bank (ECB) Governing Council member (and head of the Austrian central bank) Ewald Nowotny:

The euro will survive even if Spain were cut off from capital markets, European Central Bank policymaker Ewald Nowotny said, adding the currency was in solid shape despite financial problems in some member countries.
We have to prevent this situation. But even if Spain could not finance itself it would not automatically mean that it would exit the euro. There is no nervousness about the euro itself, just about individual countries.

Who is right? That question is rather important. If Nowotny is more right than Monti and Soros, then there is time to set the wheels in motion towards more fiscal and banking union, and those moves could, we say could, have a stabilizing effect on the markets. But even those moves are far from straightforward. They face two sets of problems:

  • The political leaders have to be able to come up with a solution, that is a compromise
  • They have to be able to get it through national parliaments

Debt collectivization
The euro area as a whole doesn't have worse public finances than the US, the UK, or Japan. These countries, while not without problems, are facing record low interest rates on their public debt, despite the enormous debt outstanding and budget deficits.

The main reason for that is that these countries are in a balance sheet recession where the private sector is deleveraging, so generating excess savings. Excess savings are also generated in the euro zone, but because there is no exchange rate risk, these move around in a particularly unhelpful way.

The euro zone is like a ship that is dangerously inclining in a storm, all the passengers run to one side making the problem worse, that is, capital is fleeing where it's most needed (the periphery) to where it's least needed (the center). If only the ship can be steadied the euro zone would be like these other areas, Japan, the US, the UK.

But there is a design fault in the euro area. Some argue that it was a bad idea anyway, to join countries which have such diverse stages of economic development and productivity levels. But this isn't really the core problem, as Krugman (not a fan of the euro) points out.

Sure, Greece and Portugal are relatively poor, with GDP per capita of 82 and 77 percent, respectively, of the EU average; this means roughly 76 and 71 percent of the eurozone average, since the euro countries are a bit richer than the EU as a whole. Meanwhile, Germany is at 120 percent of the EU, or 112 percent of the EZ. But it's no different, really, than the US situation (look under per capita GDP). Alabama is at 74 percent of the US average, Mississippi at 67, with New England and the Middle Atlantic states at 118 and 116.

The problem is that the design behind the Monetary Union (the Maastricht Treaty) that gave birth to the euro is a bad one. Here is Krugman explaining one of the problems:

The difference, mainly, is that we think of ourselves as a nation, and blithely accept fiscal measures that routinely transfer large sums to the poorer states without even thinking of it as a regional issue

Such redistribution isn't possible in the euro zone as there is no large Federal state which would automatically redistribute funds from booming regions (where tax receipts are bountiful and subsidies low) to states in crisis (the reverse).

The euro area counterparts are the bailout funds and the Target 2 system, but these are credit systems, not automatic redistribution. The receivers of funds have to pay these back, in the case of the bailout funds with interest.

There is no obvious way to solve this design fault as one cannot create a big Federal euro zone state overnight. But there are things that would have a similar effect:

  • Eurobonds
  • ECB lender of last resort
  • EFSF/ESM sovereign bond buying (preferably by giving the ESM a banking license so that it can borrow cheaply from the ECB)

Now, all these would provide a solution insofar as it would make betting against sovereign debt in most peripheral countries rather unattractive. But it would also mean debt mutualization, which creates:

  • A redistribution of resources from the center to the periphery
  • A moral hazard problem, where countries do not face the full consequences of public borrowing

The possible problems are already quite substantial. Economist Charlez Wyploz:

The crisis has engulfed three small countries - Greece, Ireland and Portugal - and is now on its way towards Spain and Italy. France might well be next. These six countries' public debts amount to 200% of German GDP. With its own debt of 80% of GDP, Germany cannot indeed stop the rot.

Let alone when incentives to control public spending are loosened. This is why the center countries, like Germany, the Netherlands, Austria, Finland, are dead set against it. They want a fiscal union first, in order to guarantee that the periphery will behave after debt has been collectivized.

Fiscal union
A fiscal union involves the control mechanism by which the center countries can minimize the above moral hazard problem. That is, some Budgetary Euro 'Czar' will be created which has far reaching powers to control national budgets. Yes, this involves giving up a large degree of national sovereignty. There are two sets of problems with this:

  • The legal form of the measures
  • The political problems

Legal problems
Transfer of sovereignty on the scale needed requires Treaty changes, giving even non-euro members (10 out of 27 EU members) a veto. Clearly this has a very slim chance of working. Even in the remote case that the politicians agree, many countries will likely organize referendums.

Few constituencies can be counted upon to vote for a massive transfer of budgetary powers just to save the euro. Dispensing with a new Treaty isn't likely to provide a solution either. We've seen what the rules limiting public finances did.

The first rule, the Stability and Growth pact, was violated by France and Germany. We can sort of understand investors who are not terribly reassured by the Fiscal Compact, the latest ploy to put an upward limit on public finances.

If the euro zone goes down the route towards a fiscal union, a separate Treaty with the willing and able will be the only way. It really remains to be seen whether such a project can fly. We're highly skeptical ourselves.

Economic necessity versus political expediency
Having the EU or some related authority encroach deeply on national sovereignty isn't a vote winner. As Jean-Claude Junker, the Prime Minister of Luxemburg (and long-time euro participant) has noted after yet another summit, "everybody knows what to do for a strong euro, but we all know that these are no vote winners."

The Dutch press had stories over the weekend about Prime Minister Mark Rutte, who has quickly build a reputation in Brussels for opposing just about every possible solution. His motives are also not hard to understand. Dutch elections are near, and euro criticism is rife from the right (Wilders) as well as from the left (a resurgent socialist party).

Although German elections are not until next year, but Merkel is facing similar problems. There are two things in her favor though:

Der Spiegel has published an internal ministry report that estimates a breakup would cause German unemployment to double, and GDP to contract by 10 percent. [Yahoo]

And that hasn't covered all cost:

According to the IFO institute, German losses via all European bail-out funds if the GIIPS countries were to default amount to €704bn. [Telegraph euro blog]

Before the Greeks think they have the Germans over a barrel, they'll have to think again. These costs are for a scenario where more of the GIIPS countries leave the euro, not just the Greeks. That cost is probably manageable, as long as it doesn't force other countries leaving also (because it triggers bank runs, investor strikes, etc.).

A useful first step, a banking union
If a fiscal union is a bridge too far (which it almost certainly is), a banking union could help stabilize the markets, at least for now. Here is what the Wall Street Journal's Euro crisis blog considers a "good package" for this week's euro zone summit:

A good package would be agreement on a banking union, including a pan-euro-zone supervisor, a deposit guarantee scheme and a bank resolution authority, plus permission for the ESM/EFSF to recapitalise banks directly.

Hurray for that! And this is very, very necessary. Consider the following:

Open Europe warns that Spanish house prices may drop another 35pc.
With Spain facing funding costs of €548bn over the next three years, the eurozone's bailout funds are not equipped to handle a Spanish rescue. [Telegraph euro blog]

Imagine what such a house price fall would do to the balance sheets of Spanish banks and consider that funding problem of the Spanish state, and you'll realize that rescuing Spanish banks via the Spanish state (which has just occurred to the tune of 100B euro max) is an extremely stupid idea.

We need a euro zone TARP. Actually, we needed that three years ago. It could very well be too late already. But, according to some, we have at least another week..

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.