The Eurozone Mess Deconstructed: Germany's Legitimate Concern

by: Philip Mause

Once again, the dominant news affecting the market has been the Eurozone, possible defaults, and fears of a consequent financial meltdown. To understand what is going on and what is likely to happen, it is necessary to back away from the Eurozone and examine the other leading sovereigns. If we understand how sovereign debt works outside the Eurozone, it will give us a much better picture of what is happening within the Eurozone.

As a general matter, outside the Eurozone, sovereign debt denominated in the currency of the sovereign bears little or no default risk. This is not because sovereigns outside the Eurozone are more fiscally responsible or have a lower debt to GDP ratio than, say, Italy. Instead, it is because, outside the Eurozone, the central banks have a limitless authority to print currency and can purchase sovereign debt denominated in that currency to avoid default and, indeed, to reduce the interest rate the sovereign pays on sovereign debt. Japan has an enormous debt to GDP ratio, faces the fiscal problems associated with an aging population, and has shown no tendency to pay down or reduce its debt. It pays ridiculously low interest rates because the Bank of Japan has set the rate at a low level and everyone knows that the Bank of Japan will buy bonds in the market to keep rates at that level.

Because the sovereign is able to issue debt and avoid paying a risk premium and because the central bank with its limitless ability to print money backs up that sovereign debt, the sovereign is perceived as a reliable guarantor of deposit insurance. Thus, bank runs can be obviated by deposit insurance because depositors know that if all else fails, the sovereign will pay off the deposits by, if necessary, borrowing money using bonds which, if necessary, will be bought by the central bank using, if necessary, newly printed money. Because of these perceptions, the measures referred to above are almost never "necessary" because there aren't bank runs and, even if there are, the sovereign can sell bonds in the private market.

What I have written above is descriptive and not prescriptive. I am not saying that this is the best possible system nor even that it is necessarily better than, for example, the gold standard. But the fact that it is the system in the rest of the developed world has a big effect on the Eurozone. The reason is that the above described system provides easy, safe havens for money - readily available opportunities to park money with zero risk. Again, this may or may not be a good thing, but the fact that these havens exist has a huge effect on the dynamics of the Eurozone.

The reason is that the Eurozone is different. Sovereign debt is not in a currency totally controlled by the sovereign and is typically not purchased directly by the central bank. There is, thus, risk of sovereign default. And if there is risk of sovereign default, then deposit insurance backstopped by the sovereign is much, much less reliable and is really no insurance at all. And with readily available, totally risk free havens all around the world where money can easily be parked, it is not difficult to see what will almost inevitably happen.

Now, the system in the rest of the world has a problem. Money is in a sense a purely articificial creation of the sovereign which could, if it so desired, print an infinite quantifty of such money and render it worthless. This very thought is disquieting. Unless discipline is utilized both at the treasury and the central bank levels, there is, thus, a terrible danger of inflation. Of course, those harmed by inflation are the citizens of the sovereign whose treasury and central bank failed to behave in a responsible manner.

The fear of this inflation will hopefully breed caution in the money printing exercise and will hopefully lead to a reasonable set of policies. And if it fails to breed such caution, the pain associated with the inflation will be felt by the citizens of the sovereign itself and may lead to corrective policies. In the United States, we can already see this debate about the dangers of inflation versus the need to stimulate the economy with large deficits in our political system and, every day, on this website.

This is where the problem comes in for the Eurozone. It is almost inevitable that the Eurozone will evolve into a system in which the ECB will directly or indirectly take default risk out of at least a great deal of the sovereign debt. This will also allow sovereigns to provide risk free deposit insurance. The Eurozone will have to do this, not because it is necessarily a good thing, but because the rest of the world is set up this way and, if the Eurozone continues to try to be different, capital will flee, sovereigns will pay ruinously high interest rates to speculators and the economy will be dormant.

The problem is that the "check" on the tendency to run huge deficits and print too much money, the brake on the system, will not be there. Because the deficit run by, say, Portugal will lead to a certain amount of inflation throughout the Eurozone and not just in Portugal. So that Portugal will not have a sufficient incentive to be responsible over the course of an entire economic cycle. A Tragedy of the Commons scenario may emerge in which the failure of sovereigns to bear the full costs of fiscal irresponsibility will lead to a systemic breakdown and high inflation. I think that this, and not "having to pay off the debts of our neighbors" is a legitimate concern for Germany.

There are a number of possible solutions, one of which is that Portugal's spending may lead to more inflation in Portugal than in the rest of the Eurozone and thus lead to a political dynamic more similar to that outside the Eurozone. Another answer would be a Euro Treasury which lent to the sovereigns and penalized fiscal irresponsibility. The Euro Treasury's bonds would be periodically bought by the ECB and would be free of any default risk. There is no answer which is really perfect and there will likely be considerable flailing around with progress occurring only if and when a financial disaster looms as the only alternative.

Despite the seemingly good news this weekend, I think we will twist in the wind with this one for a while. During this time, the best place to be is blue chip, dividend paying companies that are either self-financing or have only trivial needs to approach credit markets. My favorites are Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), Apple (NASDAQ:AAPL), Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG).

Disclosure: I am long MSFT, INTC, AAPL, JNJ, PG.