My Diary 726 --- What are the possible outcomes? How to deal with the Greece exit? What are lessons from history?
Wednesday, June 06, 2012
“Now what: To break-up or To fiscal union” --- I want to devote this diary into the research of the whole European saga which has been the nightmare for investors over the past 18 months. That said, despite all of the hype in the press, today's emergency G7 call to discuss the latest flare-up in the Eurozone sovereign debt crisis and its implications for the global economy was a non-event. A European diplomat told the FT that the call was a general debate that included the financing needs of Spanish banks and Greece's 17-Jun repeat election. However, another European official briefed on the call told the paper that a potential Greek exit from the euro was not even discussed. The WSJ cited comments from a US Treasury official who said that leaders discussed Europe's efforts to resolve the crisis, including progress toward a fiscal union.
“As the time passed by, the crisis is getting ever deeper. Tensions in financial markets have risen to new highs as shown by the historic low yield on Bunds. Even more telling is the fact that the yield on British 10 year bonds has never been lower in its 300 year history while the risk premium on Spanish bonds is at a new high. The real economy of the euro zone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give…” On that note, George Soros gives an ultimatum of 3 months for the Germans to solve the problem.
Indeed, the focus continued to revolve around Germany's demand for a real fiscal union before measures such as pan-European banking resolution and deposit protection scheme can even be contemplated. However, the market remained concerned about the extended timeframe surrounding such an ambitious integration plan, while there were also worries about the opposition on the part of some member states to relinquishing sovereignty over national budgets. Reuters, citing a government paper, also pointed out that Germany does not expect Europe to make any final decisions on bolstering economic policy coordination until the spring of 2013. In the short-term, Spain remained the key area of focus in the sovereign debt crisis. Early concerns stemmed from comments from Spanish Budget Minister Cristobal Montoro, who said that high borrowing costs mean that the country it is effectively shut out of the bond market. While the issue of external support for Spain's banking sector recapitalization remained complicated due to German opposition to direct lending via the ESM, Die Welt reported on the potential for a compromise in the form a of a provisional credit line from the EFSF.
Macro wise, I start to see street economists making significant downward revisions to their global economic forecast over the past few weeks, especially last Friday. The revisions chopped about 0.5% from the annualized rate of global growth in 2H12, lowering it from near trend to just 2.1%. This is the first time this year that I saw a meaningfully change in the 2H12 forecast. It seems likely that more downward revisions are coming since not every macro research team in sell side has had a chance to respond to the latest downward trend of high frequency data. But what is really scary about the present situation is the lack of a policy safety net. In particular, Fed action has been critical to stemming past financial crises and of course economic downturns. The latitude for conventional monetary easing in the DMs is nearly nil. The Fed and other central banks could implement additional QEs, but with bond yields in US (10yr=1.52%), UK (1.58%), and Germany (1.20%) rapidly approaching those of deflationary Japan, the benefits of additional government bond purchases appear quite limited. For the time being, I think investors should look for small steps in the immediately upcoming meetings. Having said so, heightened expectations for additional monetary support from some of the world's leading central banks remained in focus. Overnight, In line with market expectations, the RBA cut cash rate by 25bp to 3.5%, the lowest level since Nov2009. The central bank highlighted the further moderation in Chinese growth and warned that Europe would remain a source of "adverse shocks". In addition, both WSJ and FT discussed the increased likelihood of another rate cut in India following comments from RBI Deputy Governor Subir Gokarn. He said that the central bank has "elbow room" to cut interest rates due to a sharp slowdown in economic growth and an accompanying decline in global oil prices.
Not surprisingly, the bulk of the focus remained on the Fed and ECB. The latter is holding its policy meeting on Wednesday and while consensus expectations are for no rate cut, there has been a recent pickup in thoughts that it could surprise with a 25bp easing given the spillover of the debt crisis to the underlying economy. Commentary surrounding the LTROs and other emergency measures, along with the Greek elections and end-of-June EU summit, is expected to be closely scrutinized. As for the Fed, street has ramped up the probability of another move (though expectations vary widely about the form) at the 19/20-Jun FOMC meeting. However, the near-term focus will be on comments Wednesday from Fed Vice Chair Janet Yellen and Thursday's congressional testimony from Fed Chairman Bernanke.
What are the possible outcomes?
In general, there were only three possible outcomes for the Euro zone crisis --- 1) an unilateral default and exit by Greece and possibly one or more additional economies; 2) a prolonged austerity for most of the crisis economies lasting as much as a decade under conditions set by the troika of EU, ECB and IMF; and 3) a rapid shift to full fiscal union. It has now become clear, that the “solution” proposed by the EU authorities – namely the 2), maintenance of the existing membership of the EMU while imposing tough budgetary constraints and recessions on the crisis economies – was unstable and would not succeed because it would not be accepted for long by Euro-area voters.
Either austerity fatigue would develop among southern European voters, or bail-out fatigue would be expressed by the voters of the core. In recent weeks the collapse of the Dutch government, the results of the French Presidential and German state elections, as well as the outcome of the Greek parliamentary elections have all reflected predictable shifts in voter sentiment away from middle-of–the-road parties toward more extreme parties, both on the left and on the right. The Dutch, German and French results demonstrate differing frustrations in the core, while the Greek results are symptomatic of sentiment across most of the peripherals. In effect the voters are saying solution 2) is no longer viable. In the next few weeks, probably soon after the Greek election scheduled for 17 June 2012, the euro zone leaders will be compelled to choose between 1) and 3).
Alexis Tsipras, leader of the radical left Syriza party and potentially Greece’s next prime minister, thinks a compromise with the troika is still possible. Quoted in an interview with WSJ (18 May 2012), he said that since “a financial collapse in Greece would drag down the rest of the euro zone... Europe must consider a more growth-oriented policy to arrest Greece’s spiraling recession and address...the growing “humanitarian crisis” facing the country.” In effect, the terms demanded by Greece are unreasonable and the dangers to the Euro of Greek exit are so dangerous, that the creditor nations and the troika will be persuaded to back down.
Currently opinion polls show that 75%-80% of Greeks wish to remain in the euro zone but they also reject the austerity program imposed by the troika – a classic case of voters wanting to have their cake and eat it too. But watering down commitments on either side would send a dangerous signal to other member states that such comprehensive agreements between states could never be relied upon. Financial markets would quickly lose confidence, outflows of funds from Greece and other peripheral economies would accelerate, yields on financial instruments would rise even further, and the euro could unravel very quickly. Effectively that leaves two options: 1) exit and default by Greece, or 3) full fiscal union. We are approaching decision time. Question is which option will the euro zone take?
How to deal with the Greece exit?
The primary problem with the exit and default of Greece is contagion. If Greece exited the Euro, introduced a new Drachma and allowed it to depreciate while defaulting on all external debts, the results could be encouraging for Greece, restoring competitiveness and growth in a matter of months. Voters in Portugal and Ireland might then demand to follow, defaulting on their obligations to the troika, with Spain and Italy surely coming under huge pressure to exit also. Strictly speaking these moves would be illegal, but EU leaders are dealing with sovereign nations that will act ultimately in what they perceive to be their national interest. If the pain and cost of current commitments are too great, they will pull out, no matter what legal documents have been signed. Ahead of their exits – as already seen in Greece and Spain – there would be runs on the banks in each economy as domestic individual and corporate depositors and foreign institutional lenders sought to protect their funds from any risk of conversion to new Drachmas, Escudos, Punts, Pesetas or Lire.
To avoid such a disastrous firestorm of contagion across the peripheral states, the EU policymakers would urgently need to erect effective firewalls. Faced with this magnitude of crisis in the next few weeks, the EU authorities would quickly need to escalate their measures in several steps --- 1) initially using the enlarged EFSF/ ESM funds to support financial instruments in the affected economies, and possibly enlarging them even more; 2) further expanding the B/S of ECB by provision of potentially several trillion Euros to banks; 3) increasing the Euro zone deposit insurance scheme beyond the current EUR100K; 4) guaranteeing other bank liabilities (as the same case of Ireland in Sep2008, or, more seriously, 5) imposing temporary capital controls.
The problem is that the above-mentioned options are set to fail due to various constraints. The intervention with EFSF or ESM funds could not succeed as they amount to only EUR700bn at most, insufficient to cope with the potential problems in Spain or Italy. Moreover, rapid escalation of the ECB’s balance sheet would face huge opposition from Germany, Holland and Finland. Again, some of these measures – particularly 2), 4) and 5) – will be regarded as contrary to the spirit or letter of the laws currently governing European institutions, but this would be an existential crisis for the euro zone, and extraordinary times would require exceptional measures. Let there be no misunderstanding: exit and default would carry grave consequences for financial markets and huge costs in terms of losses to the holders of Greek obligations – larger now than they would have been a year ago, even after the Greek bond exchange in March.
But what is the alternative? The remaining option is a rapid move to full fiscal union. Only then would the dangers of contagion and financial collapse in some of the peripheral nations be avoided. But full fiscal union implies a substantial move towards central or federal control of euro zone government revenues and expenditures, and in turn the ability of the federal euro zone government to issue bonds on behalf of all member states collectively – steps the members have steadfastly refused to embark upon since they all jealously guarded their national (budgetary) sovereignty. It is sadly to find out today that people who are in the 1990s opposed the creation of a monetary union without a fiscal union were always dismissed by Europe’s elite. At this critical stage it is therefore desirable to spell out just three of the fundamental principles governing monetary unions in the hope that this time they will not be ignored, and the next phase of European monetary union will be built on more secure foundations. None of these principles is new, and they have been illustrated in the history.
What are lessons from history?
First, there is a key lesson from a forerunner of European monetary union, namely the ERM or Exchange Rate Mechanism of the late 1980s and early 1990s. From early 1987 the UK Treasury under Nigel Lawson began “shadowing the deutschemark” with the idea of bringing inflation down in conformity with Germany’s successful control of inflation. However, almost as soon as the GBP started adhering to the ERM, interest rates in Britain needed to fall, causing credit and money growth to accelerate, and generating a housing boom. The housing bubble burst in 1990-1992, and when interest rates started declining, Britain’s overvalued exchange rate came under downward pressure as funds fled. In response the government tried raising rates, but to no avail, and was forced to abandon the whole sorry ERM experiment in Sep1992. Although still sometimes presented as a failure, Britain’s decision to leave the ERM was, in retrospect, possibly one of the best macroeconomic decisions of the past two decades because it freed Britain to be able to pursue an independent monetary policy.
The lesson for European monetary unions was that even economies of comparable per capita income such as Britain and Germany may require independent monetary policies. As a corollary, economies of widely differing per capita incomes (such as Germany and Spain or Germany and Ireland) would face huge difficulties on maintaining monetary stability within a monetary union. All this was well known. Academics and politicians recognize these problems as the “Walters critique” after Alan Walters, who, as Margaret Thatcher’s advisor, maintained a continuing battle against the Treasury for its foolish adherence to the policy of pegging GBP to the Deutschmark. Yet this knowledge was deliberately ignored in constructing ERM II and later the European Monetary Union itself.
The second lesson comes from HK which, since 1983, has maintained a special kind of fixed exchange rate with USD called a Currency Board under which HKD is essentially a different denomination of USD. To maintain HK’s peg intact for the past 30 years, HK has followed eight fundamental rules to ensure the robustness of its economy, its public finances, and the balance sheets of its banks, companies and households. The lesson for Europe is that the Maastricht criteria and the later Stability and Growth Pact conditions were hopelessly inadequate measures of whether an economy was performing well enough to maintain membership of a fixed exchange rate system.
The third lesson comes from the early monetary history of the United States, and it concerns the relationship between the fiscal position of the constituent states and the fiscal position of the federal government. It answers the question of whether it is better to set up a monetary union first followed by a fiscal union, or the other way around. Briefly the US created a fiscal union before it formed a monetary union, and it did this in two stages --- 1) following the War of Independence against Britain, the federal government was weak and indebted whereas the states, though indebted, had sources of revenue. Accordingly in 1790 Alexander Hamilton devised a plan (the “First Report on Public Credit”) to bail out the states and pay off foreign creditors using the credit of the federal government in exchange for granting the federal government limited powers to raise revenue in future. State debt was essentially nationalized. This is exactly where the Euro zone is today. A stronger federal government of Europe is needed to absorb the debts of the member states, and to enable the combined states of the Euro-area to be able to raise revenues and authorize expenditures in future, and to issue bonds in the name of the Euro zone as a whole in future. If Brussels were to take over the debts of Greece and other struggling peripherals, the immediate credit crisis would recede, and Euro-area credit would establish itself alongside US Treasury debt as one of the foremost debt markets in the world.
Note, however, that when there was a slump following the railroad boom of the 1830s numerous US states again became over-indebted, but on this occasion the federal government did not bail them out. Once the federal government had established its good name in the credit markets the failure of individual states did not undermine the federal government’s credit standing, and there was no merit in damaging it by bailing out the states. The monetary issues were not finally settled until after the Civil War, but the principles are clear. The US established a fiscal union before a monetary union, and the subsidiary of states’ debts to federal debt was unequivocal from the 1790s onwards. The Euro-area is not in a position to re-wind the clock, eliminate the monetary union and start afresh with a fiscal union. However, based on these lessons of history a stronger European monetary union can be built over the next decade.
Here are the conclusions
To sum up all the above analysis and lessons, first of all, it is a huge mistake to try to combine economies with widely differing per capita incomes, productivity trends, labor markets and social systems into a single monetary union. Booms and busts in the periphery are inevitable, and will unavoidably result in debt crises, banking crises, and balance sheet recessions when the bubbles burst– problems which will be exacerbated both on the upside and on the downside by wider income differentials. All of this will undermine the integrity of the monetary union, especially if there is no strong federal Treasury to counter the weaknesses of the periphery. Second, having created a monetary union, the rules to be followed to ensure robustness of the member states’ finances need to be far more extensive than the three Maastricht criteria or the two Growth and Stability rules. Hong Kong’s experience over the past 30 years provides a much better template. Pretending otherwise is simply to jeopardize the future of the monetary union – just as is happening now. Third, as Alexander Hamilton accurately foresaw, there needs to be a fiscal union which is contiguous with the monetary union with the powers to tax, borrow and spend in the name of the union. If the federal entity is secure and soundly financed, then at the level of the member states one can enforce a strict no bail–out rule – something the Euro zone has signally failed to do over the past two years. As a result, Euro zone capitulation to the need to bail out Greece, Ireland and Portugal has undermined the monetary union, and the risk of contagion to Spain and Italy now threatens its very existence.
To conclude, we have seen that there are now only two options open to the euro zone. Which path will be followed – break-up or full fiscal union? Either way it looks as though we shall know the answer in a matter of weeks.
Good night, my dear friends!
