More on What I Think Will Happen in Europe

About a month ago, as the crisis in Italy became acute, I wrote that I believed the path was clear; the euro area countries would move to tighter fiscal integration, which may or may not eventually include Eurobonds. The alternative, an implosion in Italy, would mean economic Depression.

Since that time, despite the impression that some serious policy makers believed letting Italy default is a justifiable policy choice, the prevailing view amongst euro area policy makers seems to be that saving Italy from default is necessary and that the only politically justifiable way to effect this rescue is to move to fiscal integration. All of the statements by leading euro area politicians now point in this direction.

What I said a month ago bears repeating here:

Does the ECB want to lose its trump card in dealing with Italy? No. That’s why they aren’t offering an explicit backstop. But if they don’t backstop Italy, Italian yields will remain elevated, Italy will default, all of the German and French banks with those bonds will be insolvent, and we will have a Depression. Italy is too big to fail.

If the ECB does backstop Italy credibly and fully, then yields will fall and investors will pile in again. However, this is nothing more than a temporary patch, a medium-term liquidity solution only. Clearly, the issue for the Dutch and the Germans is that Italy would have no reason under this arrangement to make reforms or move to fiscal consolidation. They fear Italy (and Portugal and Greece) would become permanent ‘free riders’, mooching off of Germany and the Netherlands’ fiscal probity, making the euro a weak currency. The right way to deal with that fear is to choose between greater fiscal integration or breaking the eurozone up at some point in the medium-term (say 2-5 years).

My conclusion: the ECB will eventually move to a lender of last resort role. The question is how much damage will be done before they do so.

Europe is already in a double dip recession and the sovereign debt crisis has already moved from Greece to Portugal to Ireland to Spain and now to Italy. Belgium, with its lack of a permanent government and 100% sovereign debt to GDP is next on this list. They would be followed by France and its implicit guarantee for a poorly capitalised banking system and Austria and its implicit guarantee for a banking system highly leveraged to central and eastern European debtors. Eventually, every country will feel the impact because a fixed exchange rate system with no lender of last resort is inherently unstable unless you have fiscal integration and/or compatibility.

The ECB’s backstopping Italy and Spain for fear of German and Dutch banks’ insolvency is like the Fed’s backstopping California and New York for fear of Bank of America, Wells Fargo, Citigroup and JPMorgan Chase’s insolvency. It is not a very palatable solution longer-term. Therefore, in the medium-term, the euro area will move to tighter fiscal integration. This may or may not include Eurobonds.

However, not all members will come along for the ride. Angela Merkel, admitting that leaving the euro zone is politically and legally possible during her commentary addressing the Greek referendum in Cannes, has already broken the taboo. Now everyone knows that it is possible to default, leave the euro zone and re-gain competitiveness in a move to a devalued currency. Given the lack of economic harmonisation in the euro area, some euro members will be forced to leave and choose this path. I predict that when Europe moves to change its constitution to include greater fiscal integration, it will also include explicit mechanisms for countries to leave the euro area.

-Why questioning Italy’s solvency leads inevitably to monetisation

This has turned out to be the correct analysis. I would like to build on this briefly, reflecting what I think the latest information we have means for policy choices going forward.

At this point, the double dip in Europe is clear based both on industrial activity and money supply data. The periphery is getting crushed by internal devaluation and austerity. Greek bank deposits are leaving the country en masse. Unemployment in Spain is well above 20%. Even in France youth unemployment is near 25% (link in German). And the fiscal cuts are coming everywhere: France, Belgium, Spain, Austria, Italy, Portugal, Ireland, and Greece. This is a deflationary policy response.

Yet, for the euro to survive, politically fiscal consolidation is a must. It is the only quid pro quo that German and Dutch voters will accept for what they perceive as yet another bailout for the periphery. Now clearly, these bailouts are about protecting creditor country banks too but the bottom line is that there is zero political appetite for any sort of union that doesn’t have serious penalties for so-called free riders and their fiscal profligacy. I don’t see the situation in those terms, but I think that’s the messaging driving the political discussion in places like Germany and the Netherlands.

What this means, therefore, is that Merkel’s push for treaty changes is going to be about transforming the stability and growth pact into something that has teeth, something that allows for euro area oversight, penalises fiscal profligacy and even creates a path for expulsion. In some ways the mechanics are less relevant because they are in flux. For example, Merkel is pushing to avoid the Schengen route to agreement as an intermediate step because it would mean a two-tier euro zone. Let’s see what happens here.

What is really relevant is the vision; and that vision is a for a bailout followed by a hard currency United Europe which practices fiscal discipline.

Getting from here to there is going to be a struggle given what we already know about the economic situation in the periphery. More than that, Nicolas Sarkozy is talking about balanced budgets in the euro area by 2016. And we know that an adjustment to balanced budgets throughout the euro zone would require either an exactly equivalent offset in private sector savings down and/or in the export sector up. This is never going to happen in countries like Greece. Sarkozy also promises no eurozone member will default too.

What does that mean for policy choices?:

  1. It means ECB intervention to bring down rates.
  2. It means moving to the hard currency United Europe which practices fiscal discipline that I have outlined.
  3. It means severe adjustments in the periphery toward fiscal consolidation and internal devaluation aka wage and price cuts.
  4. It means an implicit desire for offsetting adjustment in the euro currency down to create export competitiveness and/or equivalent private sector dissaving.

My conclusion: this is completely unworkable.

A hedge fund friend wrote me using the same language:

They can certainly agree to all sorts of budget cuts and tax hikes, but a) the governments won’t have the consent of the governed, b) the austerity measures won’t work, because economic growth will fall, and all the debt/GDP sort of ratios will consequently worsen, and c) the Germans really cannot go into an Italy or a Greece to “enforce” things.  It’s all completely unworkable.


Marshall Auerback notes that under austerity imports go down even though exports do not necessarily go up. So there will be some automatic external sector adjustment. However, Marshall also says:

But exports don’t fall and may go up as imports fall even faster, as the euro zone is pretty well a closed economy and much more mercantilist than the US…

Add to that what the Fed is doing with these dollar swaps. This is theoretically unlimited uncollateralised lending from the Fed.

As of today, the 1 Euro = 1.33 U.S. dollars. So just purchasing the PIIGS debt to fund their 2010 deficits would have required the US Federal Reserve sell around $350b, which is about 5.8 per cent of the US GDP over the last four quarters.

You therefore have a potential (albeit a limited one) for a huge injection of US dollars into the world foreign exchange markets.

That should have an impact! So, it’s not at all clear the euro countries can get anything out of the external sector. The adjustment therefore would fall on private sector dissaving.

Most likely, the cuts in the public sector will lead to a deflationary spiral in the periphery (and maybe even the core) via defaults, debt distress and bank balance sheet deleveraging. There is zero chance countries like Greece will make the grade then.

Euro zone breakup is inevitable. As I wrote last month, convergence has not come to pass. It is becoming increasingly clear that convergence will never come to pass. The euro zone is unworkable. It needs tighter fiscal integration to succeed and it can’t have that unless it gets convergence. The Europeans are starting to recognize this and so breakup is now inevitable.

I don’t think the breakup would happen straight away because we are in a crisis and a breakup now would also lead to a significant economic Depression. But the panic button to eject countries will soon be enshrined into law and the euro will no longer be a roach motel where countries check in but they can’t check out. Once the situation is stabilised, thoughts will turn to these issues.

And, yes I do think the situation will stabilise because policy makers are willing to socialise as many of the losses as it takes. They will go to any length and have their people bear any cost to prevent this thing from collapsing and triggering Depression. This was not evident before this past week. But it is certainly evident now.

This post originally appeared at Credit Writedowns and is posted with permission.

12 Responses to “More on What I Think Will Happen in Europe”

debraeddyDecember 2nd, 2011 at 3:40 pm

Dear Edward, I am consistently impressed by the quality of your posts. I entirely concur that this is far from over. there are key European elections coming up next year and I predict a move to the right and radical/national politics as the electorate refuse to accept the imposition of impossible austerity targets in southern Europe. What I would like to ask is whether your views on which countries will fallout of the Euro. I am surprised to see Merkel hitching up with France having expected her to favour a NL, Austria, Nordics "northern federation". Personally I see Greece, Italy, and possibly even Spain falling out under a controlled exit scenario.

capitalpreservrDecember 4th, 2011 at 6:47 pm

I have some questions about issues that I don't see ANYONE discussing at all, and I hope that you can respond to them.Everyone seems to want the ECB to just buy EZ bonds to keep their prices high and yields low. I am astonished at the almost complete lack of discussion and analysis of the consequences of this policy, beyond the obvious inflation, and especially if the ECB buying binge fails to lower borrowing costs. So my questions to you are as follows:
If the ECB is coerced into buying EZ bonds, then:
1. Without new tight, effective fiscal controls, then what mechanisms will stop the countries from issueing MUCH MORE debt than they did in the past before they had a buyer with infinite capital ?
2. Aside from inflation, what would be the economic/financial factor or condition that would arise to limit the ability of the ECB to buy bonds or to keep the rates "low" ?

capitalpreservrDecember 4th, 2011 at 6:47 pm

I have some questions about issues that I don't see ANYONE discussing at all, and I hope that you can respond to them.Everyone seems to want the ECB to just buy EZ bonds to keep their prices high and yields low. I am astonished at the almost complete lack of discussion and analysis of the consequences of this policy, beyond the obvious inflation, and especially if the ECB buying binge fails to lower borrowing costs. So my questions to you are as follows:
If the ECB is coerced into buying EZ bonds, then:
3. What are the consequences to the ECB and creditor countries if the debtor countries just keep issuing more debt as the old debt matures and the ECB accumulates many trillions of euros of debt ?
4. What are the consequences to the ECB and creditor countries if the debtor countries default on their bonds anyway for whatever reasons ?

iqfinsvcsDecember 6th, 2011 at 12:41 pm

I totally disagree with the writer's analysis as I believe that there is another alternative that just about gives everyone what they want and need: Autonomy, monetary and fiscal discipline. Here is my alternative solution:

The US rebuilt Europe following World War 2 and benefitted mightily as a result. This crisis offers the USA the opportunity to help lift the EZ out of a financial crisis and to help itself in the process.

Here is how. The USA should organize and lead a consortium of countries such as China, India, Brazil and other emerging market countries that are willing and able to participate in establishing a fund that will be used to purchase the sovereign debt of the failing EZ members. The Central Banks (CB's) of the participating countries will authorize the purchases with the following provisions:

(1) The EZ countries will first agree to take a substantial haircut on the debt.
(2) The EZ countries will agree to retain a portion of the debt that meets with an acceptable level of percentage debt to GDP that allows the EZ countries to maintain an investment credit rating.
(3) The remaining outstanding debt will be apportioned for purchase between the participating Central Banks based on some agreed upon formula, maybe related to percentage GDP combined with each country's appetite for such debt, etc. The debt purchases will be made in the currencies of each of the participating countries to avoid possible devaluation.
(4) Interest rates based on inflationary levels experienced in each EZ country plus a small premium will accrue on the outstanding debt during the loan payback period (The CB's will track the amounts of debt purchased from each EZ by each participating country for this purpose)
(5) The scheduled debt payback period could be a period of 30 years, with the first payment due in 15 years. This payback period will allow the EZ to return to fiscal health and growth.
(6) EZ countries will agree not to issue new debt that exceeds a certain level that impairs their investment credit ratings.
(7) To minimize the impact of the inflationary aspect of the participating CB's having to print money to finance the EZ debt purchases, the asset-rich countries can sterilize funds by selling government and/or CB owned assets.

Francois MontrelayDecember 7th, 2011 at 4:19 am

Two questions:
1. If growth returns, led by the USA, are we not all better off?
2. If the ECB becomes the lender or last resort, who will lend to them?


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Aaron Menenberg is Foreign Policy and Energy analyst, and a Future Leader with Foreign Policy Initiative. He also co-hosts Podlitical Risk (@podliticalrisk). He is a graduate student in international relations at The Maxwell School of Syracuse University. Previously he has worked at Praescient Analytics, The Hudson Institute, for the Israeli Ministry of Defense, and at the IBM Corporation. The views expressed are his own, and you can follow him on Twitter @AaronMenenberg. He welcomes questions and comments at