The elections in France and Greece held this weekend introduce yet another layer of uncertainty and complexity into what is already becoming a fascinating conundrum for investors; namely, how to factor the approaching endgame of the Eurozone crisis into their thinking and planning for the future. The ever changing political dynamics in Europe, overlaid on a deteriorating and inherently unstable economic situation, make conventional linear analysis difficult.
The issue however cannot be avoided as recent developments have brought the endgame appreciably closer. While it still seems likely that the eurozone in its current form can stagger on for a while longer, we are rapidly passing the point of no return, when Europe will be faced with two simple but binary outcomes: continuing on to full fiscal integration, including the creation of eurozone bonds and a common treasury, on the one hand, and at least a partial breakup of the existing monetary union on the other. Muddling through and hoping that something (preferably the economy) turns up is no longer enough.
I have no ideological grudge against the euro, but it seems clear to me that the odds on breakup are shortening by the week. The creators of the euro, we all know, deliberately failed to provide for any exit or breakup mechanism and Brussels officialdom, like all endangered species, remains steadfastly opposed to contemplating such an outcome. Given the huge amount of political capital that has been invested in the concept of European integration, nobody underestimates the determination of Europe’s political elite, including the leaders of its two leading lights, France and Germany, to keep their grand project alive.
Yet for all its noble ideas, there is no political or democratic mandate for ever closer integration. Growing popular resistance to the heavy social and economic costs which attempting to complete the process in a time of mounting economic stringency are imposing on member countries is making the process harder. Without the freedom to default and devalue, Greece, Portugal and Spain in the south are simply sinking under the weight of the yoke of euro membership, while voters in Germany, Holland and elsewhere in the north are increasingly rebelling against the rapidly mounting cost of being forced to keep their southern neighbours afloat.
The European Central Bank’s successful LTRO programme has bought some time, but does not – and by its nature, cannot – resolve the fundamental problems that beset the Eurozone. Indeed, by hastening the process by which the fate of Europe’s banks and sovereign issuers have become inextricably linked, the effect (whether deliberate or otherwise) has been to bring forward the point at which the fundamental decision whether to go on or go back will need to be taken.
Historical experience provides little comfort for the Europhiles. Currency unions are hard to sustain at the best of times. Attempting to do so in the midst of an economic slowdown while so many member countries are already hopelessly uncompetitive and their banks undercapitalised and possibly insolvent, as is the case across the Mediterranean economies, is many times more difficult. A stubborn insistence on pressing on in these exceptionally difficult circumstances may be seen by some as heroic. The more likely outcome is that it risks making a bad situation worse without changing the eventual outcome.
When announcing their short list last month, the judges of the Wolfson Prize for Economics, which is to awarded shortly for the best suggestions on how a break up of the euro might be achieved, rightly praised the research firm Lombard Street Research for its analysis of how the eurozone had arrived at its current state of crisis. Its analysis demonstrates clearly how the imbalance in competitiveness between the member countries of the Eurozone, which is at the root of the currency’s current difficulties, has widened over the 13 years that the euro has been in existence.
It is not just, in other words, the global financial crisis and its fallout which has brought the euro to its knees (though the fallout has clearly exacerbated it). It was not working anyway. The eurozone was extended too far and too fast to include several countries that should never have been allowed to join when they were ill-prepared for the structural reforms that were bound to be needed if they were to survive, let alone prosper, within a monetary union.
The prospect of failing currency union in Europe was enough to send the markets into a mild panic last summer. If it happens next year, the process is unlikely to be pretty, though it won’t be a shock. There are multiple paths and multiple possible outcomes, all of them involving a measure of uncertainty, which markets hate. As Warren Buffett remarked some while ago about the Greek debt crisis, the current state of affairs is akin to a horror movie – you don’t know how it is going to end, you only know it is going to end badly.
We have to hope that if the worst comes to the worst, the outcome in practice won’t be quite as bad as many fear. That may not be an idle hope. In his shortlisted submission for the Wolfson prize, Jonathan Tepper of Variant Perception shows that history records many examples of currency unions that have ended without enduringly painful economic consequences. This conclusion, he concedes, “flies in the face of conventional wisdom”. But, he adds, “the exit from the euro should be looked at as an emerging market crisis, where countries defaulted on private and/or pubic debts, abandoned pegs or managed exchange rates, and devalued. The euro merely overlays currency exit to what is a classic emerging market crisis”.
Jonathan Davis 