Why the Euro is where it is

To all the readers of the Pattaya Mail, I would like to wish everyone a Merry Xmas and a Happy & Prosperous New Year.

More than a few readers have recently requested a guide to the EuroZone problem and to the recent manoeuvrings. Here goes:

Post 1945 Europe had to rebuild after the devastation of two world wars that straddled the Great Depression. Capital wealthy America funded the recovery of Europe and Japan plus the emergence of newly independent countries in Asia and Africa.

The universal mood focused on desperately avoiding further wars at all costs. Allied to the distribution of the prosperity dividend this helped bring about a collaborative Federal Europe. At the core of this federation was Germany, with France attached at the hip to its erstwhile adversary. This symbiosis reflected French deeply embedded suspicions and German war guilt. In both countries the ravages of war dominated the thinking of successive generations.

Ironically, Germany’s engine of growth, which drove much of the post-war prosperity, dated back to the 19th century harnessing of phenomenal natural and human resources in a powerful and energetic young country and fuelled the over-exuberant economic development and ambitions that ultimately caused World War I.

The EU grew out of a primarily Franco-German trade and tariff organization for the steel industry that expanded to include the whole manufacturing sector in the post-war era. Harmony and homogeneity were initially and subsequently far from universal – military regimes prevailed at various times in Spain, Portugal and Greece whilst the Iron Curtain cut a line between central and Eastern Europe that provided the starkest aftermath of WW II long after Western Europe had rebuilt, with Germany itself once again divided and a small corridor providing the only access to the western sector of Berlin.

The same urge that eventually unified Germany also drove forward the creation of a federal bloc that ultimately became the largest economic entity on the planet, despite a bureaucratic administrative system that famously interfered in every aspect of life.

To serve its relative prosperity this Franco-German alliance sought the continuing evolution of the fragile Federation, which remained divided by national borders, languages and currencies. A single currency was conceived twenty years ago and introduced a decade ago as a way of keeping alike the twin dream of a perpetually fast growing federation bounded by homogeneous fiscal, monetary, political and social standards. This is where the wheels started to come off. In fact, there had been clear warnings when the likes of the UK had shown themselves unable to operate within the structures of the Exchange Rate Mechanism (ERM) that had preceded the currency itself.

Stark national and regional differences continued in many ways to grow ever wider. Giving previously unimagined access to cheap and easy capital to those EU members whose economies featured a structural lack of competitiveness merely facilitated a transfer of wealth to the more productive core and a transfer of debt to the less competitive periphery.

Borrowing was suddenly so cheap and so easy for countries that had previously experienced difficulties raising capital because the myth was propagated that lending to all EuroZone members was the same. Basically, when the bonds of the GIPSI countries (Greece, Ireland, Spain, Portugal and Italy) were each rated as being similar to German or French bonds, institutional buyers such as banks and pension funds bought the higher yielding but apparently equivalent risk GIPSI bonds in preference to lower yielding Teutonic ones. This caused the market price differential (the spread) between them to narrow to the point that it virtually disappeared altogether, further embellishing the myth that leverage had created uniform prosperity across the EuroZone, whereas for the periphery the leverage had really only begat a series of bubbles.

Like all bubbles, these fed in a virtuous cycle: spiralling asset prices fuelled high growth rates. However, like all leveraged bubbles, the debt levels eventually started to impact on growth and asset values when slowdown set in. The process of deleveraging caused these bubble economies to slow even further. This coincided with the bursting of America’s bubble, further showing European growth, further exacerbating the debt burden and suddenly leaving Ireland, Greece and Portugal struggling to service their existing debts in an environment where capital became much more difficult to access.

Shackled by a currency whose strength was far more to do with Germany’s positive current account than the budget deficits of the smaller, weaker economies, it was impossible for these economies to grow their way out of trouble.

The heart of the federation’s economic system, the European Central Bank (ECB) began providing short-term solutions to immediate cash flow deficiencies in 2008 whilst failing to address the structural imbalances. Despite astonishing endeavours by the likes of Ireland to cut spending, the shortfalls have persisted strangling these economies into the recessions that persist today. Less imbalanced larger economies, such as Spain and Italy, took a little longer to reach the same point.

Having now reached that point, the crisis is of such a scale that the entire EuroZone is in recession, the Euro banking system appears grid-locked by mistrust and on the back of a liquidity crisis where the ECB seems to be the primary source of bank funding and the domino ripple of sovereign defaults still appears imminent, despite the agreement that each country can now work around the EU’s own founding treaties and constitution to do whatever bilateral deals are necessary to secure short and medium term funding requirements.

Ultimately, capital is still available from the ECB via the core, from America (whose own financial system might not be able to withstand Euro defaults) or possibly from Asia, where neither Japan nor China want to see Europe slow down any further. However, neither big bazookas nor tiny pea-shooters of short-term liquidity will fix structural insolvency and imbalances. It will merely delay the inevitable.

Beyond short term remedies, there are 2 structural solutions:

1. Countries revert to appropriate national currency policies. ASEAN 1997 is the playbook for this – Europe 2011 faces the added headache of a world that, except Asia, may well already be in recession (and Asia may not be so far behind). GIPSIs can, however, choose to debts in Drachma, Lira, Peseta, Escudo and Punt allowing for a much quicker healing after a period of initial extreme volatility.

2. The core countries, primarily Germany, can point enough Euros to plug the EUR5 trillion holes in Europe’s financial system, investing this as permanent capital in assets that will depreciate sharply in value, along with a much weaker currency. This might work. However, to create a sustainable solution, it requires a homogeneous EuroZone to be created.

To create equivalence across the EuroZone may well be possible especially after the monetization of the German balance sheet by printing an unprecedented amount of currency to swap back some of the core’s ill-gotten gains from the Euro experiment back to the periphery.

But to my mind it is far likelier to result in equivalence being achieved by reducing the competitiveness and standards of Germany down to the levels of Greece than by improving the standards and competitiveness of the GIPSIs in line with the core. To that end the recent agreements amount to little more than further kicking the can down the road with the added caveat that in recent weeks the EU has supplanted democratic processes in Greece and Italy (in the words of Eric Rosenkranz “Germany’s just chosen a new Prime Minister…for Greece”) and abrogated its own constitution. This “democratic deficit” to use Nouriel Roubini’s description, may well be a long-lasting problem, well after the warm glow of the short term fix has worn off. Caveat emptor!