Anticipating Eurozone Collapse

The Germans are pressing a hard line on all fronts of the sovereign debt crisis in Europe – not only with austerity measures for Greece but for a planned European Monetary Fund (EMF) as well. The most critical part of the German negotiating stance, however, is now Eurozone exclusion, something that started when Finance Minister Wolfgang Schäuble publicized plans for the EMF.

But now German Chancellor Angela Merkel is also pushing this line. I saw her as rather dovish earlier in the crisis. But, the domestic politics have changed this. She calls for more severe sanctions including Euro exclusion for persistent free riders. In fact, Merkel wants to change eurozone rules in order to kick out any repeat offender of the stability and growth pact. The rhetoric is the toughest stance yet by German officials and makes the chances of a systemic crisis that much greater.

An article just released in today’s German weekly WirtschaftsWoche (Business Week) puts together the salient points quite well. My translation is below.

The Chancellor stands firm and refuses to help the Greeks. She wants new rules for the euro.

The Greeks are creating pressure. When European leaders meet in Brussels on Thursday and Friday, Prime Minister Jorgo Papandreou expects to finally have a concrete pledge for the ailing Mediterranean state. “It is important to make a decision at the summit,” said the Greek. “We have to put the loaded gun on the table to ensure that the markets react properly.” Previously, a senior Greek official had announced that Greece would apply to the International Monetary Fund no later than the Easter weekend in order to extricate itself from its financial plight. Papandreou denied [that Greece has made] the request to the IMF. But the message itself weakened the euro and made it clear to the political leadership in Europe, that it can not remain idle.

The Greek pressure generated counter-pressure. Chancellor Angela Merkel, who so far has steadfastly refused to support the Greeks lightly, wants to avoid future dilemmas like the current one. Her conclusion from the Greek crisis: she wants new rules for the euro.

So, you have Greek politicians threatening to go cap in hand to the IMF, involving the Americans and humiliating the EU, if the EU doesn’t bail the Greeks out. Then you have the Greek Prime Minister denying this and telling the other Europeans they must put the loaded gun on the table this week or the debt markets will implode. Meanwhile, the response from the Germans is ‘Nein.’  In fact, Angela Merkel wants to retroactively change the eurozone criteria so that the Greeks can be excluded from the eurozone if they continue to deficit spend. This doesn’t sound like a lovefest of Friede, Freude Eierkuchen to me. More likely, we have the makings of a more severe crisis.

This is a far cry from last March when it was widely reported that The EU promised to bail out eurozone members and might have even made assistance available in Eastern Europe as well. But, today, the Dutch are also onboard with the ‘no bailout’ approach of the Germans. Elections in June in the Netherlands are top of mind for Dutch Prime Minister Balkenende. He has consulted with Merkel to take a united stance on the issue. Others see the German stance as ‘absurd.’

WirtschaftsWoche again:

After a visit with the Dutch Prime Minister Jan Peter Balkenende last Thursday, for example, she stressed: “We need sharper tools in order to force compliance with the European Stability and Growth Pact.” Last week she went one further and asked to “improve” European treaties so that countries could be thrown out of the euro zone, if they did not comply. The President of the European Central Bank, Jean-Claude Trichet, described the suggestion as “absurd”. But now it is out there and the debate will not end so quickly.

Exactly. This thing is spiralling out of control and lines are being drawn in the sand. I am not in favour of a bailout. But, the issue here is negotiating tactics. Some tactics bring resolution; others bring escalation. When I lamented the politicization of economic problems, this kind of rhetoric is what I was referring to. At some point, there will be no backing down.

The hardness with which aid to Greece was rejected by Merkel in recent months has brought her a reputation as a Neinsagerin [lady that is not for turning]. In the coming EU summit, Merkel will again argue against premature support for Greece with the argument that the Greeks have not even asked for help. But now their attitude takes on a new quality: it aims to reform the monetary system.

This is a risky course which far from all countries wish to follow. France and Belgium would like to put together a rescue package for the Greeks. Collisions at the meeting of 27 Heads of State and Government are therefore very likely.

I am now going to have to reverse myself here. Ambrose Evans-Pritchard has been pushing the inevitability of the breakup of the eurozone. As recently as January 2009, I said that I didn’t foresee a breakup of the Eurozone, although I did see banking crises – in Ireland in particular – and the prospect of sovereign default within the Eurozone.

My take on events is that a number of countries within the Eurozone will face banking crises, starting with Ireland.  At that point, leaving the Eurozone will make no sense because the damage has already been done.

Evans-Pritchard’s calculus is more to the point: Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

The Eurozone and the spectre of banking collapse, Jan 2009

The Germans, apparently, will not go along with this. But even before then, back in August 2008 – before the Lehman panic, before the Greek crisis – I asked “Will the global recession end the Euro?” My answer was no and laid out my case.

Ambrose Evans-Pritchard of the Telegraph in London is one of the more interesting reporters on the business scene. In today’s Telegraph, he chronicles the depth and breadth of the global slowdown now taking form.

However, the crux of his article revolves around Spain and the sharp downturn they have experienced. While his article suggests Spain’s slowdown will test the Eurozone’s cohesion, I believe the Euro will pass this test. The global recession will not end the Euro…

I don’t see Eurozone disintegration as very likely. The political pressure to remain in the Euro is too great. Moreover, the costs of leaving the Euro would be prohibitive.

The most likely scenario is some sort of relaxation of the stability and growth pact along with political pressure on the ECB to provide monetary easing — pressure we have already heard from France’s Sarkozy…

given the large current account deficit the recession is likely to be deep and protracted. And then there is the question of Spanish banks and likely writedowns from property losses.

All of this speaks to Evans-Pritchard’s main theme of strains in European cohesion as Spain suffers a sharp and deep recession with no monetary stimulus to offset it. The first outgrowth of this has been a divergence of Eurozone interest rates. Spreads of Spanish sovereign debt have been widening over German Bunds. But, I don’t see this going any further than that.

Whilst Europe may be going through a difficult period, and a severe recession for Spain is a foregone conclusion, the political and economic costs of breaking up the Eurozone are too large to bear. For now, the Euro remains safe.

That was then. Now, all bets are off. The Euro is not safe. The eurozone is looking very weak indeed. And with Merkel pushing the Eurozone exclusion angle, you can almost see the writing on the wall.


Merkel fordert neue Regeln für den Euro – WirtschaftsWoche

Update 800EDT: when I say ‘collapse’ I mean economic collapse rather than break up. If I had to bet on likely outcomes (as many, undoubtedly, are via the CDS market), I would:

  1. still bet on a sovereign default within the Eurozone as the most likely outcome; that’s the writing on the wall, Eurozone economic collapse – particularly in Greece, Spain and Ireland. But a double dip of some sort would hit Germany as well (see posts here and here).
  2. Second would be some sort of bailout mechanism. I see this as a second choice option because my understanding is that we need a unanimous backing of any bailout mechanism. The Dutch and the Germans are the most negative here in this regard. But what about Sweden, the Baltics and Ireland? None of these nations want to see a bailout either. Some European politicians are already trying to position specific types of support as ’support’ rather than bailout. Maybe they can pull it off, especially given intra-EU bank exposure to Greek sovereign debt and the Greek banking system.
  3. A Eurozone breakup, something I dismissed as the eventuality proffered only by Eurosceptics, is now possible in my view. I don’t see it as the most likely possibility, but it is no longer a non-negligible possibility. And that’s what this article is trying to say.

Update 810 EDT: Clearly the downside risk in all of this is the weak global economy and political pressure that would result from an economic collapse.  Moreover, the intra-EU exposure to the Greek banking system is probably dwarfed by the exposure in Spain.  In my view, the economy in Spain is the real question mark in all of this.  If contagion were to spread to Spain – even in the event of a bailout, downside risk increases.

Also the parenthetical “lady that is not for turning” is a reference to Margaret Thatcher which I inserted. It’s not in the original text, hence the parentheses.

Originally published at Credit Writedowns and reproduced here with the author’s permission.

One Response to "Anticipating Eurozone Collapse"

  1. Guest   March 24, 2010 at 6:18 am

    As a Greek, I would agree with your analysis. I believe the Greek public debt is insupportible and will have to be renegotiated. The Euro has gutted the Greek private economy and Greece has a huge external trade deficit. The Goverment sector is massive. There is no way to pay down the debt to workable levels. Tax revenues are based heavily on VAT with an imploding economy in deep recession. The new taxes are simply cannibalizing what little is left of the private sector. Greece is a difficult case even for the IMF.