Pettis on Eurozone Pathways and Endgames

Michael Pettis, like Simon Johnson a few days ago, has tried mapping out what he thinks future scenarios for the eurozone might be, and what that means in terms of possible winners and losers.

One of Pettis’ strengths is that he takes the time to be explicit about his reasoning, which gives readers the opportunity to see where they might beg to differ. And as much as I like his post, I think he makes one fatal assumption at the top, that the eurozone has more time than it really does. Here’s his frame:

If Europe is going to “resolve” the current crisis in an orderly way, it is going to have to move very quickly – not just for the obvious financial reasons, but for much narrower political reasons. I am pretty sure that the evolution of European politics over the next few years will make an orderly solution progressively more difficult.

For ten years I have used mainly an economic argument to explain why I believed the euro would have great difficulty surviving more than a decade or two. It seemed to me that the lack or fiscal centrality and full labor mobility (and even some frictional limits on capital mobility) would create distortions among countries that could not be resolved except by unacceptably high levels of debt and unemployment or by abandoning the euro. My skepticism was strengthened by the historical argument – no fiscally fragmented currency union had ever survived a real global liquidity contraction….

….in spite of very clear historical precedent, very few analysts, even the greatest euro-skeptics, are wondering about of the changes in electoral politics that are likely to take place in Europe over the next few years as a consequence of the euro adjustment. For example Wolfgang Munchau has an excellent article in the Financial Times in which he concludes, like I did in my post last week, that:

The eurozone is manoeuvring itself into a position where it confronts the choice between two alternatives considered “unimaginable”: fiscal union or break-up.

…. After my piece last week on financial prospects in Europe I received a lot of comments and questions from clients, especially about this part:

Political radicalism in these countries will rise inexorably as a consequence of rising class conflict. As Keynes pointed out as far back as 1922, the process of adjusting the currency and debt will primarily be one of assigning the costs to different economic groups, and this is never an easy or conflict-free exercise. Of course the less stable a government becomes as a consequence of this adjustment, the more likely it is to prefer very short-term solutions.

…..The point I was trying to make in the passage is an obvious historical one – that the resolution of Europe’s crisis will inevitably involve a difficult political debate over apportioning the cost of the resolution.

Obviously I think he is right, but I would add that the window for that choice is a small one. If Europe doesn’t move quickly, within two or three years it will probably be very difficult, if not impossible, to engineer fiscal union. By then domestic politics are likely to be too unstable for the European political elite simply to arrange union over the heads of the citizenry.

I’m curious to get reader input (and do read the entire Pettis piece, it’s wonderfully thoughtful), but I see the conundrum in plain view. The eurozone does not have two to three years to come to resolution. The markets are pounding on weak countries now, and the inter-related credibility of nation-states and their banks are in serious doubt. And he is right, that the difficulty of apportioning costs, particularly among so many players, means that this situation cannot be resolved quickly. Political processes and market responses operate on hopelessly different time scales.

Richard Smith and Swedish Lex were similarly doubtful about Pettis’ conclusion, while still admiring his analysis. Swedish Lex noted:

I believe that he underrates the risk of a sudden and chaotic death for the euro, the reason being that absolute crisis management can only be successful in containing disaster for so long. The rottenness of the euro system is now so apparent that markets AND le peuple will see through the propaganda immediately.

Had I been Irish, I would never have accepted this level of servitude.

The real fix – political and fiscal union – would probably cause political and constitutional crisis in Germany. So the Germans are unlikely to go down that path, should they ever realize that this was the only viable solution, which is far from certain.

I guess this leaves us with Trichet to print money in the short and medium term. Trichet and Bernanke will then have become the money printing duo that occupy the field in the absence on political leadership on both continents. I wish I could draw cartoons.

Note it is not yet clear the Irish will accept this level of servitude. The critical date is December 7, when the Irish Parliament is due to pass the austerity budget. However, there is good reason to think that that might not happen. And if the Irish politicians, as might be expected, refuse to drink from a poisoned chalice, at least as far as their careers are concerned, Lord only knows what happens next.

Originally published at naked capitalism and reproduced here with the author’s permission.