Wednesday, June 6, 2012
How Europe Will Disintegrate
In The End of the Euro: A Survivor's Guide, Simon Johnson and Peter Boone do not talk about how to guide Europe out of the crisis but rather how can investors save themselves when the inevitable is going to happen.
Simon Johnson, a former IMF chief-economist is the co-author, with James Kwak, of the recently published book White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. Peter Boone, a long time collaborator of Simon, is chair of Effective Intervention, a UK-based charity, an associate at the Centre for Economic Performance at London's LSE and a principal in Salute Capital Management Limited.
The crisis in Europe is not over because Europeans, especially Germans, can't decide whether to pursue a truly European agenda or to each go their separate ways. Had they been able to make up their mind right away, Europeans would have either bailed-out the Greeks and guaranteed the debt of all European countries under the same umbrella or they would have quit the European Union and let the Greeks (and others) fail.
But you can't have a middle of the road solution. It's seems that, now that it has been revealed that the Greeks have gone rogue, Germans wish that they had never been naive enough (once again) to be part of the EU and agree to a common currency. In fact, most Germans did not want to have a common currency ten years ago. What convinced them to accept the Euro was that Germany was never going to be on the hook for the debts of other nations. And many believed this lie!
As Michael Lewis explained in his book, Boomrang, Germans are too disciplined to believe that others can be "Greeks". They bought loads of crappy mortgage securities before the financial crisis for the same reason: they could not believe that some bankers could dishonestly unload their crap on them. After bailing our East Germans in the nineties and, a only few years later, being left holding "perfumed" securities sold to them by U.S. banks, Germans now have enough. But they still can't agree on what to do and will be left, once gain, holding the bag of bad debt.
They know that they are the butt of the joke once again; and they have yet to finish paying for the reunification of Germany and for their more recent losses stemming from the U.S. mortgage crisis. This time, it's Greeks, Portuguese, Irish and Spanish that are leaving droppings on the door steps of Germany. If it works, Italians and others are sure to follow.
Had the Germans really believed in the European utopia, they would have bailed-out the Greeks and converted all sovereign debt into Euro-denominated/Europe guaranteed bonds at the start of the crisis. With harsh conditions imposed on potential borrowers, they could have contained a local crisis from developing into a continental one. The other options was to pull out of the Union and admit that the European dream did not work out as expected; because it was not properly concieved form the beginning. Nobody should have let the Greeks borrow their way to death. As one of my friends puts it: You can't be serving drinks to an already drunk alcoholic without asking for trouble before the evening is over!
But admitting that you are wrong is hard. Thus, the muddling through solution - which is not a solution - is still being pursued. It is only hopes and pipe dreams. Meanwhile, the situation is developing into a full blown crisis that risks bringing us all down.
The channels through which this is going to happen are exposed in the Johnson-Boone article below. It is a must read. Like many things pushed through the European parliament, it is through a very undemocratic and bureaucratic system that the crisis is now developing. The back door nature of the interventions of the European Central Bank is sure to backfire when Germans and others start realising what is really happening to them: They are on the hook even without knowing it. And they are swallowing the whole thing under anesthesia as we speak. For now, it is painless paper going through the bureaucratic channels of a system that most fail to grasp. But the awakening is sure to make them gag. That's when the real shit is going to hit the fans!
Here is the recently published piece (it is also available in French):
In every economic crisis there comes a moment of clarity. In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone. Economic chaos awaits them.
To understand why, first strip away your illusions. Europe's crisis to date is a series of supposedly "decisive" turning points that each turned out to be just another step down a steep hill. Greece's upcoming election on June 17 is another such moment. While the so-called "pro-bailout" forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens. It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers -- either because they can't pay or because they expect soon to be able to pay in cheap drachma.
The troika of the European Commission (EC), European Central Bank (ECB), and International Monetary Fund (IMF) has proved unable to restore the prospect of recovery in Greece, and any new lending program would run into the same difficulties. In apparent frustration, the head of the IMF, Christine Lagarde, remarked last week, "As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time."
Ms. Lagarde's empathy is wearing thin and this is unfortunate -- particularly as the Greek failure mostly demonstrates how wrong a single currency is for Europe. The Greek backlash reflects the enormous pain and difficulty that comes with trying to arrange "internal devaluations" (a euphemism for big wage and spending cuts) in order to restore competitiveness and repay an excessive debt level.
Faced with five years of recession, more than 20 percent unemployment, further cuts to come, and a stream of failed promises from politicians inside and outside the country, a political backlash seems only natural. With IMF leaders, EC officials, and financial journalists floating the idea of a "Greek exit" from the euro, who can now invest in or sign long-term contracts in Greece? Greece's economy can only get worse.
Some European politicians are now telling us that an orderly exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves. They are wrong. Greece's exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone.
During the next stage of the crisis, Europe's electorate will be rudely awakened to the large financial risks which have been foisted upon them in failed attempts to keep the single currency alive. When Greece quits the euro, its government will default on approximately 121 billion euros of debt to official creditors, and about 27 billion euros owed to the IMF.
More importantly and less known to German taxpayers, Greece will also default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone). This includes 110 billion euros provided automatically to Greece through the Target2 payments system -- which handles settlements between central banks for countries using the euro. As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail. This role is taken on by other euro area central banks, which have quietly lent large funds, with the balances reported in the Target2 account. The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.
The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies. But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data). This amounts to over 200 percent of the (broadly defined) capital of the euro system. No responsible bank would claim these sums are minor risks to its capital or to taxpayers. These claims also amount to 43 percent of German Gross Domestic Product, which is now around 2.57 trillion euros. With Greece proving that all this financing is deeply risky, the euro system will appear far more fragile and dangerous to taxpayers and investors.
Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that -- to avoid a greater calamity -- all remaining member nations need to be provided with unlimited funding for at least 18 months. Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.
We agree: Once it dawns on people that the ECB already has a large amount of credit risk on its books, it seems very unlikely that the ECB would start providing limitless funds to all other governments that face pressure from the bond market. The Greek trajectory of austerity-backlash-default is likely to be repeated elsewhere -- so why would the Germans want the ECB to double- or quadruple-down by suddenly ratcheting up loans to everyone else?
The most likely scenario is that the ECB will reluctantly and haltingly provide funds to other nations -- an on-again, off-again pattern of support -- and that simply won't be enough to stabilize the situation. Having seen the destruction of a Greek exit, and knowing that both the ECB and German taxpayers will not tolerate unlimited additional losses, investors and depositors will respond by fleeing banks in other peripheral countries and holding off on investment and spending.
Capital flight could last for months, leaving banks in the periphery short of liquidity and forcing them to contract credit -- pushing their economies into deeper recessions and their voters towards anger. Even as the ECB refuses to provide large amounts of visible funding, the automatic mechanics of Europe's payment system will mean the capital flight from Spain and Italy to German banks is transformed into larger and larger de facto loans by the Bundesbank to Banca d'Italia and Banco de Espana -- essentially to the Italian and Spanish states. German taxpayers will begin to see through this scheme and become afraid of further losses.
The end of the euro system looks like this. The periphery suffers ever deeper recessions -- failing to meet targets set by the troika -- and their public debt burdens will become more obviously unaffordable. The euro falls significantly against other currencies, but not in a manner that makes Europe more attractive as a place for investment.
Instead, there will be recognition that the ECB has lost control of monetary policy, is being forced to create credits to finance capital flight and prop up troubled sovereigns -- and that those credits may not get repaid in full. The world will no longer think of the euro as a safe currency; rather investors will shun bonds from the whole region, and even Germany may have trouble issuing debt at reasonable interest rates. Finally, German taxpayers will be suffering unacceptable inflation and an apparently uncontrollable looming bill to bail out their euro partners.
The simplest solution will be for Germany itself to leave the euro, forcing other nations to scramble and follow suit. Germany's guilt over past conflicts and a fear of losing the benefits from 60 years of European integration will no doubt postpone the inevitable. But here's the problem with postponing the inevitable -- when the dam finally breaks, the consequences will be that much more devastating since the debts will be larger and the antagonism will be more intense.
A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008. In fall 2008 the decision was whether or how governments should provide a back-stop to big banks and the creditors to those banks. Now some European governments face insolvency themselves. The European economy accounts for almost 1/3 of world GDP. Total euro sovereign debt outstanding comprises about $11 trillion, of which at least $4 trillion must be regarded as a near term risk for restructuring.
Europe's rich capital markets and banking system, including the market for 185 trillion dollars in outstanding euro-denominated derivative contracts, will be in turmoil and there will be large scale capital flight out of Europe into the United States and Asia. Who can be confident that our global megabanks are truly ready to withstand the likely losses? It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering.
For the last three years Europe's politicians have promised to "do whatever it takes" to save the euro. It is now clear that this promise is beyond their capacity to keep -- because it requires steps that are unacceptable to their electorates. No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.
Whenever nations fail in a crisis, the blame game starts. Some in Europe and the IMF's leadership are already covering their tracks, implying that corruption and those "Greeks not paying taxes" caused it all to fail. This is wrong: the euro system is generating miserable unemployment and deep recessions in Ireland, Italy, Greece, Portugal and Spain also. Despite Troika-sponsored adjustment programs, conditions continue to worsen in the periphery. We cannot blame corrupt Greek politicians for all that.
It is time for European and IMF officials, with support from the U.S. and others, to work on how to dismantle the euro area. While no dissolution will be truly orderly, there are means to reduce the chaos. Many technical, legal, and financial market issues could be worked out in advance. We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system. Some nations will soon need foreign reserves to backstop their new currencies. Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.
Unfortunately for all of us, our politicians refuse to go there -- they hate to admit their mistakes and past incompetence, and in any case, the job of coordinating those seventeen discordant nations in the wind down of this currency regime is, perhaps, beyond reach.
Forget about a rescue in the form of the G20, the G8, the G7, a new European Union Treasury, the issue of Eurobonds, a large scale debt mutualization scheme, or any other bedtime story. We are each on our own.