Scary Stuff

In a post which appeared earlier this week Tobias asks us whether, given some of the possible consequences of a French “non”, it might not be reasonable to ‘scare’ voters a little by spelling out some of the potential fallout which might follow a French rejection of the Constitution Treaty.

Perhaps the phrasing is unfortunate, but undoubtedly voters in Eurozone countries need to think long and hard about one especially sensitive area of impact: the future of the euro itself.

Obviously it is precipitate to start speculating about what would happen ‘if’………. In the first place the final outcome is far from decided, and in the second next months vote will hardly be the end of the story. One thing is sure though: if the French were to vote no the future of the institutional structure of the EU would become much more uncertain. And if there is one area where such uncertainty can be painfully expensive it is that of financial markets. Hence the interest in the euro.

And this is where the ‘scary movie’ might just begin. I think it isn’t spelt out often enough and clearly enough that the existence of the single currency is predicated on the long term evolution of an integrated political platform to make it solvent. This is why those states which have shown most reticence at the idea of European federalism have understandably (the UK is the most obvious case) been the most reluctant to adopt the common currency. This is also one of the reasons why a no vote in France would be much more important than a no vote in the UK. In the worst case scenario of an eventual British rejection it could be just possible to find some alternative structure to work round, but to have the eurozone’s second largest economy institutionally ‘out’ would be really unthinkable.

The implications of just such a development are explored by Morgan Stanley economist Joaquim Fels in an article entitled “euro at risk”. Now this is not the first occasion on which he has expressed views which might seem alarmist to some. Back in January 2004 he wrote a piece entitled Euro Wreckage? which evidently drew blood since it evinced an immediate response from Nobel economist Robert Mundell (intellectual ‘parent’ of the euro) in the EU Observer. Simply put Fels pointed out there that the technical and legal obstacles to leaving the euro were not as great as was often thought. Some evidence to back this point of view might be found in the fact that Greek expulsion from the common currency was one remedy proposed in some quarters after the ‘deficit manipulation’ scandal came to light.

This time Fels makes three central points:

As I see it, there are at least three developments with potentially lethal implications for European integration: (1) the surge of protectionism, especially in Germany, against perceived ?wage dumping? from Eastern member states; (2) the probability of a rejection of the EU constitution in France and the Netherlands; and (3) the prospect of much larger fiscal deficits in coming years now that the Stability and Growth Pact has been watered down beyond recognition.
Source: Morgan Stanley Global Economic Forum

Now adroitly side-stepping the first – protectionist – problem (which could reasonably involve a separate post), the second and third points do seem to me to be interconnected in a way which gives some force to Fels’ argument in the sense that a combination of the two could lead to increasing speculation about the very viability of the euro itself.

Essentially the ‘loosening’ of the stability pact has meant that there is now much less control on the continuing accumulation of deficits. This in the medium term wouldn’t necessarily present an insurmountable problem (ie one which was going to produce a ‘crisis’ situation) if the problem of the ongoing political unification didn’t present itself. Put bluntly the latter is necessary to guarantee the solvency of the former. If the economically stronger states are not going to be bound (morally if not legally) to bail out the weaker ones, then one day the markets will wake up to this and pressure on the government debt of these states will begin to pile up. Italy and Greece are prime canditates here with relatively stagnant economies and government debt already above 100% of GDP.

The FT today offers one indication of what might become an ongoing trend: divergence on the relative interest rates paid by the various eurozone governments on their debt (the so-called ‘sovereign spread’) is increasing:

The French referendum on the European Union constitution is starting to unnerve debt markets, prompting investors to become more discriminating about eurozone bonds.

In particular, the price of German bonds has recently diverged from Greek or Italian instruments, because investors are favouring paper issued by stronger eurozone countries. This helped to push the 10-year yield on German government bonds down to just 3.389 per cent on Thursday the lowest rate for at least four decades.

(meantime)…. the cost of protection against a default by Greece or Italy, using credit default swaps, has risen. Last month it cost about ?14,000 to insure ?10m of Greek or Italian debt; it now costs ?23,000 and ?17,500 respectively. The swap spread between Greek and German assets has also risen by 6 basis points in the past month from a normal spread of 10-15bp.
Source: Financial Times

In other words it now costs more for the Greek and Italian governments to raise money. As the FT points out these differences are currently relatively small (and indeed miniscule in comparison with the differences prior to monetary union). However as political union proceeded these spreads had been converging, now they are diverging. A major hiccup like a French no, coupled with a failure to seriously address the deficit problems would only see this process accelerating, and it would be this acceleration which could seriously place the unity of the eurozone in question. Ironically government finances in Greece and Italy are only sustainable due to the very low interest rates made possible by euro membership. Should debt costs start to escalate (remember we are talking here about servicing debt to the tune of 100% of GDP) then financing interest payments would almost inevitably lead (as we saw in the case of Argentina) to an ongoing spiral of expenditure cuts, economic stagnation and even higher interest rates. The end result would almost certainly be default, and normally default would require the significant devaluation of a currency and the application of an independent monetary policy, both of which imply the return to an independent national currency.

Of course, telling the French electorate that they need to vote yes so the will be able to shore up those eurozone economies with serious public debt problems may not be the best way to convince them (there *is* intended irony here NB), so perhaps those who suggest we shouldn’t be in the business of scaring people (we can leave that in the capable hands of Wes Craven) may be right after all.

8 thoughts on “Scary Stuff

  1. You should never ever try to stabilise a currency by saying it is under threat. That would have the exactly opposite effect. Nice idea for the contra side, though.

    Secondly why would Italy collapse today while it could live with more debt in eg. 1995?

    Thirdly, we’d better give the euro a stress test now than later. If it really fails, the sooner the better.

  2. “euro is a goner. 5 yrs max before it explodes”

    Crickey, that’s a rather risky prediction. I’d be careful before putting too much money on the table to back it up.

    What I’m saying – and here I very much agree with Fels – is that a French no vote would make some determinate outcomes (say Italy and Greece having to leave) slightly more probable, but here there are no certainties, it’s only one possible story among many others. BTW if the euro did “explode” (which I personally don’t consider very likely) the ensuing tsunami which would reverberate through all the international financial markets would be extraordinarily bad news for all concerned.

    If the scenario was one of euro membership being reduced to a smaller but more select group of economies, then of course the market value of the euro itself might even rise, so anyone betting against it (I am talking about the euro itself here and not euro denominated Italian government bonds) might actually lose out. Currency market movements are rather difficult to foresee. Sorry about that(if you’re going to lose money I mean).

    “why would Italy collapse today while it could live with more debt in eg. 1995?”

    This is an interesting question. Why would say offering a 30 year mortgage to a person of 25 be (all other things being equal) a better proposition than offering one to a person of 55. Ability to pay back over the timescale would be one of the reasons. Where’s the comparison? Well………… the average age of Italian citizens is rising and is significantly higher today than it was in 1995. This is essentially the original idea (which has been cutely put to one side) behind the growth and stability pact.

    Essentially Italy will soon reach a point (which Japan has already reached) where the number of people in the workforce is declining, and the number of elderly dependents is rising. Under these conditions (given the weight of pension and especially health costs) at some point government expenditure will be rising sharply whilst revenue may well be falling. If this is coupled with rising interest rates the situation can become unsustainable.

    ie there is a closing window of opportunity for putting this straight.

    “we’d better give the euro a stress test now than later”

    This would be a nice idea if it were possible. Unfortunately the time-frame required for any definitive judgement is relatively lengthy. My guess is you need a decade or so to really see what is happening. In other words, whilst I think it is a lot easier today to find people who will admit that there are plusses and minuses to the euro than it was when it was launched, the prevailing feeling is bound to be “well, we’ve come this far, so we’d better at least give time to see if we can really make it work”. At some point people who think like this now may become more pessimistic, if that were to happen then that would be the moment of the first real stress test.

  3. The end result would almost certainly be default, and normally default would require the significant devaluation of a currency and the application of an independent monetary policy….

    How so? I seem to recall that New York City came close to default a few decades ago, but nobody suggested an independent monetary policy. If Greece and/or Italy default, the lenders lose their money; end of story. That’s why they are getting higher interest rates.

  4. “If Greece and/or Italy default, the lenders lose their money; end of story. That’s why they are getting higher interest rates.”

    Fraid it’s not that simple. There really isn’t a clear comparison with a large city. The Italian state has assets which it holds on behalf of citizens – like pension funds – which could be embargoed. Then there is the messy business of an entity which is effectively bankrupt running things like schools and hospitals and old peoples homes without the resources to pay anyone.

    The example of Argentina is an important one. In the short term you would undoubtedly need some sort of ‘unofficial’ paper money – the Argentinians used patacos and lecops – to keep paying people while things got sorted out.

    Obviously a ‘rescue package’ could and undoubtedly would be mounted, but there is just one tricky problem: Italy and Greece are democracies. There is just no way on a first pass that the majority of citizens in a modern democracy would be prepared to accept the kind of package which would be offered. Again Argentina is instructive here.

    I have no doubt at all default would be accompanied by an exit stage left, one which was fostered by demagogic and populist politicians who would surely encourage people to look anywhere except towards the real source of the problem.

    I don’t read Greek so I have nothing concrete to offer on that score, but just a cursory glance around the Italian press will reveal that even now there are plenty of voices ready to blame the current economic crisis either on the high euro (normally the right) or the neo-liberal excesses of free market economics (mainly the left). Just bring these two currents together in a default setting and off you go: fireworks guaranteed.

  5. The Italian state has assets which it holds on behalf of citizens – like pension funds – which could be embargoed.
    I won’t pretend to have studied the Italian government’s loan agreements but I would be astonished if they contained clauses giving a lender that kind of power and totally gobsmacked if such clauses could actually be enforced.
    On your final point though, it is surely true that in a crisis some politicians will be calling for the resurrection of the lira. Anyone who thinks that’s the solution to their problems has a very short memory, but from what you say about the Italian press there must be many thus afflicted.
    Even if Greece and Italy do exit the system it should be possible for the remaining members to keep it in being. It took long enough to create; ever since the Bretton Woods system collapsed European governments have been working towards a single currency.

  6. “but I would be astonished if they contained clauses”

    Probably you are right that I am over dramatising here simply to make a point, the point being that ‘normal life’ would be badly disrupted. As we have seen again in the case of Argentina part of the problem of negotating things like this would depend on which country any attempted action was initiated, as obviously progress would be hard within the legal system of the defaulting country.(Hard, but of course not impossible, remember many of the people loosing money would be individual citizens who would feel very aggrieved and could find a sympathetic judge. Again one needs knowledge of local law to really hold an opinion on all this).

    On the pension fund front the most likely danger would be the pilfering of any accumulated pension resources by an incumbent government trying to stave off the inevitable. In fact Japan – the world’s number one candidate for a hypothetical default with debts variously estimated at somewhere over the 150% of GDP mark – has such a complex web of internal finances that it is probably impossible to tell what percentage of accumulated social security funds would actually exist if push ever came to shove.

    I’ve also seen Krugman suggesting somewhere that some fraction of the US social security surplus could see itself at risk of being used to offset the effects of the tax cut on current spending in the US. The problem is that what may seem relatively harmless under a ‘normal’ regime suddenly comes to look very ominous if things turn nasty.

    Incidentally drawing attention to the unreliability of the political process is the normal riposte of those who wish to defend private pension schemes from the perceived vulnerabilities of the equity markets: basically if a stock market collapse could leave the value of a pension fund greatly reduced a political crisis could see the politicians ending up leaving the ship with the cupboard bare.

    “Even if Greece and Italy do exit the system it should be possible for the remaining members to keep it in being.”

    Obviously I agree with this, and I am sure the departure of some states wouldn’t need to imply the end of the euro. Also I wouldn’t like to be seen as simply being prejudiced against Italy and Greece (Belgium for instance also has a very large accumulated debt). I have been simply using the two of them as a potential example of what *might* happen if some current trends are allowed to continue.

    Japan is much richer than either of them, so while on paper Japan’s problem is worse, and I have no idea at all how they can ever actually ‘square the circle’, I don’t anticipate any early demise of Japanese government finance. Also, of course, Japan already has its own currency, and is master of its own monetary policy.

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