This post introduces an exercise in Risk Scenario Analysis (RSA), about the future of the Euro-Zone. It introduces the main fragilities in the currency union and discusses them in some detail. The temporal focus of this post is on the period between 2012Q2 and 2013Q2. While there will be several developments that are too far removed to be considered here, the issues discussed below are sufficient to present a rather fragile environment that is prone to leading to several crises. The risks that Europe faces fall within one of any of the following three categories: Political instability caused by elections, Economic recession caused by austerity and Social unrest caused by institutional unresponsiveness.
Here’s my take on them.
As a recent post showed, there are extremely important elections looming over Europe. The focus of risk is in the elections that will take place in Greece, France, Italy and Germany.
- In Greece, the elections are likely to trigger an overhaul of the country’s leadership. While it is possible that a grand coalition will remain in power, under the leadership of technocrat Lucas Papademos, this is not at all certain. Given the survey figures described in the post provided above, PASOK seems headed towards the same fateful performance as its Hungarian homonym in 2010. With its obliteration it will no longer be a “mass party”. This reshaping of Greek party politics (temporary though it may be) will have extensive implications. What would traditionally be deemed a “grand coalition” between New Democracy and PASOK, will be anything but that and as a result, the first is likely to have to consider other unreliable partners. These are in scarce supply and heated in spirits. However, while the “outrageous” demands that will accompany their entry into government is likely to further destabilise the country and the economy, it might give the government of Greece the right aura of insanity necessary to obtain better deals from its European partners.
- While I expect the situation in Italy to remain under control until April 2013, when parliamentary elections are likely to take place, what happens after that is anyone’s guess. The center left is presently poised to take over, but a lot can change in a years time. Least of which, it is likely that the electorate’s memory of Berlusconi’s pantomine behaviour will fade, raising the possibility of yet another hung parliament. I am not sure that I share Bloomberg and the Economist’s enthusiasm or its optimism that a new generation of law abiding uncorruptible politicians will take over after the next election. Call me cynical, but in my view politicians’ behaviour is shaped by the institutions in which they operate, which are unlikely to change. The only path presently available to reach that goal is for the decrease in government expenditure to create a vacuum sufficiently great that it puts an end to the clientelistic relationships famous in Italian politics. But this is a slow process that probably takes generations and generations of fiscal responsibility and legally binding commitments to avoiding moral hazard. In their absence, patrons and clients will just hide in the shadows of the system until the storm passes, ready to take over their traditional roles once life returns to business as usual. Notwithstanding this, in the short to medium term, Italy will remain relatively stable.
- Finally the dynamics of France and Germany seem to have become intertwined into a unique Franco-German party political organism. While in France Mr Hollande seems poised for a landslide victory, such a result should not be taken for granted. This is what the French socialists must have learned with the defeat of Lionel Jospin at the first round of the 2002 election. However, precisely due to that unexpected turn of events in 2002, such a surprise is no longer possible and Hollande’s campaign seems to have been extremely well managed. In Germany however, despite the recent fall from grace of the Greens and the sustained popularity of Merkel, my view is still that this center right government will fall before the next parliamentary election is due. In particular, I believe that such an event becomes more plausible with the rise of a socialist government in France. This is where I believe that the French and German political cycles have fused. Initial Franco-German relations after an election in either of the countries are always tentative and marred by lack of synchronicity. Sarkozy and Merkel were famously at odds in the beginning of their terms. The same is likely to be the case with Hollande. Moreover, while the partisan and personal animosity that exists between Mrs Merkel and Mr Hollande is likely to recede somewhat after the French election, I believe that relations will remain tense and distant at best, if not outright conflictuous. Much as Merkel has taken a stake in Sarkozy’s election campaign, Hollande will probably return the favour and taint the Iron Lady’s image. In the worst scenario, this could lead to a standstill in European decision making, which could bring about another crisis. It could also take a more subtle shape. The socialist are ideologically opposed to austerity. While their rhetoric will have to adapt to the realities of public office, I believe that they’ll continue to put an onus on growth and fiscal expansion that Merkel and her coalition partners are uncomfortable with. The apparent conflict, if well coordinated between the French and the German left elites through the media could provide the right amount of spin necessary to tarnish Merkel’s image as an effective leader. Given the past coordination between the French PS and the German SPD, I believe that the fall of the German government will become increasingly likely.
While the paragraphs might be read in a democratically suspicious tone, the above statements should not be interpreted as a condemnation of democratic institutions. The situation would be much worse under autocratic governments. If nothing else, that’s what we ought to have learned from the 1930s-1940s. While holding the potential of being terribly disrupting, these elections are necessary in order to allow national governments and their interactions to take stock of the evolution of voter preferences. Hopefully, given the inability to engage in warfare and the economic interdependences of European nations, leaders will find a European compromise from these frictions that will better internalise the preferences of European citizens. However, until such a compromise is reached, the political risks remain.
In my view, there are at least three risk fronts that from which further economic trouble may come over Europe: Lack of liquidity in the financial sector due to the Greek PSI and the sovereign debt crisis; Economic slow-down due to fiscal austerity demanded by fiscal-monetary conservative leadership; and an external shock due to an internal crisis in some other region.
- The liquidity shocks in Europe have been many and in both directions. Starting with the Lehman Brothers bankruptcy destroying balance sheets, these recovered somewhat thanks to the liquidity operations promoted by the world’s major central banks (including the ECB). However, Europe went on to experience the shocks from the Basel III rules and of course the rise in Greek, Portuguese and Irish default risks. Throughout, the ECB has made efforts to mitigate these shocks by injecting liquidity into the economy through more or less orthodox channels, with arguable levels of success. Liquidity shocks such as these, caused by a destruction assets, have different effects whether the institutions under question are well regulated commercial banks, pensions and insurance companies which operate under reserve requirements, or whether they are relatively unregulated investment banks operating under Value at Risk rules. However, despite the fact that the effect is of different amplitudes in these financial sectors, the direction is always the same: a destruction of assets decreases liquidity. While this has a more pronounced effect in investment bank sector, the effect is milder in the other industries. However, those are also industries that are required to hold government bonds, so they are naturally more exposed to public sector financial shocks. As a result, the destruction of 53% of the value of Greek bonds (the ongoing PSI) will actually represent a liquidity shock much superior due to the multiplication effect of (de-)leveraging, that is about to take place. Assuming that the PSI will wipe out €107 Bn from balance sheets, and that they have a 8% reserve ratio, then they are leveraged 6.125 times [1+(100/8)]. If so then wiping out €107 Bn will actually cause the destruction of € 655.375 Bn. If the reserve ratio is 6%, then the figure explodes to € 1.783(3) Tn. Indeed the liquidity shock multiplier increases exponentially as the reserve ratio falls.
The impact is considerably harder when we consider the fact that invesment banks, who follow a VaR investment rule, do not simply decrease their holding to maintain the same level of leverage, but actually decrease their leverage in order to keep a (+/-) constant VaR. The Greek default is no light affair. The prospect that a further cut is due in 6 months and contagion fears should concern all parties involved, be them private sector investors wanting to make a profit, conservative central bankers or politicians wanting to win elections.
- Regarding the risks threatening economic growth, commodity price inflation and disproportional sensitivity of central banks to it could see a supply shock (rise in oil prices) accompanied by a monetary contraction. However, the main risk to economic growth can be found in the deep and unrelenting fiscal adjustments pursued by EU governments. This policy line is being pursued in a dangerously pro-cyclical manner which threatens to inflict long-term structural damage to European economies, potentially exposing them to the dangers of hysterisis and protracted stagnation. While the risks in Germany and other Core countries are relatively small, the damage this policy is doing to the periphery is enormous. In particular it threatens to create further hurdles to countries subjected to EC/ECB/IMF adjustment programmes. These risks were highlighted recently in a Debt Sustainability Analysis of Greece. While the quantitative conclusions are specific to Greece, the logic applies to all of the Core countries.
- Finally, there’s always the chance that exogenous shocks will take place. Earthquakes, tsunamis, nuclear meltdowns and revolutions were some of the preferred forms of this phenomenon in 2011. Tautologically, it is always difficult to establish what might be coming our way through the blind spot, but we can proxy this, by the things no one is paying attention to:
- It could be a Chinese hard landing. While this is not altogether impossible, China seems to handling its economic woes well enough.
- It could be a Russian Revolution, although the majority of social tumult seems to have passed, since the presidential elections.
- It could be a Middle East conflict spurred by conflicting Western and Iranian interests.
- It could be newly uncovered statistical fraud in the Euro-Zone.
- It could be a triggering of CDSs caused by a default that quickly turns into a free for all as that market is shown to be underfunded.
Whatever the causes, there seems to be a large range of causes for economic turbulence, the incidence of any could be sufficient to trigger another crisis.
- It is likely that the interaction of political and economic risks will conspire to bring about increased social unrest in the EU. In particular, I would expect Greeks, first, soon followed by Portuguese and Italians, to take up their banners and take to the streets in order to voice their impotence towards foreign diktats. The issue is not that the EU does not represent peripheral nations, but rather that in its present institutional structure, agenda setters (Core countries) do not internalise Greek preferences. Merkel would be much less aggressive in the manner in which she pursues Greek austerity, if her job depended on Greek votes. In this environment, it is not suspicious that Greek public opinion about Germany and its policy is as negative as surveys show.
- It is not unimaginable that a phase transition, from the present unsustainable critical point to a more stable social equilibrium, could take place. While for the time being the police and the armed forces remain stable and non intrusive in civilian affairs, if austerity were to affect them as well, it is not unreasonable to ponder as to whether they would continue to oblige their governments. I believe a good tipping point would be the withdrawal of support from law and order. Clearly delays or decreases in wage payments could result in this. As voters’ voices are not taken into account, antagonism, distrust and street protests will continue to shed their shadow over the old continent, the stability of which depends on the compliance of the police. While under normal circumstances this issue would not arise, such a scenario can no longer be dismissed outright.
The lines above have attempted to argue that the risks of a crisis in Europe and in particular in the Euro-Zone are extremely high. This exercise is conducted as part of an effort to show that the present self congratulatory mood reigning in Europe is premature and should not leave private and public decision makers under no illusions that the problems are completely over. The immediate crisis ended but many others remain until the EU reaches an political economic equilibrium.