This post is based on a report I wrote some time ago about the future of the Euro-Zone crisis. It is divided in four parts: The first offers a recap of the crisis until May 2013. No details as to recent localised crisis are given. Information on this issue is periodically updated in the “Chronology of Euro-Zone Crisis” section of this website. The second part, discusses the options available for the future and makes a cautious and qualified argument in favour of fiscal federalism. The third part describes and uses a simple and tractable scenario analysis approach (mentioned in earlier posts) to map some of the potential future paths ahead. It argues that the single most likely path ahead is “stealth mutualisation”, a number of policies that would not require the paradigm shift constitutional reforms of a new and formal stage of fiscal integration while providing relief to bailout peripheral countries. Finally, the last part concludes with an overview of the future implications for financial markets both directionally and positionally.
Europe’s crisis is caused by the flawed architecture of the Euro-Zone, in which a majority of EU member states have been dragged down along the way. These flaws have materialised in a three-fronted crisis characterised by divergence, deleveraging and convergence into economic recession. Finance and the real economy shrink. In the absence of reforms the status quo is likely to continue to deteriorate the welfare of the continent as well as real investment opportunities; eroding popular and elite support for the single currency, making medium term reform likely.
The Euro-Zone Crisis – The status quo
The Euro-Zone crisis is the result of a fundamentally flawed institutional structure. In a monetary union that is not a fiscal union the intervening economies are unable to deal with asymmetric shocks. When one country suffers and others do not the monetary adjustment is limited by the fact that it must take into account the wider union. For the country hit by the shock, the currency depreciation is not sufficient to offer the necessary adjustment towards the new equilibrium forcing the brunt of the adjustment on falling wages, rising unemployment and contracting GDP more than usual. For the others, decreasing rates and depreciation will make them more competitive, leading to falling unemployment and rising GDP.
This has been the case in the Euro-Zone periphery where deficits continue to persist despite austerity(Figure 1), GDP growth (Figure 2) and inflation (Figure 3) trending downwards, consistent with a contraction of demand that has pushed output below its potential (Figure 4), raising unemployment (Figure 5).
Financially, divergence took root as dictated by credit rating downgrades (Figure 6). Sovereign debt yields have widened (Figure 7), the yield curve has steepened (Figure 8) and issuance of debt across the European fixed income market has seen a decrease in net supply of short and long term securities (Figure 9), consistent with deleveraging. Liquidity in interbank markets also fell, as core banks stopped providing their peripheral neighbours with cash, prompting the ECB to take over as is patent in the evolution of Target2 imbalances (Figure 10).
What is the End Game?
Going forward, the choice for Europe remains the same as for the last 3 years: fiscal integration or disintegration. Given that neither option is particularly appealing, the path that will eventually be taken will inevitably be the least of two evils.
There is much support for the view that exit is the most likely outcome. There are two version of this argument. The first is that the periphery would exit. Martin Feldstein, Kenneth Rogoff and Nouriel Roubini, to mention but a few, have supported this view. However, there are several costs that this simplistic analysis omits. Legally, expulsion is impossible and any voluntary exit requires a country to also exit the EU, in principle. The logistics are also cumbersome considering the costs reprogramming of computers servicing of vending machines and the replacement of physical currency.
Financially, banks would be left completely illiquid, unless an exit was supported by the ECB. This is unlikely as depreciation would necessarily impose costs that it would unlikely be willing to bear. One only needs to remember the effect of the ECB’s threat to withdraw ELA support to Cyprus to realise this problem. The second version of the arguments is that the creditors will leave. An example often cited is the disintegration of the Ruble zone following the collapse of the Soviet Union, on the initiative of Russia, the creditor of the newly independent republics which used to belong to the USSR. The argument resonates with proponents of the narrative that persistent Target2 imbalances are the result of ECB financing of current account deficits in the periphery rather than liquidity provision of liquidity to support solvent but illiquid peripheral banks.
Ultimately, leaving the Euro-Zone would destroy the financial system of the periphery and destroy, through devaluation or outright default, much of the international assets held by French and German banks (Figs 11 & 12).
How do we Get to What End Game and When?
In the short term, Germany and Austria are paralysed until their general elections take place in September of this year. In Greece, the state has forbidden strikes while in Portugal the prospect of defeat at the coming local elections has begun eroding the stability of the coalition, which has had to be salvaged twice this quarter by Presidential intervention. In the long run, although fiscal integration may be the cheapest way forward, it is certain to clash with nationalistic concerns, not least from the Netherlands, Finland and Austria, who have consistently opposed the development of every crisis-fighting mechanism. This was patent in their ability to get Germany to flip-flop on legacy assets regarding banking bailouts last year. Meanwhile, in the periphery, recession, austerity and impotence have continued to excite popular discontent.
Taking these facts into consideration, Figure 14 offers a stylised description of what the future may hold. Domestically, Euro-Zone countries are faced with the choice of remaining or exiting the Euro-Zone. At the European level, a choice must also be made between inaction (Status Quo), “stealth mutualisation” and actual fiscal federalism. “Stealth mutualisation” refers to a number of policies that would not require the paradigm shift constitutional reforms of a new and formal stage of fiscal integration while providing relief to bailout peripheral countries. It could include restructuring EFSF loans into perpetual zero coupons as recently mentioned by Citigroup’s Willem Buiter, and/or a write-down on the principal value of the bonds held by the ECB, the EFSF and core sovereigns.
The figure offers a tractable template of the evolution of the crisis that is overlapped with speculative perceptions of the likelihood of the sequence of events. For simplicity’s sake, by treating these events as independent it is possible to multiply these speculative probabilities through the branches to arrive at a quantifiable probability that the crisis is to end with disintegration or not. An alternative conclusion to the crisis is also added in the form of the outcome “Crisis Ends”. This accounts for other solutions to the crisis outside of the immediate parameters of this analysis.
(The framework of scenario analysis has several problems and is in no way perfect. Clearly it is not accurate or complete, in that I am unable to predict the future. However, it is a useful analytical tool that allows the user to trace back his/her steps and consider evolving developments that may allow the situation to evolve down towards other scenarios as time passes.)
From this analysis, there seems to be a 35% probability that the Euro-Zone crisis will end in disintegration, leaving a 65% probability that this will not be necessary. There is a strong element of path dependency. While fiscal federalism is perceived to be impossible in the next three years, the present status quo may hold. In that case no reforms would be introduced; creating an environment that would be propitious for the polarisation and radicalisation of the periphery.
The main scenario from this analysis is that fiscal federalism will be initiated, if not achieved, over the next four to ten years (“Future XXII” with 22% probability). This is consistent with the on-going trend of reforms, strong pro-European feelings among French and German elites, contagion and negative convergence towards economic recession.
With “stealth mutualisation” progressing in the next three to four years, markets are likely to continue supporting peripheral countries back into the market. Peripherals will maintain a bias towards fiscal discipline, in order to ensure that the terms are eventually watered down. In the medium term, as the fiscal integration moves to the forefront of the reform agenda, any debt remaining may receive a similar treatment to the one the USA subjected its revolutionary debt to, upon becoming a federal state in 1791, wiping out much of the cost. Economic recovery should then pick up close to the end of the medium term, in eight to ten years’ time. This implies a long-term target maturity to exploit.
Directionally, the short end of the yield curve is clearly overpriced. Shorting it for a ten year run seems appropriate, consistent with an inevitable bear flattening once the ECB begins raising rates.. Longing floaters is both cheap and likely to be profitable given the market’s present bearishness. Meanwhile, based on the current recessive environment, and consistent with expectation growth expectations, inflation-linkers, both French and particularly Italian, are likely to be particularly cheap. Repo’s also offer an interesting opportunity. As deleveraging proceeds, the amount of collateral available will decrease, the price of collateralising bonds will increase, thus offering good returns to those holding government bonds. France is a good vehicle for this, given the relatively lower price for a relatively similar credit rating to Germany. Alternatively, local or state authority bonds tend to enjoy the same credit rating, particularly in France, while selling at a discount to their sovereigns.
Positionally, Italy and Spain are too big to fail. Any opportunity to buy below par and hold to maturity is sure to make a profit. Moreover, the recovery in Ireland appears strong so that the same logic can extended to the emerald isle. Good value can probably be found by longing these markets and shorting the core. Due to the complexities of any official bail-in in Greece and Portugal, it would seem unwise to enter at a time when the market is going through a relatively bullish tone.
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