Photo: Copyright — Tomasz Raś
As Europe barrels ever closer toward the edge of the cliff, it’s worth reviewing the different ways the crisis might get resolved (or resolve itself).Here are the 4 basic possibilities:
1. Europe’s leaders will agree to more bailouts that will kick the can down the road for a while longer. It is finally now apparent to almost everyone–even, possibly, Europe’s leaders–that the situation is an absolute crisis. This should trigger some response. Whether the response is the rumoured $800 million IMF bailout of Italy (which the IMF has denied and can’t afford), or a huge new move by the ECB (or the Fed), or the sudden flotation of “Euro-bonds” that will be backed by Germany, the powers-that-be will probably do something. And in all likelihood, this something will just throw good money after bad and postpone the flashpoint a while longer, because it won’t solve the underlying problems (which is the competitive imbalance and trade deficits created by the varying strengths of the underlying economies).
2. The Euro-zone will break up. Gavyn Davies at the FT has outlined three different break-up scenarios, all of which would take more time to pull off in an orderly fashion than the Euro-zone likely has remaining. These three scenarios are:
- Peripheral countries leave the Euro-zone and go back to their own currencies. e.g., Greece, Italy, Spain, etc. This would leave Germany and France in the “Euro-zone.” The value of the Euro would rise sharply, and the value of the new country-currencies would fall sharply. This would restore the competitive balance (with respect to exports) by making France and Germany less globally competitive and Italy, Spain, etc., more competitive. Doing this in an orderly way would require years of planning, just as the phasing in of the Euro required years of planning. We don’t have years. Or months. Or even, possibly, weeks.
- Germany withdraws from the Euro-zone and launches its own currency; the rest of the countries remain in the Euro-zone. If this happened, the value of the Euro would crash and the value of Germany’s currency would soar. The same balance of competitiveness would be restored. Again, this would take years to do in an orderly way.
- The Euro-zone ceases to exist and all countries go back to their own currencies. This would also restore the balance of competitiveness. But it would be one hell of a mess. (Think of all the contracts that are written in Euros!)
3. Full fiscal integration with the creation of a full-fledged central bank and Euro-bonds. In this scenario, Europe would become more like the United States: “Europe” would issue bonds that would be backed by the whole of Europe, a full-fledged central bank would have the ability to print unlimited amounts of money, and deficits in individual countries would be paid for by other members of the Euro-zone. Unlike the first solution above, this would actually target the root of the problem, which is the fact that less-competitive countries can’t devalue their currencies to make their economies more competitive and to repay their debts. This solution sounds is the only long-term solution (other than break-up), and it sounds as though Europe’s leaders are finally headed in this direction. But this solution would/will be severely challenging. What happens when Greece, Italy, Spain, etc., continue to run enormous deficits? Are the Germans going to keep paying for them? What about taxation? Are the Italians going to be cool with Germany (effectively) having the right to tax them more? Etc. Full fiscal integration sounds great, but it will be very challenging, and it will take time to pull off.
4. Collapse. This is what will happen if no one does anything. What “collapse” will look like and mean, exactly, is anyone’s guess, but we can speculate:
- Borrowing costs for Italy, Spain, Belgium, etc., continue to soar, until they reach the point at which the countries can’t afford to borrow any more money. At that point, the countries will default on their debts rather than not make payments to their government employees and contractors.
- The run on European banks that own European debt will continue in earnest. They’ll start going bust in droves (think lots of Lehman Brothers, one after the other).
- The run on US and Asian banks will commence. Who knows how many trillions in derivatives these folks have written against European debt and European banks? Who knows who the counter-parties are, and what the collateral requirements are?
- Credit markets will seize up, first in Europe, then around the world. When banks go bust, they can’t lend. Companies that need overnight financing, therefore, will not be able to roll over their debts. They’ll then stop making payments to employees and vendors.
- If credit markets stay seized up–if a new flow of money from a lender of last resort–doesn’t start the oxygen flowing again, companies will start firing employees, cancelling contracts, and going broke. This will spike the unemployment rate and demolish the economy–first the European economy, then the global economy.
- And so on…
Would “collapse” really be SO BAD?
No, it certainly doesn’t need to be SO BAD.
If there were a super-strong central resolution and lending authority, like the FDIC and Fed combined, the central resolution authority could simply seize and restructure financial institutions as they went bust, penalising their bondholders and shareholders but continuing to honour their customer transactions. And this central authority could then recapitalize countries and companies with SENIOR debt–loans that are senior to all existing loans–until the necessary restructuring was complete.
This would be the fairest solution, because then the bankers made all these idiotic loans would pay the price for their idiocy, and the countries that borrowed all the money would no longer be able to keep spending it willy nilly with no consequences, and the world could just push “reset” and begin anew.
But there’s no super-strong central resolution authority in Europe. We’re dealing with more than a dozen sovereign countries, some of which have hated each other for thousands of years. The reason the crisis hasn’t been solved so far is that these countries can’t agree on anything. So it’s hard to see how they’ll agree on anything now.
So, what’s the most-likely scenario here?
In my opinion, we’ll get another round of can-kicking, perhaps through Euro-bonds or bailouts or some other mechanism. And that will postpone the “day of reckoning” for another day. (Maybe just another day).
But, eventually, Europe will have to confront the fact that the current European Monetary Union just does not work in its current incarnation and will never work in its current incarnation, unless there is deep fiscal integration, which will be extraordinarily challenging.
The latter, in my opinion, will continue to be a lot easier to say than to achieve.
And in the meantime, every day that goes by brings us one day closer to “collapse.”
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