Cross-posted from Credit Writedowns
How should I begin this post? Let me start out with my former default position:
I have always seen a sovereign default and restructuring within the euro zone as more likely than a break-up of the euro zone. I would say I considered the dissolution of the euro zone as an outlier. See my thoughts from "Anticipating Eurozone Collapse" in March. Increasingly, this possibility is being raised. Granted, the chances are increasing but it still cannot be the baseline case.
This is no longer my view. Breakup is my default case now. Let me tell you why.
The German Constitutional Court decision is critical
In June, I wrote that the chances of a euro zone breakup are now increasing, giving background for the current political turmoil surrounding Greece. My conclusion was “the policy decisions that governments and the EU are making cannot be maintained politically in the periphery or in the core”. A few days later, Nouriel Roubini wrote a very good note explaining then why the Eurozone could break up over a five-year horizon. We both stated that the key to maintaining the euro zone at all was the potential for closer integration of the member states. But the German Constitutional Court decision makes this nearly impossible:
"The Bundestag’s budget responsibilities may not be transferred through open-ended appropriations to other actors. In particular, no financial mechanisms can lead to meaningful fiscal burdens without prior approval," said the opinion.
"No permanent treaty mechanisms shall be established that leads to liability for the decisions of other states, especially if they entail incalculable consequences," it said.
The ruling is "a clear rejection of eurobonds", said Otto Fricke, finance spokesman for the Free Democrats (FDP) in the governing coalition.
Above all, the court ruled that the Bundestag’s fiscal sovereignty is the foundation of German democracy and that Article 38 of the Basic Law prohibits transfer of these prerogatives to "supra-national bodies".
By stating that there can be no further bail-outs for the eurozone without the prior approval of the Bundestag’s budget committee, the court has thrown a spanner in the works and rendered the EFSF almost unworkable.
It restricts the ability of Chancellor Angela Merkel to strike rescue deals at EU summits, leaving it unclear how she or any future Chancellor could respond to the sort of crisis that blew up in late July of this year when Italian and Spanish bond yields reached danger levels above 6pc. Moreover, Finland, the Netherlands and Slovakia are all eyeing variants of this legislative veto.
This ruling by the German Constitutional Court does allow the EFSF to operate as planned. Most commentators have focused on this. However, the language of the decision means there can be no eurobonds and no “supra-national” fiscal agent because these are in violation of the German constitution.
As I indicated when the sovereign debt crisis began, the Eurozone is unworkable in its present state.
This whole problem points back to my thesis that a Depressionary bust in Ireland is echoed in California, meaning that the individual sovereign states in the Eurozone are akin to U.S. states because the single currency gives them neither monetary control nor wide latitude on the fiscal front. More correctly put, I would now say "a depressionary bust in Spain is echoed in California" because the challenges facing the Eurozone are most evident in Spain. As in Ireland and California, Spain had a massive property bubble that has burst. The result in all three is high unemployment and a severe fiscal crisis.
In my view, the fiscal crisis in California demonstrates that a federal treasury is no panacea. After all, the U.S. has a federal treasury and California contributes more in transfer payments to that treasury than it receives. Yet, it too must cut spending like mad and raise revenue in order to pay its bills. Having a treasury would not have ended the economic pressures for Spain, Greece or Ireland – and I am dubious about a United States of Europe because of the greater fundamental differences within the EU.
Nevertheless, I anticipate some type of change is coming to eurozone treaties. The present setup is unworkable – and if maintained will force a breakup.
The European Harmonisation Fund is the only option
Yes, I am a eurosceptic and have always been. But we are here now. The euro exists. And that does change things.
It would easy for me to say something like, “see I told you so. The euro is an abomination and the peripherals should simply leave or be tossed out of the euro zone.”
But, again, we are here now. The political imperatives for closer European ties that created the single currency are still with us. And the negatives of abandoning it are many, both politically and economically – in the periphery and the core. I recognize this.
In my view, eurobonds and a “supra-national” fiscal agent are almost the only mechanisms which make the euro zone viable. Therefore, with these options now excluded, the euro zone is almost doomed to failure. The euro zone double dip is almost here and I think that spells bailout fatigue, austerity fatigue, default, and political unrest which will break the euro zone apart.
Internal devaluation and austerity is not a solution. They are politically unsustainable. It is obvious to most that defaults are coming. For Greece, sovereign default is a foregone conclusion. For Ireland, by dint of its socialisation of bank losses onto taxpayers, sovereign default is a real possibility. In Spain, bank losses have not been socialised and so the sovereign remains relatively healthy. However, Spanish banks have been slow to recognize losses and that means many contingent liabilities keep the market for Spanish government bonds in a state of stress. Portugal is well above the Maastricht 3/60 hurdles and contagion has spread to Belgium, Italy and France. Meanwhile, the public in countries like Slovakia and Finland want no part of future bailouts, while the public in countries like Greece and Spain are fed up with double digit unemployment and the prospect of a decade more.
I say the euro zone is “almost” at the point of collapse only because there is one other option, what I dubbed a European Harmonisation Fund when I recommended it in as the sovereign debt crisis began in March 2010. I envision this as a pre-funded emergency fund designed to distribute funds based solely on changes in economic outlook.
All euro states would fund the mechanism during cyclical upturns. However, in downturns, the euro zone would disburse funds based on changes in levels of economic data which indicate recession: disposable personal income, retail sales, industrial production, unemployment, and GDP growth. Originally, I had said these funds should be loans but given the pre-funded nature of the fund, it is better as disbursements.
At the same time, the EHF would only disburse funds if the states in need forced through pro-cyclical policy via budgetary discipline to comply with the Maastricht Treaty. If any member state refused to make the necessary changes or repeatedly failed to meet targets, the EHF would not disburse the funds.
Finally, the ECB would have to support the EHF by promising to supply unlimited liquidity in the event f a liquidity crisis by buying member state sovereign debt.
The EHF would therefore be beneficial in at least the following political or economic ways:
- The EHF would give states policy space via counter-cyclical disbursements while still moving them toward the Maastricht criteria.
- The EHF would not balloon the debt to GDP trajectory of the countries receiving the funds by saddling them with loans that could prove unpayable
- Via the ECB’s promise to backstop euro states as the Fed backstops the US government, the EHF would eliminate liquidity crises which worsen debt to GDP trajectories by increasing borrowing costs
- The EHF would be politically more acceptable than bailouts as the disbursements would be pre-funded by all member states and the budgetary discipline would be enforced via a previously recognized mechanism
- The EHF would enforce the budget discipline of the Maastricht Treaty and therefore asssuage fears of moral hazard that bailouts entail
- The EHF would allow defaults within the euro zone without contagion
This could constitute an effective ‘transfer union’ without moral hazard. I see it as the last hope for the euro zone. And hope we should – at least over the medium term; the global economy and financial system is still so weak that a euro zone breakup would be financial Armageddon, that much is assured.