Alexander Gloy: Funeral music for the Euro?

By Alexander Gloy, the founder and CIO of Lighthouse Investment Management

This week, EU leaders will try to agree on limited EU treaty changes at a summit (December 16-17). The aim is to establish a permanent rescue mechanism for countries in financial difficulties. On Monday and Tuesday (December 13-14) foreign affairs ministers will meet in Brussels to prepare draft conclusions. The BBC claims to have obtained a draft communiqué. We will analyze if a new European Stability Mechanism (ESM) has any chance to save the Euro.

It will be interesting to see how far the idea of eBonds (supra-national bonds issued by the EU to funnel money towards countries in difficulties) will get amidst opposition from the two largest contributors – Germany and France.

It is unclear why it took a French-German summit[1] to state the obvious, namely that bankrupt entities, including sovereigns, should be allowed to go bankrupt. “Bankrupt” not as in “the end of the world”, but rather as a way of making a debt problem manageable by restructuring it. Orderly bankruptcy proceedings, by the way, are in the interest of creditors (since otherwise creditors would create more damage in a “first-come-first-served” rush to secure collateral at the detriment of others).

After peripheral European bond spreads exploded, Ms. Merkel tried to limit the damage by assuring investors that no haircuts would have to be borne until mid-2013 (when the European Financial Stability Fund – EFSF – is supposed to be terminated). In a desperate attempt to calm markets, European finance ministers[2] specified “that this does not apply to any outstanding debt”. But what, should the Euro-zone still exit in 2013, would that mean in practice (apart from the effect of having a two-tiered bond market[3])?

Euro-zone politicians to taxpayers: This mud-pie to hit your face by 2013

Sovereign bonds with issue date before mid-2013 would be “exempt” from restructuring? Who in his right mind would venture out to buy bonds issued by a heavily indebted country after that fatal date? Obvious answer: nobody. Even if that country managed to sell a few new bonds – those bonds would make up only a small percentage of total debt outstanding (but would have to bear the full burden of haircuts, dramatically impacting expected recovery value). Even if such an event was to occur – how much debt relief would the issuing country gain (if, say, 99% of bonds outstanding have been issued prior to mid-2013 and hence will not suffer haircuts)?

This plan is not only half-baked, it is akin to a pile of sand and mud mixed together by a couple of 2-year olds and presented to their parents (the taxpayers) as a “beautiful cake”.

Euro-zone taxpayers might be in for another surprise. As Irish bond yields kept rising even after the EUR 85bn bail-out was announced the European Central Bank (ECB) bought Irish, Greek and Portuguese government bonds in earnest. What will happen to those holdings in case of a default? According to a statement by the Euro Group[4] (meeting of finance ministers of the Euro zone) an ESM (European Stability Mechanism) loan “will enjoy preferred creditor status, junior only to the IMF loan”. FitchRatings agency warned[5]: “The preferred creditor status of ESM lending and therefore the subordination of private creditors’ claims could result in lower ratings (…)”. While arguments can be made in support of seniority of ESM loans (it is, after all, taxpayers’ money used to bail out other countries) this has other consequences:

1. Crowding out of private investors: Private investors are being subordinated (which alone should lead to rating downgrades and further losses for bond holders). This will make their participation in future government bond sales even less likely. ESM bail-outs effectively make it more difficult, not easier, for a sovereign to access capital markets.

2. Stealth shift of restructuring burden onto taxpayers: By loading up on sovereign government bonds the ECB becomes a subordinated creditor of over-indebted countries (not even mentioning ECB lending to insolvent banks). Since the bonds are being bought in the secondary market at steep discounts to par value the ECB is unlikely to be able to claim same creditor status as ESM loans.[6] Should a bailed-out country finally default, the ECB might be left holding the bag, with the taxpayer footing the bill.

This opens an entire different thought: what if “strong” countries left the Euro ahead of any sovereign bankruptcies? Surely those countries would set up their own central banks and could leave countries stuck in the Euro-zone to share ECB losses amongst themselves. There might be a “first mover advantage”, as those who stay until the end of the party usually are being recruited for cleaning up the mess.

While Euro Group claims to act in the interest of taxpayers (“…in order to protect taxpayers’ money”)[7] they achieve the opposite. Bail-outs are neither in the interest of the recipient (i.e. Ireland, as only more debt is added to an already indebted creditor), nor in the interest of taxpayers in contributing countries, nor in the interest of bond holders (subordination). The question may be raised in whose interest those bail-outs really are. Many fingers point towards French, German and British banks who risk becoming insolvent should their foolish loans go up in smoke.

De-leveraging (reduction of debt levels) leads to lower GDP growth and, possibly, to deflation. As seen in Japan, nominal GDP will trend below real GDP[8]. As debt is supported by nominal GDP, deflation makes elevated debt-to-GDP ratios more difficult to bear. I doubt there is any chance for Ireland to achieve the overly optimistic GDP growth numbers of its National Recovery Plan (“The Plan projects that real GDP will grow 2.75% on average over the 2011-2014 period”)[9], and any spells of deflation will make the situation only worse.

Can the Euro be saved?

It seems politicians in the Euro-zone are trying to save the Euro by shifting the burden of debt restructuring onto taxpayers and allowing enough time for financial institutions to get rid of their loans. Reduced debt levels would give a couple of years of “breathing room”, but not address the problem of diverging trends in unit labor costs and trade balances. It would merely postpone the unavoidable. As argued earlier, a Euro exit would lead to the same “punishment” as bankruptcy (elevated interest rates and limited capital market access) for a limited period. It should be noted that yields of some countries government debt (i.e. Greece) have already reached levels more consistent with the event of re-introduction of their own, weaker currency.

Apparently Sarkozy threatened leaving the Euro in May (in order to force Germany to accept the 750bn bail-out). This was clearly an empty threat, but with Merkel partying with Putin in Moscow and the German finance minister hospitalized the Germans took the bait.

Mrs. Merkel plays her highest card

Recently, The Guardian reported Mrs. Merkel to have threatened the same[10] at an EU summit in Brussels at the end of October. Now, it is unlikely the author suddenly found out about this threat more than a month after the incident. Instead, it looks like an aide to Mrs. Merkel leaked this information to a British newspaper (more credible than a German newspaper). Threatening to leave the Euro is, of course, the highest card Mrs. Merkel can possibly play. Playing the highest card smacks of desperation and reveals huge differences among European politicians. Of course, if everybody threatens to leave the Euro, that threat loses its effectiveness. We might already have entered the end game.

The end game: Which one is the least chaotic option?

Assuming the end game is a break-up of the Euro-zone, which is the least chaotic option?

Imagine a single “weak” country leaving the Euro-zone and introducing its own currency. Bank depositors would face a forced conversion of their Euro savings into the new, weaker alternative. A bank run (into gold or Euro deposits at banks in other countries) would be guaranteed to ensue. Bank runs could destabilize other indebted countries, too.

However, should Germany (plus Netherlands, Finland?) quit the Euro zone and introduce their own respective currencies, the majority of savers in remaining Euro-zone countries might think twice before moving their savings into new and unproven currencies. Of course, a New Deutschmark would appreciate versus the “Mediterranean” Euro and lead to problems for German exports. But those companies could be compensated by currency gains stemming from paying old Euro debt with New Deutschmark.

An independent Germany would surely want to have back its Bundesbank – which would compete directly with the ECB (and I would not expect the ECB to be keen on such an outcome).

The stakes are high. Even the IMF has gotten cold feet ahead of the vote by the Irish Parliament on the EU-IMF Financial Assistance Program (December 15th) and delayed a vote by its own board until the 16th. A “no” from Dublin would be a significant blow for the Euro – but a huge win for Irish taxpayers.

[1] Merkel and Sarkozy concluded at a meeting in Deauville on October 18 2010 that future rescues of Euro-zone states should involve losses for private bond holders.
[2] G20 meeting in Seoul, November 11-12, 2010.
[3] Sovereign bonds of, say, Ireland would trade at different yields depending on their issue date.
[4] Statement by Eurogroup, November 28, 2010, page 2
[5] “Contagion, Support and Euro Area Sovereign Ratings”, Comment, by FitchRatings, December 2010
[6] See “The seniority conundrum: Bail out countries but bail in private, short-term creditors?” by: Daniel Gros, Center for European Policy Studies, December 5, 2010
[7] Statement by Eurogroup, November 28, 2010, page 2
[8] Real GDP growth = nominal GDP growth minus rate of inflation. If inflation is positive, real GDP growth is lower than nominal GDP growth (and the opposite in case of deflation).
[9] “The National Recovery Plan 2011-14″ leaflet, page 1
[10] “Angela Merkel warned that Germany could abandon the Euro” by Ian Traynor; in: The Guardian, December 3, 2010

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  1. I love Sarah Palin

    Mr. Glow,

    Everyday someone or other is predicting ‘funeral music about ***’ – (replace *** with stocks, bonds, goldman, citibank, US dollar, Yves smith). Can you explain why you are worth listening more than those other clueless dickheads and vagina-heads? What is your track record?

    1. Hubert

      Would you please go away and not litter this site with your language and what you seem to consider as thought process ?

  2. aw70

    To quote Mark Twain:

    “The report of my death is an exaggeration”

    The Euro might last a lot longer than everyone here suspects. After all, there is no immediate reason to abandon it for anyone (!) – except that some of the PIIGS states have to clean up their current swinish state finances (and political systems) much more thoroughly if it stays. But that should be a reason for it to stay, not for it to be abandoned.

    This implicit sanitising aspect rarely gets mentioned: one of the reasons why the political and economical systems in the PIIGS states could deteriorate to the current levels of imbecility and corruption (something which takes quite a long time to achieve) was of course the fact that these states were, for the past 5 or 6 decades (or even longer), closed systems. If the political leadership screwed up badly enough w/r to economical matters, well, then they devalued their currency, and that was it. This made everyone who was economically capable, and who was still stupid enough to hold assets in the local currency, take a haircut – with all the indirect effects for the local economy this brought: massive capital flight to safer countries, lack of trust in the system, etc.

    Enter the Euro, and these cozy little corrupt fishtanks are now directly exposed to the wider world. This exposure is actually enormously beneficial, since it means the thoroughly corrupt local elites can no longer play their stupid and enormously counter-productive little games with impunity.

    And to all those who will now whine: “well, o.k., it would be nice if the Euro stayed, but it is much too late for that – the imbalances are far too large”…

    Take a long, hard look at the domestic imbalances within the U.S. There are huge differences in productivity between states there also (granted, not as large as within the Eurozone, but still considerable – especially if you take a long-term historical view), but has this ever led to the Dollar being abandoned?

    Just my two cents (Euro or otherwise)


  3. Maju

    I think that Germany should consider leaving the euro and all other Eurozone partners should encourage it to do it. Obviously it’s a lose-lose situation for Germany, so they’ll chicken.

    Instead the rest have something to win from getting rid of the annoying excessive German demands which are stagnating the EU and particularly the Eurozone, so inviting Germany to leave is a win-win situation. Obviously that Germany leaves is not ideal, but that Germany remains with this imperialist arrogance is much worse.

    So far we have followed the German lead and it has brought us this cul-de-sac. So it’s in any case time for other countries to take the lead. Sadly I look around and I see no leaders, much less ones of European size: they are all mere administrators for their clique of oligarchs (national Big Capital).

    They should be administering the public matters, not the interests of a small oligarchy. And there is where the problem lays.

  4. Wolf in the Wilds

    I totally agree with your view on the EU and the ECB, and have said as much in my own blog. It seems no government or central bank (even in Asia and EM) is willing face up to the reality and do the right thing, vs doing the convenient thing. At the end, the world will pay for this lack of leadership and the resulting chaos will be on their heads.

  5. Some dude

    If you look at the plain naked numbers, the US is in the same category as the PIIGS countries: sum of public and private debt on Greece levels, vanishing industrial base of the economy, economy dependent on financial sector, ugly unemployment rates and so on.

    For some strange reason, all these Euro critics never discuss the possibility of an US Dollar collapse. Makes you wonder why, doesn’t it ?

    1. Yearning to Learn

      For some strange reason, all these Euro critics never discuss the possibility of an US Dollar collapse. Makes you wonder why, doesn’t it ?

      1) I think many of us do predict a possible Dollar collapse. How do you think that we, too, got trapped in the “austerity” debate? We have a whole “new” Tea Party that is specifically worried about Dollar collapse and things we can do to “avoid” it. We have conversation after conversation about how our government and our country are “bankrupt”. etc.

      2) obviously the Euro and Dollar have different dynamics.

      we can argue whether or not a country could/would leave the Euro because it IS a possibility.

      there is NO possibility that a state could leave the Dollar.

      perhaps in some Fantasyland we can imagine that the EMU countries are like “States” of the USA… but they are not. The USA is a sovereign nation, and the states ARE subservient to it, although they do have their own States rights.

      On the other hand, the EMU nations are sovereign nations, held together by treaties that are being renegotiated as we speak.

      there will be no renegotiation of the “treaties” that hold the USA states together. None.

      Thus: we can argue about the validity of Greece or Germany leaving the EMU.

      but arguing about California leaving the Dollar is just plain dumb.

      there are a fringe few who have this idea that the USA will break up into different countries, but I personally think they haven’t thought things through very well… and thus I leave that debate for now. Although technically possible for the USA to break up, it would take a massive civil war, and I see no sign of civil war in the near to medium term barring some unknown destabilizing force.

      all that said: I personally see that the Dollar will need to transform in some way. Either it will lose Reserve Currency Status, or we will get “New” Dollars, or something.

      But the USA will continue to have a national currency in some form. (The Amero seems increasingly unlikely to me).

  6. a

    “It will be interesting to see how far the idea of eBonds (supra-national bonds issued by the EU to funnel money towards countries in difficulties) will get amidst opposition from the two largest contributors – Germany and France.”

    Opposition from Germany and France? The idea is dead on arrival. That’s about as interesting as a Patriots-Jets game.

    1. Hubert

      Yes – if they really mean it. But we do not know this yet. They might mean it or not or just keep their options open. What politicians are saying is generally rightly discarded. We have to watch what they do …..

      1. Elli Davis

        I am more inclined to say the latter – public opinion and open options are way higher on their priority list than stating the truth and/or obvious.

        But, as you said, we have to watch them what they do.

  7. pebird


    Of course the difference between the US and Eurozone is that the US has federal fiscal power to a much greater extent and uses that redistribute spending regionally. Where California receives federal spending equal to 78% of its federal taxation, South Carolina receives 135% of their federal taxes.

    Europe does not have the capacity to do this very easily, from both political and operational perspectives.

    Also, labor can migrate in the US with more ease than in Europe which, along with the federal redistributive capacity, provides the US with both supply and demand levers to manage internal imbalances.

    Why Merkle threatens to leave the Euro makes no sense to me, it has to be short-term political theater. If Germany were to make a credible threat, every other Euro country would be forced to make similar plans; the entire structure would collapse before anyone could leave.

    What would make more sense (but won’t happen) is for the ECB to provide a controlled exit process from the Euro for a peripheral country, so that a country could return to currency sovereignty, devalue and go through a relatively fast and sharp restructuring. What would happen to such a country’s Euro debt could be negotiated through a controlled exit plan – keeping the bond markets (and banks) from exploding (too much).

    What will most likely happen (who knows when) is that Europe is moving towards a federal system with federal spending capacity. It is happening now via the ECB buying Euro bonds (that is a fiscal action, not a monetary action, IMHO, as is the supra-Euro bond idea) The path to a federal system is not easy, but the alternatives don’t look much easier.

  8. Hubert

    Hot Summer 2013.
    If Merkel knows any date it is that one of the next federal elections in Germany in Automn 2013. If you think Summer 2013, a date which she conjured, just by chance came up so close to these elections, then I have a bridge here to sell to you.
    She is hopelessly trailing in the polls with a good economy. She might be gambling on a real monetary crisis in 2013 because Germans might not like to handover the mess to a Socialist-Social Democrat- Green coalition. This is brinkwomanship but she seems to be going for it, for tactical reasons as always.

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