Few options left to save the euro zone

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.

Three options for the euro zone: monetisation, default, or break-up

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.

German court curbs future bail-outs, bans EU fiscal union

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.

The European Sovereign Debt Crisis

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:

  1. The EHF would give states policy space via counter-cyclical disbursements while still moving them toward the Maastricht criteria.
  2. 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
  3. 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
  4. 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
  5. The EHF would enforce the budget discipline of the Maastricht Treaty and therefore asssuage fears of moral hazard that bailouts entail
  6. 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.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com


  1. Foppe

    The Dutch/German mercantilism, combined with the SGP’s/convergence criteria’s singular emphasis on keeping interest/inflation low, will still blow this up. At best you’d end up creating a permanent transfer union (since this EHF is basically nothing more than a stopgap, which allows for the continuation of the current trade/competitiveness imbalances).
    At the same time, it seems to do nothing to prevent future lending sprees/bubble blowing by the the banks (see the Basel 3 farce), which guarantees people will (at best) become disenchanted with having to fund the EHF (since there won’t be time to prefund the EHF so long as the banks are running loose)..

    1. aet

      I note the Estonians have the foresight to suggest that it might be wise to set up a less ‘untidy” method of withdrawal (or expulsion?) in advance any such event.


      And wasn’t it the Finns who have raised the sticky issue of the adequate “securitization” (that is to say, for adequate collateral for the monies to be advanced) of certain obligations to be undertaken by certain members?

      Oh those socialist Scandinavians!

  2. David Jones

    The majority of this commentary is excellent, however, when there is discussion of the creation of a European Harmonisation Fund things jump into fantasy.

    Does the author really believe that considering the present state of Europe’s problems that they are going to agree to create a sovereign welfare fund of unlimited liquidity that will hand out large gifts of money based on meeting budgetary discipline criteria?

    Seriously, that is a solution in the abstract only and will NEVER happen.

    The original premise of this article is correct – a Euro breakup is inevitable

    1. Edward Harrison Post author

      Your comments are inaccurate. The EHF proposal is pre-funded, meaning it is PAID FOR during cyclical upturns. It is not ‘welfare’.

      The question is about getting beyond the present problem. Getting from here to there is tough. The only way to do it right is to have sovereign defaults, debt writedowns and bank recapitalisations. That would give the euro zone a reset.

      1. David Jones

        Edward, thank you for your reply. However, please tell me, considering Europe’s current debt/austerity spiral mess, when are they going to remotely have “cyclical upturns” to “prepay” for an EHF fund?

        I’m sorry, but that is completely unrealistic.

        Europe is perilously close to bailout overload already.

        1. Edward Harrison Post author

          I answered the question ALREADY:

          “The only way to do it right is to have sovereign defaults, debt writedowns and bank recapitalisations. That would give the euro zone a reset.”

          Also, I have to reiterate that this is NOT a bailout plan because you keep mischaracterising it as such. It is a pre-paid fund.

          1. IF

            It does seem to me that a prepaid fund, by definition, is of limited size at time of crisis. This means it would be tested in times if crisis and found insufficient if there really was a crisis. Isn’t the whole idea of having a printing press to be able to at least threaten to commit unlimited amounts after the fact? See SNB.

          2. Edward Harrison Post author

            IF, the fiscal transfers are limited by what governments can pay in and they have to be. The ECB’s provision of liquidity is unlimited of course, which is why you have to use the ECB and not the EFSF for example.

            The point is to uphold the tenets of the EZ which are price stability and budget probity without necessitating a deflationary response to downturns that causes the union to break apart. This was exactly the problem with the gold standard in the Depression. The eventual response then was to leave the gold standard and to re-enter at a devalued currency level. But that’s a one-off that doesn’t get to the structural deficits of the EZ.

            As the EZ now stands, the stability and growth pact is the only budgetary constraint. You can’t police it; so you get free riders. That has no teeth whatsoever. The EHF would do because it would withhold funds in the tens of billions that governments had already paid in but would forfeit if they failed to comply.

  3. Jim Haygood

    ‘Breakup is my default case now.’

    Welcome to the fold, Ed. Our lonely little ‘breakup’ laager is turning into a roiling Woodstock!

    ‘I envision … 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.’

    You know, this has been the whole premise of countercyclical fiscal policy since the days of Maynard Keynes. Yet when has it ever been implemented, even in a single country?

    The US has experienced several business cycles in the past forty years, yet has not run even a handful of cash surpluses. Imagine herding prickly eurocats to run surpluses in an orderly manner!

    Given the way unemployment persists for a couple of years after an expansion starts, running surpluses is politically unpopular in the early stage of a fresh business cycle. And by the late stages, the conviction that ‘we’re rich; we can afford to invest in our future’ takes hold. (We have some palatial libraries and fire houses around here to prove it.)

    A harmonisation fund is a sweet hashish dream, but best saved for late nights round the campfire, as skippy serves wine and pills to enhance the brainstorming.

    1. Edward Harrison Post author

      The EHF idea is not the same as just promising to run countercyclical policy. It is a mechanism that FORCES this to occur. It is similar to what is being proposed for bank capital, topping it up in good times to prepare for the undercapitalisation of bad times.

      The EHF won’t happen, no. The politics just won’t allow it. But I don’t appreciate your calling it a ‘hashish dream’. Maybe that’s the kind of snarky commentary that works at NC. To me it just creates a negative environment.

      1. monday1929

        There are no “mechanisms” that force anything to occur, when there is no Rule of Law. Humans have a way of fouling up “mechanisms”. Wasn’t there a mechanism that forbade bailouts in the EU?

  4. Jim Haygood

    Oh my, oh my!

    Bloomberg’s TJ Marta:

    From colleague: trader friend just hit me with the following: There is “Chatter” in the market of a Greek Default this Weekend – and their CDS is over 400 wider … Soc Gen is off 7% on exposure – German CDS more expensive than UK’s – despite the ballooning in the CDS prices for Lloyds and RBS.

    I could use some of them pills now … skippy.

  5. Keating Willcox

    Southern Europe Financial Zone

    1.Portugal, Greece, Spain, Italy and Ireland all leave the Eurozone at once, and default on their loans

    2.They establish their own currencies, at once.

    3.Each currency is backed by a basket of commodities and vouchers from that country. These commodities would represent the goods and services required by the elderly or poor population such as wheat, olive oil, dairy, wood, bricks, vouchers for routine dental and medical care, and energy. In this fashion, each new currency would actually be backed by commodities such that if there were a run on that currency, it would produce jobs and prosperity.

    4.Each country would have a tax rate very favorable to corporations, and a small free port, in the manner of Hong Kong.

    5. Travel within the zone is passport required but unlimited tourist visa. Major limits on work permits and residence permits. Assimilation expected. Work permits mostly for folks who start businesses and create jobs.

    6. Tax policy is set to reimburse zone corporations for currency transaction expenses within the zone. Even though there are five different currencies, it should be almost expense free to do business in the other zone currencies.

    1. Pat

      “1.Portugal, Greece, Spain, Italy and Ireland all leave the Eurozone at once, and default on their loans
      2.They establish their own currencies, at once.”

      This might work, but if and only if the re-establishment of native currencies comes as a surprise and takes effect immediately (i.e. within one or two days.)
      Otherwise, if people in these countries know what is going to happen beforehand, there will be a massive bank run with everyone withdrawing their bank accounts in their own accounts and moving them to banks in Switzerland, Germany, Netherlands etc. (Greeks have reportedly already packed away some 280 billion Euros in Swiss bank accounts.) This would be the “mother of all bank runs,” with most banks in southern Europe becoming insolvent as a result.

      In the real world, of course, such currency transitions would require long debate and planning, so that everyone knows what is going to happen.

      I don’t know what the solution is — maybe drastic Emergency Laws that shut down all banks for several weeks and impose severe currency restrictions, and maybe shutting down stock and bond trading.

  6. Bam_Man

    Germany finds itself trapped in a classic “prisoner’s dilemma” with Greece and the rest of the PIGS.

    Failure to continue to prop up the Greek bond market will immediately lead to several large German banks going belly up. Continue to prop up the Greek bond market and they are “throwing good money after bad” and they know it.

    Greece passed the point of no return years ago, and is now firmly in the grasp of a compound debt trap. The other PIGS have also passed the point of no return and will find themselves in a similar situation soon.

  7. Ed

    Everyone brings a hobbyhorse to ride on European matters. My hobbyhorse is that the European Union overexpanded, bringing in alot of countries institutionally and/ or culturally incapable of supporting the closer union that the original six countries seem to want.

    The original six, covering essentially Charlemagne’s empire, was a pretty cohesive unit, and while Belgium and Italy are major political, and in the case of Italy financial, headaches, a good organization can handle a couple of headaches. I wonder why no one is proposing kicking out Portugal, Ireland, and Greece, the EU can presumably survive without some of its smaller members out on its periphery.

    1. Jim Haygood

      Looks like one of them may be kicking itself out, sooner than we ever thought:

      Chancellor Angela Merkel’s government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said.

      The emergency plan involves measures to help banks and insurers that face a possible 50 percent loss on their Greek bonds if the next tranche of Greece’s bailout is withheld, said the people, who spoke on condition of anonymity because the deliberations are being held in private. The successor to the German government’s bank-rescue fund introduced in 2008 might be enrolled to help recapitalize the banks, one of the people said.

      Greece is “on a knife’s edge,” German Finance Minister Wolfgang Schaeuble told lawmakers at a closed-door meeting in Berlin on Sept. 7, a report in parliament’s bulletin showed yesterday. If the government can’t meet the aid terms, “it’s up to Greece to figure out how to get financing without the euro zone’s help,” he later said in a speech to parliament.


      Schaeuble’s reported statement bears an uncanny resemblance to ‘sauve qui peut.

      Got lifeboats?

  8. Linus Huber

    We always are trying to solve problems but never get to resolve the origin of it. A banker’s job is to be extremely conservative and diligent when extending credit with regard to the overall debt levels as well as to the individual’s capability to pay interest and pay back the loan within a reasonable period of time. The banks failed in this core function miserably because their compensation policies enhance risk taking allowing for some to earn millions which is normally reserved to entrepreneurs who also have to accept downside risk. But here the bankers have arranged to transfer the downside risk to the public domain. This whole scheme is an extreme violation of the spirit of the rule of law and until now no end seems to be in sight. The western society is build on the rule of law and its violation does produce much wider problems down the road that will put the whole system at risk.

    We first have to stop the looting and make those that did not do their job properly while lining their pockets with ill received benefits, accountable on a personal level. They will stop only then and not a day before.

    Once that base level has been established, we can go to resolve the results of those poor performance of bankers.

    1. Because

      The problem is with that, alot of the “banks” which did the lending weren’t even that big. While you have crooked banks like Goldman Sachs who were “good” and didn’t lend toxically like the others. But they still need to die.

      I think the problem isn’t so much the banks, but a system that worships global wealthy capital owners over country, but then try and rationalize that as ‘patriotic’. How Orwellian.

  9. Hugh

    The eurozone is untenable. This is far more than a monetary problem. It’s the pattern of trade flows dominated by an export oriented “beggar thy neighbor” Germany. It is about kleptocratic elites operating at both the European and national levels. Current European institutions are remote and anti-democratic. National leaders have shown repeatedly that they have neither the ideas nor the desire to rethink anything or create a European union that actually works.

    The pre-funded EHF reminds me a lot of the pre-funded Social Security trust fund. Where would those funds reside? How big would they be? What would those I am supposign trillions be doing? You see the Social Security funds were spent. All that is left of them is the promise to honor the social commitment they represented. But here’s the thing. If it is all about the social commitment, the trust funds are an irrelevant extravagance. To honor any shortfalls to the Social Security system, the government would need to pay them out of its general funds, but this would be the case whether the trust funds existed or not. Remember the money never actually sat in them like a bank deposit. I don’t see how the EHF is any different. Its pre-funding just seems like another relic of the gold standard era. At best, it is unnecessary. At worst, as with the Social Security trust funds, it is a con.

  10. Because

    Somebody is going to be ringfenced in. Either Chindia,US or Europe. Which is it Euro’s? You make the obvious ones to ringfence.

    Why not come back together with your ole bastard son and lets destroy Chindia in this lifetime. But you won’t do that as much as we won’t because of the bloodlines. Those Dupont’s, Astor’s, Bundy’s,Rockafeller’s,Rothchilds,Renyolds,Li,Freeman,Collins.

    When you live in a globalized society, you will have globalized consenquences. Europe is the obvious victim. It will be economically destroyed so we may prosper.

    1. aet

      On the contrary, it is China and India (fully 2/5 of humanity) and especially the needs and desires of their youth, which will provide the world economy with both the demand and the wherewithal to meet that demand.

      Nice to see you call so openly for a World War based upon perceived cultural differences though – very refreshing honesty!

      Even if vile.

  11. solo

    Yves: You present a compelling argument, but I think that this discussion could benefit from closer attention to the TIME FRAMES involved. The article is entitled, “Few Options Left To Save The Eurozone.” But then note the inconsistent temporal qualifiers “viable” and “at the point of collapse” in your following statements: “In my view, eurobonds and a ‘supra-national’ fiscal agent are almost the only mechanisms which make the euro zone viable . . . . 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 . . . .” –Your “viable” connotes middle- to long-term, as does your citation of Roubini’s “five-year horizon” for the “break up” of the Eurozone. But “at the point of collapse” connotes near-term both of problem and, most crucially, of solution to the current crisis–brought to a near-term climax by, say, Greece’s default next week. The question then becomes, What might the Europeans do in such a case, especially in order to prevent a cascading crisis that would plunge Europe, hence the world, into financial collapse and recession?
    What seems a likely response, given (a) the constraints against Eurobonds that you note, but in conjunction with (b)the resolve of the European financial and political elite to maintain the Eurozone (which you also note), is, I submit, implicit in the middle- to long-term solution that you propose: “. . . . the ECB would have to support the EHF by promising to supply unlimited liquidity in the event of a liquidity crisis by buying member state sovereign debt.” For a near-term response (to the hypothesized Greek default next week), why not scrap your EHF (European Harmonisation Fund)–which, however politically viewed, would take much time to set up–and have the ECB directly buy up the bad debt of Greece et al.? Won’t this possibility naturally suggest itself to the luminaries of Europe?–Yes, this is “kicking the can down the road,” and yes, it stinks of moral hazard, but would it not alleviate the cascading effect of the crisis in the near term? Analogy: If California’s debt crisis became so severe that widespread rioting and looting occurred (police & firefighters laid off) while citizens are dropping dead in full view of the media (collapsing infrastructure), don’t you think that the Fed would step in and buy California’s debt? Wouldn’t the ECB do the same in a similarly dire situation?

  12. Paul Tioxon

    Ed, while there is more detail in finance that I can follow, this, in addition to being an economic/financialized crisis is a problem of international relations. In the following link, an interview with on RT News points out that there is no legal exit from the Eurozone. You can’t leave or get kicked out.

    I maintain, there are two mindsets, that are mostly unconscious, a business mindset and a political mindset. The business mindset views social relations as contractual, legalistic between actors who do not have the option of using violent force to get what they want. The operations are within a limited power, arbitrated by the greater power of the nation state.

    The nation state mindset is sovereign, does not liquidate it self or allow constituent components to leave or breakup the relationship, such as in a contract. Corporations can be liquidated by being offered a good enough price to dissolve, and merge with a buyer. What is in the interest of the shareholders, today, means the termination forever of an organization. The nation state would view such an overture as an act of war.

    It is clear that the Eurozone is an integration of a common currency and has not completely allowed for commensurate political integration, leaving member states at a disadvantage to another relative to the strength of their economies, nation governments, and legal structures. Of course the treaties are a function of international relations and the internal politics of Germany as written in their Constitution, disallow sovereignty to be diluted by treaty.

    While there does not seem to viable financial work arounds, political work arounds also seem to be a barrier.

    Is is correct, that there is no legal exit from the Eurzone, meaning, this political integration is not a contract that can simply be mutually dissolved? International relations is more binding than commerce, because the issues of power are not bargained for in the open market, but built up or changed in a completely different manner, as the German Courts and Bundestag sovereignty indicate. While time is money for a business person, expediency reigns, but with power, the calculus is altogether different.

      1. solo

        From the Roubini link cited in the article (above): “Of course, today, the idea of leaving the EZ sounds inconceivable, even in Athens and Lisbon. It is simply not on the table. And of course, the costs of exit would be significant: A country leaving the EZ might also be kicked out of the EU as there is no mechanism to exit EMU without exiting the EU.”

  13. Bluffraise

    EHF stands for “Euro Has Failed”
    Not sure why you are even talking about this issue at this juncture.
    Germans are on the right track. Protect the banking system so your economy can function and rebuild. Period.

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