Envisioned by the EU Treaty on Monetary Union, the common currency, the euro, has suffered from two core problems during its decade-long existence: the lack of a parallel political union and the issue of debt. Many in the financial world believe that what is required for a viable currency is a fiscal union that has taxation power — and that is indeed needed. But that misses the larger point of who would be in charge of the fiscal union. Taxation and appropriation — who pays how much to whom — are essentially political acts. One cannot have a centralized fiscal authority without first having a centralized political/military authority capable of imposing and enforcing its will. Greeks are not going to implement a German-designed tax and appropriations system simply because Berlin thinks it’s a good idea. As much as financiers might like to believe, the checkbook is not the ultimate power in the galaxy. The ultimate power comes from the law backed by a gun.
Europe’s Disparate Parts
Europe simply isn’t to the point of willing conglomeration just yet, and we do not use the American Civil War or German unification wars as comparisons lightly. STRATFOR sees the peacetime creation of a unified European political authority as impossible, since Europe’s component parts are far more varied than those of mid-19th century America or Germany.
The point is this: With Europe having such varied geographies, economies and political systems, any political and fiscal union would be fraught with complications and policy mis-prescriptions from the start. In short, this is a defect of the euro that is not going to be corrected, and to be blunt, it isn’t one that the Europeans are trying to fix right now.
The Debt Problem
One impact of this commitment is that Germany’s low interest rates are applied throughout the currency zone, even to states with mediocre income levels, lower educational standards, poorer infrastructure and little prospect for long-term growth. Following their entry into the eurozone, capital-starved southern Europeans used to interest rates in the 10-15 percent range found themselves in an environment of rates in the 2-5 percent range (currently it is 1.0 percent). To translate that into a readily identifiable benefit, that equates to a reduction in monthly payments for a standard 30-year mortgage of more than 60 percent.
As the theory goes, the lower costs of capital will stimulate development in the peripheral states and allow them to catch up to Germany. But these countries traditionally suffer from higher interest rates for good reasons. Smaller, poorer economies are more volatile, since even tiny changes in the international environment can send them through either the floor or the roof. Higher risks and volatility mean higher capital costs. Their regionalization also engenders high government spending as the central government attempts to curb the propensity of the regions to spin away from the center (essentially, the center bribes the regions to remain in the state).
This means that when the eurozone spread to these places, theory went out the window. In practice, growth in the periphery did accelerate, but that growth was neither smooth nor sustainable. The unification of capital costs has proved more akin to giving an American Express black card to a college freshman: Traditionally capital poor states (and citizens) have a propensity to overspend in situations where borrowing costs are low, due to a lack of a relevant frame of reference. The result has been massive credit binging by corporations, consumers and governments alike, inevitably leading to bubbles in a variety of sectors. And just as these states soared high in the first decade after the euro was introduced, they have crashed low in the past year. The debt crises of 2010 — so far precipitating government debt bailouts for Ireland and Greece and an unprecedented bank bailout in Ireland — can be laid at the feet of this euro-instigated over-exuberance.
It is this second, debt-driven shortcoming that European leaders discussed Dec. 16. None of them want to do away with the euro at this point, and it is easy to see why. While the common currency remains a popular whipping boy in domestic politics, its benefits — mainly lower transaction costs, higher purchasing power, unfettered market access, and cheaper and more abundant capital — are deeply valued by all participating governments. The question is not “whither the euro” but how to provide a safety net for the euro’s less desirable, debt-related aftereffects. The agreed-upon path is to create a mechanism that can manage a bailout even for the eurozone’s larger economies when their debt mountains become too imposing. In theory, this would contain the contradictory pressures the euro has created while still providing to the entire zone the euro’s many benefits.
Obstacles to the Safety Net
“Houses in order” are the key words here. When the not-so-desperate eurozone states step in with a few billion euros — 223 billion euros so far, to be exact — they want not only their money back but also some assurance that such overindulgences will not happen again. The result is a deep series of policy requirements that must be adopted if the bailout money is to be made available. Broadly known as austerity measures, these requirements result in deep cuts to social services, retirement benefits and salaries. They are not pleasant. Put simply, Germany is attempting to trade financial benefits for the right to make policy adjustments that normally would be handed by a political union.
It’s a pretty slick plan, but it is not happening in a vacuum. Remember, there are two more complications. The second is that the Dec. 16 agreement is only an agreement in principle. Before any Champagne corks are popped, one should consider that the “details” of the agreement raise a more than “simply” trillion-euro question. STRATFOR guesses that to deliver on its promises, the permanent bailout fund (right now there is a temporary fund with a “mere” 750 billion euros) probably would need upwards of three trillion euros. Why so much? The debt bailouts for Greece and Ireland were designed to completely sequester those states from debt markets by providing those governments with all of the cash they would need to fund their budgets for three years. This wise move has helped keep the contagion from spreading to the rest of the eurozone. Making any fund credible means applying that precedent to all the eurozone states facing high debt pressures, and using the most current data available, that puts the price tag at just under 2.2 trillion euros. Add in enough extra so that the eurozone has sufficient ammo left to fight any contagion and we’re looking at a cool 3 trillion euros. Anti-crisis measures to this point have enjoyed the assistance of both the ECB and the International Monetary Fund, but so far, the headline figures have been rather restrained when compared to future needs. Needless to say, the process of coming up with funds of that magnitude when it is becoming obvious to the rest of Europe that this is, at its heart, a German power play is apt to be contentious at best.
The third complication is that the bailout mechanism is actually only half the plan. The other half is to allow states to at least partially default on their debt (in EU diplomatic parlance, this is called the “inclusion of private interests in funding the bailouts”). When the investors who fund eurozone sovereign debt markets hear this, they understandably shudder, since it means the European Union plans to codify giving states permission to walk away from their debts — sticking investors with the losses. This too is more than simply a trillion-euro question. Private investors collectively own nearly all of the eurozone’s 7.5 trillion euros in outstanding sovereign debt. And in the case of Italy, Austria, Belgium, Portugal and Greece, debt volumes worth half or more of GDP for each individual state are held by foreigners.
Assuming investors decide it is worth the risk to keep purchasing government debt, they have but one way to mitigate this risk: charge higher premiums. The result will be higher debt financing costs for all, doubly so for the eurozone’s more spendthrift and/or weaker economies.
For most of the euro’s era, the interest rates on government bonds have been the same throughout the eurozone, based on the inaccurate belief that eurozone states would all be as fiscally conservative and economically sound as Germany. That belief has now been shattered, and the rate on Greek and Irish debt has now risen from 4.5 percent in early 2008 to this week’s 11.9 percent and 8.6 percent, respectively. With a formal default policy in the making, those rates are going to go higher yet. In the era before monetary union became the Europeans’ goal, Greek and Irish government debt regularly went for 20 percent and 10 percent, respectively. Continued euro membership may well put a bit of downward pressure on these rates, but that will be more than overwhelmed by the fact that both countries are, in essence, in financial conservatorship.
That is not just a problem for the post-2013 world, however. Because investors now know the European Union intends to stick them with at least part of the bill, they are going to demand higher returns as details of the default plan are made known, both on any new debt and on any pre-existing debt that comes up for refinancing. This means that states that just squeaked by in 2010 must run a more difficult gauntlet in 2011 — particularly if they depend heavily on foreign investors for funding their budget deficits. All will face higher financing and refinancing costs as investors react to the coming European disclosures on just how much the private sector will be expected to contribute.
Leaving out the two states that have already received bailouts (Greece and Ireland), the four eurozone states STRATFOR figures face the most trouble — Portugal, Belgium, Spain and Austria, in that order — plan to raise or refinance a quarter trillion euros in 2011 alone. Italy and France, two heavyweights not that far from the danger zone, plan to raise another half-trillion euros between them. If the past is any guide, the weaker members of this quartet could face financing costs of double what they’ve faced as recently as early 2008. For some of these states, such higher costs could be enough to push them into the bailout bin even if there is no additional investor skittishness.
The existing bailout mechanism probably can handle the first four states (just barely, and assuming it works as advertised), but beyond that, the rest of the eurozone will have to come up with a multitrillion-euro fund in an environment in which private investors are likely to balk. Undoubtedly, the euro needs a new mechanism to survive. But by coming up with one that scares those who make government deficit-spending possible, the Europeans have all but guaranteed that Europe’s financial crisis will get much worse before it begins to improve.
But let’s assume for a moment that this all works out, that the euro survives to the day that the new mechanism will be in place to support it. Consider what such a 2013 eurozone would look like if the rough design agreed to Dec. 16 becomes a reality. All of the states flirting with bailouts as 2010 draws to a close expect to have even higher debt loads two years from now. Hence, investors will have imposed punishing financing costs on all of them. Alone among the major eurozone countries not facing such costs will be Germany, the country that wrote the bailout rules and is indirectly responsible for managing the bailouts enacted to this point. Berlin will command the purse strings and the financial rules, yet be unfettered by those rules or the higher financing costs that go with them. Such control isn’t quite a political union, but so long as the rest of the eurozone is willing to trade financial sovereignty for the benefits of the euro, it is certainly the best thing.
Europe: The New Plan is republished with permission of STRATFOR.