On the 28th day of June 2012, the great leaders of
Europe solved the crisis engulfing their
It was the 19th time that the crisis had been solved. Unfortunately
God seems to be an evil speculator.
The next domino in the line is
Italy. After that the barbarian
hordes will be at the gates of the “special partner” whose bonds are ironically benefiting from flight to quality.
The buyers must be using some complex mathematical formula whose understanding
eludes the rest of the world. French CDS at 180bps when Spain is at 620bps and Italy at 540bps
is the cheapest short available. The problem of course is that soon after
French CDS starts its inexorable rise upwards, laws will be changed and the
market made illegal. With this trade, timing is everything.
This is also the moment when the twin bazookas of EFSF and ESM turn into water pistols even in the eyes of the most ardent optimist.
guarantees 12.75% of EFSF and 11.904% of ESM. Italy further guarantees 19.18% of
EFSF and 17.914% of ESM. The abstract problem of valuing an insolvent state’s
guarantee on loans to itself has suddenly assumed practical dimensions.
With everyone concentrating on
and Italy, problems from the
original schuld of Greece have
moved to the periphery. This loss of focus is going to prove costly. IMF has threatened to withhold aid funds (Bloomberg story referencing original Spiegel article) due to Greece missing its bailout targets.
If it does follow up on the threat then catastrophe beckons. Argentinian
default on 23rd December 2001 happened after the IMF pulled the plug
on further aid on 5th December. The remarks of the German Vice-Chancellor
that Greek exit “had lost its terror” shows the cluelessness of decision
makers. Unless he has turned into a fatalist, the implicit assertion that a
Greek exit will be manageable is foolhardy.
A Greek exit will result in a complete collapse of the economy as it is deluged by a tsunami of bank, corporate and household bankruptcies. Ordinary Greeks will see their savings and pensions evaporate overnight. Inflation will soar as the newly introduced Drachma plummets. The waves will hit the rest of the Eurozone through both private and official channels. The former will be hit by a redenomination of contracts and default while the latter will be hit by the repudiation of TARGET2 liabilities of the Bank of Greece. Further, seeing the plight of Greeks, citizens in other distressed countries will redouble their efforts in stuffing their mattresses with hard currency. Banks runs across the Eurozone will follow. A truly Creditanstalt moment.
Having dithered for so long and continually put good money after bad, there are no good choices left for European leaders. The silver lining is that there are still choices. If they continue in the same vein and hold a 20th summit and a 21st and so on then those choices will no longer be available. The key question is whether they want to stand their ground or retreat from the European Monetary Union (EMU). Advancing to a fiscal union is out of the question given the mismatch in expectations and the political opposition within member states. Everyone may want “more
Europe” but they define it differently. By the time the
disagreements can be ironed over, their position would have been overrun.
As I’ve argued before, standing ground at this stage requires monetisation. That will take away default risk and cause sovereign bond yields to drop. A fall in value of the Euro will make adjustment easier for uncompetitive peripheral economies. It is an implicit wealth transfer from
Germany and other northern European
countries but that is the price to pay for continuing with the EMU.
The second option is of an orderly retreat. Letting states exit the EMU but abide by all the other rules of the EU. This will lead to a disintegration of the Euro but the single market will be preserved. It has to be an overnight big bang exit with everyone who wants to leave out and the remaining nations still in the Euro. A sequential withdrawal will just lead to uncertainty and all the ills outlined above associated with a Greek exit. In practice it means the demise of the Euro since each country would opt for its own currency in order to fully control monetary policy to deal with the shock.
Unhappily, this option is also very costly as contract redenomination and defaults will follow. An initial peg of a national currency to the Euro for redenomination may make it easier but it is likely that capital controls will have to be introduced. Further, a redenomination of TARGET2 liabilities means a wealth transfer from northern
Europe. However, de-facto the
transfer has already taken place due to the actions till date. Whichever way
this resolves itself, Germany
is left holding the can. And the longer these continual crisis summits stretch the
crisis, the bigger is going to be the eventual wealth transfer.
Further attempts to buy time are likely to make these choices moot as disintegration starts through market contagion, bank runs and riots (the Argentine case).
Disclaimer: All ideas elucidated above should not be taken as investment recommendations. The reader should perform his/her own analysis before making any investments.