Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Saturday, 3 November 2012

The Rhyming of History


“If there is ever another war in Europe, it will come out of some damned silly thing in the Balkans.” 
– Otto von Bismarck

An incident in one of the Balkan countries which should have been settled without much fuss grew rapidly malignant and engulfed the entire continent. This was the assassination of Archduke Franz Ferdinand which led to the Great War. Although one would be justified in thinking that it also applies to the current state of affairs. A €20bn cheque to Greece at the beginning of 2010 with behind the scenes conditionality might have settled matters. Unfortunately elections in North-Rhine Westphalia along with typical EU bureaucratic swiftness led to characteristic delay in decision making. By the time the first inept rescue was mounted, the fire had spread.

Despite two bailouts, one restructuring and numerous masterplans, not only is Greece in worse shape but it is still at the exit door. A Greek exit may have lost its horror for those ensconced in a bubble of sanguinity but they are deluding themselves. Just as before 1914 when massive instability was hidden behind a fa├žade of economic and political stability, today’s quiescent markets are covering an increasingly unstable equilibrium.

The oft-repeated refrain is that the European elite will never allow a Greek bankruptcy and exit. All their actions so far lend credence to this hypothesis. This belief has been further strengthened with every red line that has been erased in the misplaced hope that reality will match rosy forecasts. Now, once again a fudge is being created to allow a loan repayment extension and the disbursement of the next €31.5bn aid tranche. This is familiar to the refrain leading up to 1914. It was thought that civilised nations which are economically interlinked can never go to war. Each incident which heightened tensions and made the Great War more probable was dismissed on the belief that the irrationality of mutual destruction could never prevail. No less a person than Winston Churchill thought “…It is too foolish, too fantastic to be thought of in the twentieth century...No, it is nothing. No one would do such things. Civilization has climbed above such perils. The interdependence of nations in trade and traffic, the sense of public law, the Hague Convention, Liberal principles, the Labour Party, high finance, Christian charity, common sense have rendered such nightmares impossible.” One can hear the echoes in the reassuring pronouncements of European leaders today.

More importantly the argument of never allowing a Greek bankruptcy and exit looks at only one side of the problem. In a marriage either party can file for divorce. Of course the EU leaders want to make it work and are trying their best, but the Greeks don’t seem to be so keen on what they perceive as an abusive relationship. Support for anti-bailout parties is growing (including worryingly for extremist parties such as Golden Dawn) and even the coalition government is about to fall apart. Fanning the flames is the non-binding ruling by the Greek Court of Audiors that pension reform is unconstitutional. Despite EU elite’s best efforts, Greece can unilaterally decide to exit (i.e. implode). The argument that the majority’s preference for the Euro over the Drachma will prevent such an occurrence is hogwash. History is full of cases of unofficial and official dollarization preceding and succeeding default. Greece can still use the Euro even if it is not in the Eurozone.

Another worrying similarity with 1914 is the inability of leaders to understand the consequences of a trigger event and their gross underestimation of eventual impact. Until the declaration of war diplomats thought that the dispute between Serbia and Austria-Hungary could be contained. Once war was declared in August, all sides thought it would be a fairly short affair likely to be over by Christmas. Kaiser Wilhelm II famously told German troops in August 1914 that they would be back home before the leaves fall from the trees. A disorderly Greek default and exit would not be an isolated event. First, it would destroy the credibility of the European elite which has already risked immense amounts of economic and political capital by successive Greek bailouts. Second, it would likely lead to contagion as both markets and citizens wonder who is next. Third, it would inflict large losses on official institutions and European partners making further bailouts difficult if not impossible.

The argument that a Greek exit would actually lead to austerity relaxation and unlimited bailouts just as Lehman’s failure triggered a surge of monetary and fiscal support is wrong. First, the EU is not the US and hence the speed of decision making cannot be the same. Second and more importantly, political positions which have been taken and conveyed to voters have solidified over the course of the crisis. Each concession wrangled out at summits has increased bitterness and entrenched positions. North and South Europe are more polarised than they were before it all started in 2010. Therefore a sudden change of direction is unlikely. Just as alliances and political stances of countries pre-1914 made a catastrophe inevitable, so too will current irrational politics contribute to a cataclysm. Finally, the post-Lehman financial sector bailout has generated a tremendous backlash from ordinary citizens. A corrupt elite has been seen to be favoured as the recipient of bailout money. As pro-EU opinion ebbs away in countries like Germany a multiple sovereign bailout to “save the system” is unlikely to fly. This is especially so since public opinion in the donor Northern European countries is shaped by the caricature of the “lazy” southerner. If the latest fracas over the EU budget is anything to go by, countries aren’t going to sign blank cheques when their own economies are on the ropes.

No one thought war was possible in 1914 with the result that the yield on British 2.5% consols (perpetual debt with 2.5% interest p.a) in July 1914 was 3.34%. War and subsequent inflation saw prices more than double destroying investor capital on a massive scale. Similarly the current market isn’t pricing in the probability of an EU meltdown even as we move closer with the Greek car about to take a wrong turn.

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