Munchau: “we are moving closer towards an involuntary break-up”

September 20, 2011

This post originally appeared on Edward Harrison’s blog Credit Writedowns

I just want to highlight three things here from Wolfgang Munchau on the euro zone because he reaches conclusions I have reached.

In an FT article with the pro-European title of “Eurobonds and fiscal union are the only way out”, Munchau writes about a Greek default:

In Berlin, there is now a consensus among senior policymakers that Greece is very likely to default inside the eurozone, but not right away. By the time it happens, the European financial stability facility will be empowered to protect European banks directly. Those who advocate this approach clearly hope that the improved institutional set-up will be sufficient to deal with contagion.

That’s exactly right. There is no stomach for a full fiscal union. That’s not going to happen. Moreover, Germany is preparing for Greek bankruptcy. The markets see this as a near certainty, so it makes sense to get out in front of the event. What Germany wants is an ‘orderly’ bankruptcy, whatever that means. It’s not clear any default will be orderly, but at a minimum the Germans want to be well-prepared and that means extend and pretend.

Munchau also writes about Italian solvency:

The EFSF and its successor, the European Stability Mechanism, have been set up to handle small countries. They are not big enough to handle large countries. Besides, Italy does not have a short-term funding gap, but a long-term solvency problem. With debt of 120 per cent of gross domestic product, a potential real economic growth rate of around 1 per cent, and a long-term interest rate of 5-6 per cent, Italy’s debt sustainability is in doubt. A monetary union, which solves crises through a combination of default and backstops for the financial sector, would hardly solve Italy’s problem.

Yes, the European Sovereign Debt Crisis is a solvency crisis. My version of what Munchau writes is this:

Is it debatable whether Italy is solvent longer-term? Sure. That’s why Italy is under attack. But the right way to deal with this is to stop the panic and address the issues that could lead to longer-term insolvency. Remember, Italy has a primary surplus. It is high debt and interest costs plus slow growth which are Italy’s problems.

Bottom line: without growth or fiscal surpluses, Italy’s debt to GDP grows. That’s how the numbers work. Miraculous growth is not going to happen for demographic reasons (Italy is old). So you have to see cuts to get the debt levels down.

Finally, there’s the money quote. Munchau writes about the dissolution of the euro zone:

The ruling of the German constitutional court has raised legislative hurdles, while political hostility is rising. We are moving away from what I consider the only effective solution to the crisis. This means, by extension, that we are moving closer towards an involuntary break-up.

My version of why a breakup of the euro zone is likely:

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.

[…]

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.

Does anyone have a different view? If so, please post it in the comments.

Feel free to make comments on the original post.

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