How will the Eurozone crisis end?

June 6, 2010

-Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

Back in 1997, when I wrote about the prospects for the forthcoming European Monetary Union, I said I expected something like the Greek crisis to end with a wave of bailouts of ClubMed countries, and I followed the situation through to what seemed its logical conclusion.

I guessed that Germany and the other surplus countries would realise they were caught in a can’t-beat-‘em-may-as-well-join-‘em trap. On balance, I think I stand by that forecast today.

The problem is of course that monetary union without fiscal union requires a willingness to leave member  countries to stew in their own juice when they become insolvent.

In the current situation, this not an option because right from the start of EMU, Brussels used both direct and indirect methods to ensure that no invidious distinctions were made between the debt issued by member country governments.

So, in a regime that treated the bonds of all Eurozone countries as acceptable reserve assets, banks all over Europe (even in Britain) duly bought up sovereign debt with little regard for the creditworthiness of the issuer.

Many of the proposed exit strategies being discussed in the media are irrelevant because they miss the point altogether. The central structural problem in EMU is not that it has no stabilisation fund or any other mechanism for routinely channelling funds from surplus to deficit countries – in fact, the problem is not funding at all, it is enforcement.

Sovereign debt is not simply domestic debt writ large, it is inherently different because, while private borrowers can be forced to repay, if necessary by having their assets seized, there is virtually no legal mechanism available to a country’s creditors. So neither a European version of the IMF nor a new beefed-up version of the Stability (and Growth) Pact will be of much use.

To get an idea of the political economy involved, think back to the 1980’s, to the near-bankruptcy of New York City or to the battle between the Thatcher Government and the Liverpool City Council. (If the 1980’s seem too far back, consider the dilemma the Obama Administration will have if, or when, California faces default).

In each case, the question for the central authority is not whether to bail out, nor is it how to bail out, but rather: how to ensure that a bailout is not simply a license to carry on partying. Paying off the blackmailer may look like a bargain, but how can you be sure he won’t be back for more in a year or two? And, even more worrying, how can you be sure there won’t be copycats following him?

In the end, Washington, D.C., has only indirect ways to discipline New York City or the State of California. In Britain, former Prime Minister Margaret Thatcher solved the Liverpool problem by more or less emasculating local governments, leaving them with little or no control over their own finances – a power grab which has not yet been reversed.

Now, ask yourself, if it is so hard to resolve these issues within a political union as old as England, what hope is there for a satisfactory resolution in the EU?

It’s not as though the issue was unmentioned at the time Italy, Greece, Spain and Portugal entered the Eurozone. On the contrary, their accession was explicitly conditioned on them meeting the Maastricht Criteria, which required them to limit their budget deficit to no more than 3 percent of GDP (compared to levels of 10 percent + today). With a history like this, it would be unwise to rely on any further commitments they offer.

So what will the Germans do? They are, as ever, very concerned to do “the right thing” with respect to Europe – though their idea of what is right sometimes seems to be inspired by a vision of the EU as some kind of multinational updating of a medieval guild.

At the moment, they are being pressed on all sides to “make a contribution to restoring stability” or to “help stimulate demand in the world economy” – in other words, to relax their fiscal policy so as to offset the supposedly deflationary effects of retrenchment in the Eurozone deficit countries and the UK and U.S.

(Never mind the fact that no country has yet progressed beyond declaring the intention to cut spending, and the USA has not even gone as far as that!)

All of which brings me back to my forecast. Here is a rare occasion when what is widely (in my view, wrongly) regarded as the “right” course is also the line of least resistance. The policymakers and the commentariat are almost unanimous in telling Germany to go with the flow: spend, spend, spend.

I may turn out to be wrong and the Germans may be made of (even) sterner stuff than I thought back in 1997, but for the moment I stand by my forecast that they will ultimately give in to the pressure. In fact, they may yet end up taking the rational, if cynical, way out: exploit their strength to borrow as much as possible in Euros – then relaunch the DM and abandon the Euro to its fate.

For the rest of us, the implication is clear. A recovery in the value of the Euro is only likely as a result of Dollar weakness (and vice versa). In the long run, the Euro seems doomed – but then so does the Dollar, and the Pound, and the Japanese appear intent on national harakiri, so the Yen looks doomed. The RMB looks very strong, but it is hard (and risky) to accumulate. No wonder the price of gold keeps on rising.

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