Betting on the unthinkable in the euro zone

By J Saft
January 16, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own –

Some crises bring partners closer together. Some, as investors in the euro zone are likely to discover this year, drive them further apart.

Look for rising tensions about fiscal and monetary policy among the bloc’s 16 member nations, and for a bigger penalty to be imposed on the euro and some euro zone assets against the possibility of a breakup or a secession from the currency group.

The liquidity crisis of last year left smaller members of the euro thanking their lucky stars they were inside a big warm tent with a major currency and critically, a powerful central bank that could help banks and maintain order in financial markets.

Ireland and Greece, to name but two, could look at the disaster in Iceland, which suffered a banking and currency collapse, and see the real tangible benefits of membership.

But now that the crisis has morphed into one in the real economy, with exports plunging and employment hit, things will be less cohesive within the euro zone, with one currency having to do duty for different countries with different economies and levels of competitiveness.

European governments vary widely in their ability to withstand the fiscal squeeze from falling tax receipts, as well as having varying ability to credibly take on programs of stimulative deficit spending. That of course is about all that euro countries have open to them when it comes to unilateral action, being forced as a condition of membership to live with a common currency and interest rate policy.

The ECB is widely expected to cut rates by a half a percentage point on Thursday, to 2.0 percent, a level considerably higher than the ideal for many hard hit smaller economies.

The implication is weakness for the euro, as investors impose a breakup premia, and more weakness for the bonds of smaller peripheral countries.

Standard & Poor’s on Wednesday cut Greece’s sovereign debt rating, citing falling competitiveness and a rising fiscal deficit. S&P has also threatened the credit ratings of Ireland, Portugal and Spain on concerns about deteriorating public finances.

The extra interest Greece must pay to borrow money for 10 years as compared with Germany stands at 246 basis points, while for Ireland the figure hit 180 basis points, also a record, and spreads have widened too for Spain and Portugal. Coming at a time of low interest rates, with German 10-year debt yielding just over 3 percent, these are whopping premiums for debt that theoretically should be very tightly related.

CHEER UP, IT MIGHT NEVER HAPPEN
To be clear, the chances of a country leaving the euro zone currency project are still extremely small, though it now rates as a possibility for discussion in polite company.

For one thing there is no escape hatch, no plan as to how a national currency might be reborn. For another, there is the matter that while a bit of a weak currency and an accommodative interest rate might seem attractive at first blush, the reality would include much higher interest rates and the real risk of a Latin-American style inflation and currency crisis.

“Put very simply if either Greece or Italy, for example, left, the sort of spreads they are trading on at the moment would have to treble,” said Marc Ostwald, strategist at brokerage Monument Securities in London.

“There would be colossal inflation in both countries as a result.”

It would also be extremely tricky to pull out without very seriously impairing your national banking system, though that impairment may come of its own momentum anyway, conceivably as the flash point for a break-up. But just because something is a dumb idea doesn’t mean it won’t be advanced as reasonable.

There are other issues causing problems for countries with smaller bond markets. Investors are generally showing an almost unprecedented preference for stuff that is easy to sell, and German bonds are just a lot more liquid.

You can also argue that the kinds of very narrow spreads we saw before the crisis were simply one more manifestation of the headlong search for yield, and that some but not all of the re-pricing is warranted as a reflection of the new reality.

There are a couple of bitter ironies here for the euro zone. The world has probably never needed an alternative reserve currency more, with natural demand likely to rise for liquid, safe non-dollar assets given U.S. imbalances and monetary policy experiments.

It is also a bit raw that the downturn that will test the euro zone is not of its making. Its consumers by and large didn’t gorge at the debt feast and savings rates remained on the whole higher.

But that is cold comfort and no assurance the price of the risks of euro disintegration won’t rise further.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

25 comments

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Germany should abandon the euro. Screw the parasites.

Posted by Arfur.ffoulkes-Sake | Report as abusive

Please do not pay attention to those negative comments against the Euro….and much less to those asking for withdrawals.
The Euro is the European proof that we can withstand the U.S. Dollar policies in a much better way. The Euro is a living proof of the power of the 16 to be 27 countries that will understand the benefits to be covered and protected by the abuses of the U.S. monetary policies. By the time we will be 27 countries in the euro zone……it will take 2 dollars to purchase 1 Euro.

This is similar to James Saft’s previous article about the disuse of the U.S. dollar as a global basis. I’m not a historian. But I think sometime after WWI, Germany was forced to pay for all of the damage it caused. Their currency became worthless. In many respects the rise of the Third Reich was predictable. Like little echoes through time we see these distortions in value. I think centralized control helps to moderate instabilities, and it is perfectly fine for an economic union to assist its weaker constituents.

Posted by Don | Report as abusive

What most Europeans have not considered is that the same thing is going on in the US. One only has to look at California’s budget and bond woes to see a comparison with the UK, or Florida’s perhaps, to Spain. No one in the US expects either to secede because of it, and yes, there will eventually be assistance given to those states after the Obama administration gets in and gets settled.

What Europe needs to do is think like a larger entity, relect on John Donne, and consider the consequences to all countries if partial dissolution occurs.

Posted by Mike Fahey | Report as abusive

What most Europeans have not considered is that the same thing is going on in the US. One only has to look at California’s budget and bond woes to see a comparison with the UK, or Florida’s perhaps, to Spain. No one in the US expects either to secede because of it, and yes, there will eventually be assistance given to those states after the Obama administration gets in and gets settled.

What Europe needs to do is think like a larger entity, reflect on John Donne, and consider the consequences to all countries if partial dissolution occurs. [typo fix]

Posted by Mike Fahey | Report as abusive

Despite the doom and gloom, this crisis is more likely to push the Euro members together than force them apart. As you, James, say: Italy and Greece would pay heavily for any move to leave (even if the logistics were clear cut) – and Germany would lose so much influence as to make it the laughing stock of the world.

No – the most likely outcome is that Germany (and other more prudent nations) will come to the conclusion that it is better in the long term to lend to the feckless at below market rates (so cutting the knees from the speculators). Even though it is against EU rules for one country to stand behind another’s debt, this is what will effectively happen.

In return, the feckless will have to apply IMF spending controls (Eire is showing the way with more focus on cutting costs than Gordon Brown has in his one good eye). So the longed for convergence of the federalists will be speeded up by necessity (with the concomitant transfer of funds between economic areas) – and the EU will come to look more like the US (since with the closer economic union will come closer political union – as the founders envisaged).

I think it was Jacques Delors (or someone similar) who once said that a financial crisis would work in the EU’s favour. Now we see just such influences in action – the Med and the Baltic are being squeezed into the same currency straight-jacket to contain a collective madness.

Greece was much better before adopting the euro. Not many people will be disappointed if we Greeks leave the eurozone. Quality of life in Greece has deteriorated over the last 20 years.

Posted by Vasilios | Report as abusive

Don
You certainly know a lot of history that ain’t so, like many Historians.
After WW1, French and British Governments tried to force Germany to pay what were called Reparations, and set up the League of Nations to try and enforce the payments. The story about World Peace was a load of cant. The US disagreed with it all and refused to join.

Trying to enforce these Reparations, which were many times what these countries lost in money, and many times more than Germany could pay, France invaded the Ruhr, the industrial heartland of Germany in 1923. One of the ways that Germany resisted was the hyperinflation.

Inflation was over by 1925, unemployment down to British levels, and the Nazi vote sank. It was only after the Catholic Central Party started putting up unemployment in 1929 that the Nazi vote rose again. Instead of changing policy in 1931, as Britain did, Germany pushed unemployment up right through 1932 and to 30%. It was lack of inflation that put Hitler into power.

Hitler did indeed help the weaker nations of Europe to revive their economies, in a way.

The USA survives in spite of having a common currency. Russia and China only flourished by having a command economy, before or with Communism.

The imposition of the euro will eventually rip euroland apart – trying to treat all economies in the same, ham-fisted, way is a recipe for disaster! For example, how can you regard the economies of Greece & Germany to be the same?

But that is precisely what the air-heads in Brussels are trying to do – I would not be surprised to see a war in Euroland in 20-30 years time over this.

Posted by William Fletcher | Report as abusive

In the words of Thomas Paine, the EU will hang together
simply because there is safety in numbers and it is in their best interest to do so. Rather, the discussion should be about the imminent collapse of the US Long
Bond securities market, its effect on the Euro, world
trade, and stability in world securities markets. Please
try to explain to to your readers the ramifications of such and same.

Posted by Joseph O'Connell | Report as abusive

Strange article. The title is “Betting on the unthinkable in the Euro zone” and yet the author conceded that the chances of smaller countries leaving the Euro are practically nil — because the alternative of a new national currency is worst.
Or maybe the unthinkable is Germany leaving the Euro? But this isn’t mentioned.
Very strange logic.

Posted by ron_paulite | Report as abusive

To Wiliam Fletcher and Vasilos. The Euro has eliminated the money changers from the entrance of the available temples and will continue to do so. The Euro is a unifying tool for europe (16 now ….27 later). Prices went up in every country that adopted the Euro, just out of the retail conversions…everyone was eliminating the small change and round it up to the next higher round figure….i.e. 1.82 became 2.00
The U.S. needs to think globally while changing the Bush Administration madness as far as Monetary and International Policies are concerned. If international treaties continue to be broken, then we will be looking at World War III…..thanks to Bush. The Obama Administration has a lot of Bush damage to repair internally and internationally …is Obama going to be able and have the spine to make the U.S. become fair internationally while suffering a Great Depression? The U.S. will be paying just the interest to China for a while….not the debt caused by the Bush Administration.

Is Mr Saft afraid of the euro zone? Does he think it might be a bigger succes than the USA. Both are United States with one currencie, virtually no borders and their own specialized economies. The euro zone is gaining more momentum in the financial world every day. And this process will speed up, since we can see what havoc greedy Wall Street has caused on the world.

Posted by Peter Nooijen | Report as abusive

Well, this article is really just a catalyst for firing debate, 40% of which is contentious, 30% ration, and the remainder in the miscellaneous category.
The Euro, as long as it has political will behind it, will grow and prosper. The Euro is first and foremost a political vehicle, not economic. And that is where the debate should start. All else is rhetoric and speculation.
Have a good year All!

Posted by Mr Pepper | Report as abusive

Saft is right again. The world-export-champ Germany has just published a tax system which is nothing else but a protection of the german car industy.

Posted by Hans | Report as abusive

Nice analysis, thank you.
The unavoidable trade-offs in monetary union are not usually an issue because there is political union also. Centralised monetary authority parallels centralised political authority. This ain’t so in the Eurozone since the nation states retain much economic authority and the EU structure includes those who are not members of the Euro – notably the UK.

Your article highlights that both the costs and benefits of Euro membership are rising and are spread differentially across member countries. Sounds like a recipe for increased tensions. But the potential rewards of succeeding the debt laden U.S. dollar as the world’s currency and the uncertainties of exit costs from the Euro may be sufficient to keep everybody on-board.

Hard to see rich members of the Euro helping poor members in the way that, for example, B.C. helps out Newfoundland. They alreayd subsidise poor members through the EU and probably don’t fancy paying twice.

We wish Europe the best. We hope to rebuild our (U.S.) manufacturing so we have something to trade. We will probably resort to tariffs until our products improve. Demand is weak because we have 2 or 3 of everything we need and our income is now at risk. So we will hunker down, yardsale, fixup, and grow gardens to get by. We need to stop the party and get back to work.

Posted by Ken | Report as abusive

The irony in all this is of course.. that the only people really having this discussion about a break-up of the eurozone are eurosceptic brits looking for a justification to keep the Pound and secretly hoping for the Euro they always reviled so much to fail.

For any of the economically weak countries in the Euro, leaving would bear such a huge economic cost that it would make any of the advantages of having their own currency pale in significance. The leap from ‘there are higher credit spreads on Greek government bonds than on German ones’ to ‘people are betting that the eurozone is going to break up’ is frankly silly. There are also different credit spreads on different regional governments and government agencies in the US – does that mean people are thinking the USD zone is going to break apart? It is simply a reflection of those entities’ different financial situations .. unlike the US and UK governments, individual eurozone countries don’t have the option to monetize their debt to keep them from default, because they have no direct control over the ECB, so there are real differences in default risk among EU countries – although others members would likely step in to help, if anyone got close to that.

And as for the economically strong countries that could actually leave without causing themselves huge issues, there is zero political will for leaving – they are wielding the power after all. The only thing that could make them consider leaving would be, if the Euro devalued strongly due to the economically weaker countries and gave them the accompanying inflation and other soft currency issues, but that’s not very likely to happen with the ECB being quite hawkish and everyone seemingly steering towards a deflationary recession.

Posted by Daniel | Report as abusive

Wouldnt matter. If the Euro went and Countries went back to their old currencies. Wouldnt matter. So long as you have Countries. Think about it. Same if you had One World Currency. So long as you have Countries you get PROBLEMS.

Posted by derek | Report as abusive

the introduction of the Euro caused inflation to skyrocket, now one expect the same when gettting out of the Eurozone?? Talking about getting screwed in both holes.

Posted by matt | Report as abusive

“they didn’t gorge.” Like heck. They gorged on humongous government which allocates resources just as poorly if not worse than genius american consumers.

This comment is born out of fear!!

The US worst nightmare is when foreign lenders come to the conclusion that financing the US FIRE-economy ponzi scheme will lead to they’re money beeing wiped out and start moving money away from the US.
The fact of the matter is that the FIRE economy is dead!
The stanch is overwealming. Only because the FED is kicking the corps, it appears to be still alive.
The US is very well aware of this and in order to find greater fools to further finance the US ability to roll over it’s debt it is essential that foreigners are scared away from investing anywhere else except the US.

For instance the Eurozone, which is targeted in this comment.

Posted by Jerone | Report as abusive

When thing go too artificial or over valued, this kind of situation is emerge. The lust of more money in every country and people brought us to the today’s economical disaster. Different nations and different finanacials institutes giving many different reasons for this happening, but it is sure, it happended because of lust of money.

Posted by Al Baloushi | Report as abusive

Considering Standard & Poor’s contribution to our current plight, I’ve cut their “rating ability” rating to “haven’t got a clue”.

Posted by Quintin | Report as abusive

The US will obviously wish to protect the dollar. The main query over the Euro is NOT as one commenter put it -the UK – it is in fact the Irish Republic and Greece who are discussing withdrawal.

The Germans will wish to protect their car industry – especially as the build quality is dipping for VW, Audi and M-B – the UK is in trouble becuase “Financial Services” the main export suffers from demand and integrity issues. This is a long way from being solved.

Posted by Dorking Boy | Report as abusive