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.

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.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see

“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