Opinion

Hugo Dixon

The euro zone’s self-fulfilling spiral

By Hugo Dixon
November 20, 2011

When confidence in a regime’s permanence is shaken, it can collapse rapidly. The fear or hope of change alters people’s behavior in ways which make that change more likely. This applies to both political regimes such as Hosni Mubarak’s Egypt and economic regimes such as the euro.

Fear that the single currency may break up now risks becoming a self-fulfilling prophecy. Banks and investors are beginning to act as if the single currency might fall apart. Politicians and the European Central Bank need to restore belief that the single currency is here to stay. Otherwise, it could unravel pretty fast.

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view. Since the euro summit on Oct. 26-27, it has become a mainstream scenario. So much so that last week risk premiums on the bonds of even triple-A rated countries such as France and Austria rose to record levels, while Spain became the latest country to be sucked into the danger zone.

The summit itself made two technical decisions which have had damaging, unintended consequences. First, banks underwent a stress test that marked their sovereign bond exposures to market whereas previously regulators maintained the fiction that these positions were risk-free. This meant that lenders suddenly had to start holding capital to back their sovereign debt investments. Not surprisingly, they have become more reluctant to buy bonds. This, in turn, has made it harder for governments to fund themselves.

Second, the summit decided to strong-arm the banks into agreeing to a “voluntary” debt restructuring for Greece. Because the deal is supposedly voluntary, credit default swaps (CDS) – a type of insurance policy that pays out if an entity goes bust – won’t be triggered. This arm-twisting has convinced lenders that CDSs are a useless way of hedging the risk of investing in euro zone government bonds. Without a hedge, many prefer not to hold the bonds at all – again making it harder for states to fund themselves.

After the summit, things went from bad to worse with Greece’s disastrous plan to call a referendum on its latest bailout plan. That idea was withdrawn – but not before Germany and France suggested that Athens might need to be kicked out of the euro unless it came to heel. The snag is that it would be very hard to isolate the Greeks. If one country could leave the single currency, why not two, three or all 17?

As investors thought about the possibility of a euro break-up, they started factoring in currency risk. Under such a scenario, the new Greek drachma would plummet in value; the new Italian lira and Spanish peseta would also take a tumble; even the new French franc would depreciate versus a vibrant new Deutsche Mark. That gave the market another reason to sell pretty much every non-German government bond – again making it harder for those states to fund themselves.

As if this wasn’t bad enough, banks are also suffering from a liquidity squeeze. It’s not just investors who are getting jittery about putting their money in banks; lenders are reluctant to lend to each other because they are not totally sure that their peers will survive.

Banks outside the euro zone are also cutting their lines of credit to those inside the zone. The big four UK banks cut interbank loans by around a quarter in the three months to end September, according to data compiled by the Financial Times. Meanwhile, the United States is about to embark on a new stress tests of its lenders. This will include contingency planning against further disruptions in Europe. It wouldn’t be surprising if this provoked American banks to cut their exposure to their euro counterparts, further exacerbating their funding problems.

These vicious spirals have drowned out the good news on the political front. Italy, Greece and now Spain have new prime ministers, all of whom seem intent on cutting debts and making their economies fitter. But they will struggle to reduce their borrowing costs unless investors can be convinced that the euro is here to stay.

The one thing that probably would restore confidence is if the ECB found some way of supporting governments that were pursuing sensible policies. But the central bank itself and Germany, the euro zone’s main paymaster, have so far resisted this. In part, this is because they think governments won’t have a strong incentive to reform if they are bailed out too easily.

The logic of making countries sweat so that they address problems they have shirked for years, and sometimes decades, is a good one. But the ECB and Germany should remember that carrots are useful incentives, as well as sticks – and, if they don’t provide the carrot soon, the euro may not survive.

Comments
14 comments so far | RSS Comments RSS

We can be assured that pandering politicians will be only too glad to offer the populace the “carrot” of telling Brussels to stuff it.

Posted by johnvos | Report as abusive
 

r u holding a short position against the euro?

Posted by robb1 | Report as abusive
 

So this means the only safe haven is…… Japan???????

Posted by Sanpatong | Report as abusive
 

“This arm-twisting has convinced lenders that CDSs are a useless way of hedging the risk of investing in euro zone government bonds. Without a hedge, many prefer not to hold the bonds at all – again making it harder for states to fund themselves.”
It doesn’t say much for the EU elite that they could not foresee their policy on CDSs would have exactly the opposite effect they were looking for.

Posted by skeptic | Report as abusive
 

tHE WHOLE CRISES IS CAUSED BY UNPROFESSIONALISM AND DITHERING BY POPULIST POLITICIANS AND PARTICULARLY THE GERMANS HAVE CONTRIBUTED GREATLY TO THE CRISES SPEADING!
THANK YOU MRS. MERKEL, WEIDMANN AND SCHAEUBLE – YOU WANT TO TERMINATE THE EURO THEN PLS SAY SO!

Posted by TB7W1B | Report as abusive
 

(quote) “The one thing that probably would restore confidence is if the ECB found some way of supporting governments that were pursuing sensible policies.”

Which governments?
Sensible policies… what does that mean in relation to the eurozone?

Other than that, this article seems a rehash of points already made over the last four weeks. Or rather, “prophecies”.

Posted by scythe | Report as abusive
 

I continue to be amazed by the general belief out there in “journalist land” that the Euro was/is a viable construct. We are watching the Euro die a slow and inevitable death. Why? It’s simple. A soveriegn nation that no longer has a soveriegn currency cannot effectively manage its own finances. The economically stronger partners in a shared currency will always end up “owning” the weak. We can see on the streets of Athens what Greeks think about becoming Germany’s southernmost province.

Posted by changeling | Report as abusive
 

For example, “sensible policies” – an article by Sebastian Tong, UK Reuters: “Baltic experiment has lessons for euro zone”

Sebastian is providing well-focused policy analyses rather than frothing up old soundbytes.

http://uk.reuters.com/article/2011/11/11  /uk-eurozone-soe-reform-f-idUKTRE7AA3XA 20111111

Posted by scyth3 | Report as abusive
 

Τhe two unintended consequences are not negative:
(a) marking to market ==> truth v/s fiction
(b) showing that CDS are paper tigers ==> re-learning to judge risk instead of insuring against it.

Posted by Ecclesiastes | Report as abusive
 

I’m sick and tired of people pushing the ‘Domino Theory’ BS on us. It’s that kind of nonsense that got the US into the Vietnam War. It’s like that generalizing that the whole barrel of apples is bad because you found two or three in there. There is solidarity only where there is a common view and interest. And these generally involve a common mentality. Greece obviously doesn’t share a ‘common mentality’ with Germany. It isn’t even really a European country for this same reason. It should never have been let into the EU (same with Cyprus) let alone the Eurozone.

Posted by Eric93 | Report as abusive
 

“Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view.”

No, actually some pretty astute mainstream people have been saying that all along, they just weren’t listened to. Rejection of Maastricht has been a political reality since the early ’90′s, and the structural problems were obvious then, to whole countries like Denmark.

Posted by ARJTurgot2 | Report as abusive
 

Let reality take its course. We must now let the Euro revert to being a separate currency within Europe and we must let any nation convert to one of their own if they wish or need to devalue.

Posted by Corrigenda | Report as abusive
 

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view.

Errrr no! To anyone with a scrap of common sense, it was blindingly obvious that this made-up currency was doomed from day 1!!!

Now, I’m waiting for the next war…that is coming sooner that people think!

Posted by mgb500 | Report as abusive
 

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view.

Errrr no! To anyone with a scrap of common sense, it was blindingly obvious that this made-up currency was doomed from day 1!!!

Now, I’m waiting for the next war…that is coming sooner that people think!

Posted by mgb500 | Report as abusive
 

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