We’ve had a huge number of requests for an update on our thoughts on what’s going on in Europe.
Attention has suddenly focused on deposit flight and the risk of bank runs in the Eurozone. Deposit flight is an entirely rational response to the perceived increase in risk of the single currency disintegrating, since presumably the new Deutschemark would immediately appreciate dramatically against a new Greek Drachma or new Spanish Peseta. Deposit flight is also indicative of investors pre-empting the strict capital controls that would need to be implemented immediately prior to the currency breaking up. Such capital controls would prevent individuals from withdrawing money from savings accounts or transferring money to another currency, and were previously put in place in countries such as Malaysia in 1997 in the aftermath of the Asian financial crisis and in Argentina following default in 2001.
However while the pace of deposit flight has accelerated recently, this is not new news. The Eurozone has been experiencing a slow motion bank run ever since Greece started getting into trouble at the beginning of 2010, with deposits leaving banks in peripheral Europe and heading towards the core. This is something that we were very aware of and has been a significant factor in our avoiding peripheral Eurozone sovereigns and financials the last few years.
The acceleration of deposit flight is of course exceptionally worrying, since in the absence of guarantees, a bank run can quickly develop into a bank and sovereign collapse. The problem that Eurozone countries face is the lack of a backstop. The ECB could step in, however it is very concerned that any guarantee of either peripheral sovereign debt or peripheral banks creates rampant moral hazard. Peripheral European nations would respond by refusing to implement painful reforms safe in the knowledge that they’ll be bailed out as soon as they get into trouble. The ECB is also limited in what it can do given that it is formed of individual countries’ central banks, which ultimately belong to the taxpayers of those countries. And the German taxpayer, who would have a major responsibility for additional future bailouts, will be unwilling to send funds to southern Europe if there is no reform in return.
The medicine dished out so far has failed to alleviate the problem. Firewalls that had been half-heartedly built have long collapsed; EFSF/ESM did not prevent even the relatively small Irish and Portuguese economies requiring a bailout. Neither did the ECB’s Securities Market Program, and the massive ECB liquidity injections have failed in anything other than the short term because the problem is one of insolvency, not illiquidity.
For the Eurozone to remain a whole in the long term, it requires total fiscal unity and effectively the abolishment of individual sovereignty. But if anything, Europe seems to be moving in the opposite direction. At the heart of the problem in the Eurozone, as we and many others have long argued, are the significant current account imbalances and competitive disparities between Eurozone member states. These need to be eliminated. Up until now, the plan has been to reduce the imbalances via austerity, which reduces imports and restores the trade balance, but has the severe side effects of killing domestic demand, causing recession, and resulting in much higher public debt levels. The plan is clearly failing.
Another way the competitive imbalances could be eliminated is via higher inflation rates in the north than the south. The ECB’s inflation target for the Eurozone as a whole is 2%, and for competitiveness problems to be eliminated, inflation rates in Germany or the Netherlands need to be as high as 5 or 6% while inflation rates in peripheral Europe are 0-1%. Germany appears totally resistant to this.
The only other alternative to avoiding a disintegration of the Eurozone would seemingly be outright default within the euro. So far only the countries that have borrowed too much have been punished, why not those who have lent too much? However, again, northern Europe has been unsurprisingly resistant to this given that they are the ones who have excessively lent. (In their defence though, default would be unlikely to lead to reform, and while cutting southern Europe’s stock of debt would help, it’s quite likely that the current debt crisis would simply replay in the not too distant future).
So the disintegration of the euro looks to me to be the most likely outcome. This would be very expensive and disruptive in the short term. Some estimates put the costs at over €1tn, but in reality it’s utterly impossible to say and would depend on whether it’s a messy breakup, a very messy breakup or an unthinkably messy breakup. At least if the authorities are discussing the risks of a disorderly breakup, it should by definition become more orderly.
We may get some temporary respite from the panic if Greece manages to form a government, but this will surely just prove temporary as further austerity leads to continued recession, civil discontent and greater support for extremist political parties (which is already scary – 1 in 14 Greeks just voted for a neo-Nazi party). The ECB very probably has more tricks up its sleeve, which may be LTRO 3 or perhaps some form of Quantitative Easing (e.g. purchasing a GDP weighted portion of member states’ government bonds). But these measures will again fail to address the underlying imbalances at the heart of the Eurozone.
It’s hard to see how the Eurozone debt crisis isn’t going to get worse before it eventually gets better. Dismantling the currency union, which seems to be the best long term solution, will clearly be far more complicated than the many historical precedents of fixed exchange rates being unfixed. But the good news is that countries typically see a significant economic recovery after unsustainable fixed exchange rates are abandoned – just look at Asia in the last decade.