Sunday, 20 May 2012

Will the euro survive?

This article was published in The Malta Independent on Sunday - 20 May 2012
This is the question everyone is asking at the moment. I had asked it in a piece I had written on The Malta Independent of 13 February 2009 – ‘Friday Wisdom’. It is worth a re-read and an update. This is what I had written:

“I suppose this is a question which should not be asked, and if it is asked those who are in charge of protecting the integrity of the euro can only answer in the most absolute way that the euro will most definitely survive and even prosper.
“But such absolute assurances should not bar thinkers and realists from asking the question. The very act of posing such a question implies the existence of doubt about the euro’s long-term staying power.
“The euro has just celebrated its first very successful decade and doubters could easily be dubbed as spoilers. But 10 years is a very short time to prove the longevity of a monetary union. History is riddled with similar monetary unions between separate sovereign states, which blew up after several decades of initial success. In fact, if one looks around, it is clear that the major currencies of the world, apart from the euro, are the currencies underpinned by individual sovereign states.
“In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the way the US economy is.
“We are now at the point that the late Milton Friedman had perceived. The euro is being tested by a fierce global recession, and developments going on within the individual component states of the monetary system do not suggest much optimism that the system has the necessary resilience to come out of this challenge unscathed.
“We are seeing the euro area economy being dragged into a deep recession at an astonishing speed. In this context, we are bearing witness not only to external measures of protectionism but we are also seeing measures of protectionism even between members of the EU and the euro area.
“The euro and single market rule book has been shelved. Faced with the primary responsibility to the electorate of the sovereign state that elected them, governments have to put taxpayers’ money at risk to try to stabilise the financial system and to cushion their sovereign economy from the possibility that the recession will deteriorate into a depression. And it is obvious that once taxpayers’ money is put at risk, governments have to take narrow sovereign circumscribed measures to ensure that the benefits of such extraordinary fiscal measures will be enjoyed by the sovereign taxpayers and not by the general members of the Union. The we-are-all-in-this-together syndrome rarely goes beyond lip service.
“So we are seeing France bailing out its car industry but making conditions to ensure that jobs are kept in France and if redundancies are needed these are squeezed out of plants in other EU states. We are seeing Ireland nationalising its banking industry, guaranteeing all bank deposits, and making conditions on its now state-owned banks to give preference to local borrowers in their normal operations across the whole EU.
“It is evident that under the stress of an acute recession, potentially a depression, a monetary system that does not have the benefit of a federal government that can draw up a federal budget to support monetary measures with fiscal measures, is unlikely to withstand within its boundary the tremendous pressures that are building up inside it.
“So what could happen if the internal stress of the euro monetary system becomes too much for the system too bear?
“The first thing that will happen is that further expansion of the monetary union will be frozen till the financial markets get back to a state of normality. One could argue the fact that countries like Denmark, Hungary and Iceland are clamouring to join the monetary union (even though Iceland is not yet an EU member and would have to become one before being accepted in the monetary union) is a sign of strength resulting from the attractiveness of the Union. I doubt it! A system which has de facto suspended its rules cannot bring in new members before it re-establishes discipline. And, frankly, bringing in members motivated by their economic weakness rather than their economic strength is not conducive to stabilising what is an already fragile structure.
“The next thing which could happen is that some of the existent members could find the conditions, legal or de facto, of the monetary union tough going in order to protect their sovereign national interest or indeed to protect the popularity of their own government with the national electorate. It is tempting to think that I am referring here to the weakest links in the system, countries like Italy, Greece, Ireland and Spain either because of their huge national debts (Italy and Greece) or because they are suffering more than others in the recession from exposure to a burst national property bubble (Spain and Ireland). Wrong! These countries would be hurt most if they leave the system and would suffer a substantial downgrade of their national debt and consequently an explosive increase in the cost of servicing it.
“I am referring to the strong countries that can leave without suffering such consequences. It is countries like Germany, France, Netherlands and Austria, among others, who can afford to leave the system with little damage. If the recession worsens to an extent that weak link countries could risk default on their sovereign debt or would need support from the stronger members, we will have to see whether the fraternity bonds are strong enough for the healthy to bear the cost of bailing out the weak.
“In practical political terms, it is inconceivable that taxpayers of the strong countries would accept to carry such hardship. So the only way it could be done outside the fiscal structures is by adopting more liberal (more reckless if you wish) monetary policy leading to a downward floatation of the euro against other major currencies in order to give on a supranational basis what individual euro countries can no longer do on a national level.
“Is it not strange that I am arguing that only reckless monetary policy can save the current composition of the monetary union?”


Just three years and three months after I wrote the above, the euro is hanging by a thread. The ECB did indeed adopt reckless monetary policy through its LTRO programmes, which flooded the banking market with liquidity to keep afloat the banking system in distressed countries, particularly in Greece, Ireland, Spain, Portugal and Italy. However, liquidity is no cure for structural problems. Liquidity buys time without offering true solutions. These must come from painful restructuring decisions to render the economy flexible and competitive and thus capable of resuming growth through exports rather than domestic consumption.

But much time and resources have been wasted in these 39 months. What I had considered inconceivable (that taxpayers from strong countries would bail out countries in distress) proved not only conceivable but also unavoidable. What concerns us most is the exposure that Malta has been unfairly induced to build up on Greece through its direct and indirect participation in bailout programmes. Our direct loans to Greece and our actual and contingent contribution to the EFSF and ESM will involve us in huge losses due to irrecoverability, irrespective of whether Greece stays or leaves the euro. If it leaves, the loss will be instantaneous. If it stays, the loss will accrue gradually as it becomes evident that Greece will need further solidarity through debt forgiveness to survive.

But if Greece leaves the euro, as it will probably have to if a government mandated to abandon the austerity programme linked with the bailout conditions is elected, the losses will be even greater. The ECB will incur huge losses on the exposure it has built towards Greek banks to keep them afloat and the ECB will have to be recapitalised by calling on its members to cough up more money to restore its capital from the huge Greek hit it will take.

Worrying and unfair as such losses may be, there is an even bigger risk. It is the risk of contagion that the fallout from a Greek euro exit will lead to a loss of confidence in the banking systems of other countries already in distress; this will be too big for anyone to handle and will lead to a fast disintegration of the whole euro project.
This scenario is too horrible to contemplate but it does not mean that it is irrelevant or unthinkable. Unfortunately, it is not only thinkable but also quite possible, if as yet improbable. But it can only remain improbable if the EU prepares itself for the shock from a dirty exit by Greece from the euro. As a minimum, these preparatory measures have to include the following:

  • Huge, may be unlimited, ECB liquidity injection initiatives to ensure that banks in all EU countries other than Greece have all the necessary liquidity to meet and nip in the bud any loss of confidence by depositors in EU countries outside Greece.
  • Display of readiness by the ECB to intervene directly in the bond markets to keep within serviceable limits yields on bonds of countries undergoing and adhering to austerity programmes.
  • Launch of a huge fund (sourced by government contribution and monetisation by the ECB) whereby the EIB or the ESM will supply fresh capital to EU banks that are judged insolvent not merely illiquid. This especially applies to Cyprus, given its exposure to Greece, and to Spain given the bad assets still lying on its banks’ books.
Whether the euro survives or not, depends on these measures, and we will know soon enough.

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