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business newsWhat Will Happen to the Eurozone?
By
Mitchell Hall Jan 28, 2011 1:45 pm
Germany has postponed the eurozone's looming moment of truth, buying muddle-through time until 2013. What happens then?
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The creation of the eurozone in 1999 gave the poor member economies -- mainly around the Mediterranean -- access to low interest rates, ie cheap credit, which they had not fiscally "earned." It was “like giving southern Europe dad’s black Amex card when starting college,” says STRATFOR Eurasia analyst Marko Papic.
This led to great growth. The problem of course, is that it created bubbles, and there was no way for the European Central Bank (ECB) to halt the bubbles. “Nor did it really want to,” remarks Papic, “So in order for everybody to tighten fiscally now, to start running tight budgets; that only works if they find a different source of capital, because they do need capital in order to be more competitive with Germany, because they don’t have [currency] devaluation as an option.”
While the low interest rates of the last decade effectively gave the poorer economies access to the capital they needed, those rates aren’t coming back any time soon. So now eurozone members need to figure out a new mechanism, but nobody seems to want to do that -- “and this is where we don’t see the eurozone as a viable long-term solution,” says Papic. “The biggest issue in 2011 in terms of inter-European relations is going to be the debate that’s going to start on the 2014-2020 financial perspectives.”
Germany has been essentially funding these historically low interest rates for the region, as well as directing the recent bailout funds to the likes of Ireland and Greece -- but why? Germany has benefited hugely from its membership in the eurozone. Firstly because of the increased market for its exports, and secondly because the poorer countries’ inclusion in the monetary union effectively devalued Germany’s currency -- making it much more competitive. (Of course the flip is also true: Membership inflated the poorer countries’ currencies, making them less competitive, as well as removing devaluation as an option.)
Germany is no longer restrained by the Cold War, or the Cold War institutions of Nato and the European Union. It’s reunified and is a strongly growing country looking for its own sphere of influence. This is why Germany can’t just ditch the eurozone or let it collapse. It has a stake in it. And its stake is its sphere of influence, just like Ukraine and Belarus are Russia’s sphere of influence.
Germany is actually keen to expand the eurozone. Chancellor Angela Merkel has even asked Poland and the Czech Republic to speed up their eurozone application. The reason they are targeting Poland and the Czech Republic specifically, is because they feel those two countries are much more committed to tighter fiscal rules than the southern Europeans. So while the eurozone is absolutely crucial for Germany -- its exports, its sphere of influence -- they’re not necessarily committed to its current makeup.
Right now investors are still seriously worried, which means making fundamental changes to the eurozone isn’t going to fly. Accordingly, Germany is absolutely committed to doing “whatever is takes” to maintain financial stability in the region. “What that means to us,” observes Papic, “is that in the short term the eurozone’s future is very robust. It’s not going anywhere.” By short term he means until 2013, when Greece is highly likely to default when its bailout runs out (unless renewed for another three years).
The Greek bailout was always about buying time for member countries to grow, to allow investors to digest the situation, and to allow soft, orderly defaults. Once the panic has subsided, then they can cut Greece loose and think about reconstituting the eurozone membership.
But until then, with the current climate of investors and bondholders looking at every single statement by every government in every capital, Germany will do whatever it takes -- including quantitative easing. “We are forecasting essentially that at some point, if push comes to shove, the ECB will go into full QE," says Papic. “They will do whatever it takes. Don’t read the laws of the European Union, don’t read the treaties, that all is irrelevant at this point. They are committed to defending the eurozone, and they have consistently showed us that laws and regulations, rules, things we thought were written in stone -- are not so written in stone.”
For example, the ECB had a very strict policy of what kind of bonds it accepted as collateral. But when the crisis struck Greece they consistently lowered the credit rating for government bonds accepted for collateral at the ECB. That artificially inflated the value of the Greek bonds when they should have been worthless. But banks could still use them as collateral. So they did that.
The crisis with Ireland was essentially started when Chancellor Merkel said that in the future investors would have to take a “haircut," or take some losses, which immediately set off the panic. Why made her say that? Germany consistently has to speak to two audiences: a domestic audience of Germans, which is very euro-skeptical, and then the audience of investors and fellow eurozone member states.
During the Greek crisis of early 2010, Merkel was essentially speaking mainly to her domestic audience -- in harsh, hawkish terms -- while finance minister Wolfgang Schaeuble spoke mainly to the eurozone member states and investors. The Greek bailout came on May 10, not so coincidentally, the day after Germany’s North Rhine-Westphalia election on May 9. So the whole back and forth between Germany speaking separately to its investors and to domestic audiences was about domestic politics.
That increased uncertainty and investors were spooked. They heard various German politicians talking about making Greece sell its islands. Clearly, that’s not reassuring.
Now, after their bailouts, both Ireland and Greece are less urgent problems, and are largely beyond the point of hugely mattering. If social unrest in Greece caused it to collapse and a new government came to power that reversed its commitments to the bailout terms, that would change, however. Similar is the case with Ireland, where both Sinn Feinn and Labor are looking strong and both have said they may not necessarily want to pursue the bailout terms.
So what’s going to happen in Ireland when elections come? Will the incoming government maintain its commitment to the austerity measures agreed upon with Europe? There are two center-right parties, Fianna Fail and Fine Gael, that don’t really cooperate with each other because of the Irish civil war, even though their economic policies are very similar. But the bailout may force them to cooperate.
But more to the point, the question on investors' minds is, who’s going to go down next? Many believe Portugal will be next in line to be frog-marched to the chopping block. This is because investors have basically been picking off the smaller countries that are fiscally in trouble with bad balance sheets: “The argument being they can’t deal with the crisis, and it’s true... They have a very low threshold for what constitutes a panic amongst investors," says Papic.
(Like Greece, Portugal’s problem isn’t its banking system. Portugal’s banks aren’t really exposed to Europe at all, and in fact have a lot of exposure to emerging markets -- a good thing.)
No positions in stocks mentioned.
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