Eurozone lurches ever closer towards an end game
In the longer-term is was always inevitable that the unsustainable level of debt in a number of the zone’s countries would ensure that the crisis would not go away. However, even those same sensible people have been taken somewhat aback by the rapidity and ferocity of the instability that has erupted this week. The short-term relief has indeed proved to be just that.
This weekend the eurozone is in a deep crisis and is lurching ever closer to some sort of end game. Unfortunately, it is still very hard to say what exactly that end game might look like. Market declines this week have been as dramatic as those seen in the midst of the sub-prime crisis in 2007 and 2008, and the fear and uncertainty that have so firmly grasped markets is very unnerving and unfortunately is not quite familiar.
Granted activity levels in the markets are pretty light as many players are on holiday. However, that fact is quite irrelevant because when fear grips the markets it becomes very difficult to get on top of.
For the deal agreed a few weeks ago to work, economic growth in the eurozone would have had to be sufficiently strong over the next couple of years to generate the tax revenues that would reduce the debt burden in the afflicted countries to manageable proportions. Unfortunately, it was never likely that growth would be sufficiently strong.
Over the past couple of months we have started to see compelling evidence of economic slowdown emerging. The majority of recent economic indicators in the developed world have disappointed, even in Germany.
Data yesterday showed that the two countries that are currently at the eye of the storm — Italy and Spain — both recorded very anaemic growth during the second quarter. Such anaemic growth has the implication that borrowing targets will be more difficult to achieve and the debt burden would then become more unbearable.
The markets got some mild sense of relief yesterday from the US employment report, which was stronger than expected. However, such relief is likely to turn out be very short lived and in the absence of a major political initiative over the next few days, business as normal is likely to resume next week.
Given the unprecedented nature of the current crisis, it is still very difficult to get one’s head around what the end game might look like.
One possibility would include a breakup of the eurozone as we know it today. That could involve a weak country such as Greece deciding to exit, or a strong country such as Germany deciding to make the same decision. While either of those eventualities is possible, I think both are still unlikely. This assessment is predicated on the notion that a breakup of the euro would have a devastating impact on the European banking system and the damage inflicted on all countries would be so great as to deter the political leadership in any country from making such a momentous decision.
However, the existing situation is also not sustainable. The European Financial Stability Fund (EFSF) will have to be increased dramatically, to levels of at least €2 trillion, from €440 billion at the moment, and the ECB will have to be allowed buy all sorts of bonds. Such a move would be very difficult for the Germans in particular to swallow, but swallow they will eventually have to if they want the euro to survive.
ON balance, I think they would conclude that reversing EMU would be an even worse and more painful policy option than increasing the EFSF dramatically.
I have never been a fan of the Euro project dating back to the early 1990s, but even I would have to recognise that we have it and we will have to live with it. The logistics of re-introducing national currencies would be horrendously difficult and destabilising. I think the moribund eurozone political elite will eventually come to that conclusion in order to avoid one hell of a banking and business crisis.
Meanwhile, here in Ireland, things are looking somewhat better relatively speaking. We are no longer the focus of market attention. Our bond yields over Germany have narrowed appreciably and the Standard & Poor’s decision yesterday not to downgrade our debt any further demonstrates a belief that we are making some progress and, more importantly, that the eurozone crisis has spread its tentacles well beyond Ireland to much bigger fish.
We should now keep the head down and continue to press ahead with a domestic reform agenda. It will also help Ireland that even the dinosaurs in the ECB would have to recognise the stupidity of increasing official interest rates any further.
However until the EU political establishment and the ECB step up to the plate, this crisis will continue and get considerably more dangerous.
