Monday, September 27, 2010

My best effort to think out the end-game for the Eurozone

The principal threat facing the global economy today is the risk of a default by a eurozone member on its debts. That would be Greece or Ireland.

We need to ask the following questions:
  1. What is the EU’s current strategy for resolving the financial crisis on the periphery?
  2. What are the prospects for success?
  3. What are the potential downside scenarios?
  4. How would these downside scenarios play out in the global and US capital markets?

The EU strategy is as follows: The combination of the implementation of credible austerity policies over the next two years, bridged by the backstop provided by the Eur440B*
“European Financial Stability Facility” will provide the PIIGS (or should I say the GIs?) with a path back to market access and financial stability.

[*In today’s FT, Wolgang Munchau explains in detail why (1) the EFSF is much smaller and more punitive than markets think, and (2) that basically it is a band-aid that won’t solve anything. Heavy stuff.]

I don’t see how the austerity plans will bring down deficits and borrowing needs to a level that allows spreads to come in and market access to resume. Spreads for Greece and Eire have remained sickeningly wide since the facility was announced in May. Hold your breath that they will tighten. They will widen.

Two bad things will happen: (1) the pain of adjustment (see: depression) will ultimately become politically impossible; and (2) the debt markets will remain closed such that that the peripherals must either hit the eject button or issue debt under the stability mechanism’s guarantee (and your guess is as good as mine what these bonds would yield: what rational person would buy those bonds? It’s the ECB or nobody).

My view is that by this time next year, one or more of the peripherals will have hit the wall: the deficit targets will not be met, the pain level will be unbearable, and the markets will remain closed (i.e., even higher yields than now). Refinancing under the stability mechanism solves none of these problems.

This would then force the EU (Germany) to decide between an even bigger, almost open-ended facility, or letting (watching) the sick countries do what they have to do (default, reschedule, redenominate, repudiate) whatever.

I just don’t see the German electorate agreeing to refinance or guaranty the entire periphery. They didn’t sign up for it. Merkel agreed to the stability facility in the face of strong domestic opposition. Germany joined the eurozone on the explicit condition that it would not be responsible for the debts of other eurozone members. This is in the treaty, and also in the German Constitution (according to the Federal Constitutional Court). In my opinion, Germany will not backstop the entire eurozone, nor should it.

Therefore, I see three possible outcomes (by yearend 2011):

1. A peripheral announces a distressed exchange offer of new, long-dated, euro-denominated, low-yield  bonds in exchange for its outstanding (higher-yielding) debt. Since most euro-denominated government debt is issued under domestic law, creditors would have little alternative to accepting the offer.

2. A peripheral unilaterally leaves the euro, reverts to its domestic currency, and redenominates all debts, public, private and foreign (including to the ECB) into the domestic currency at an arbitrary exchange rate. Again, creditors would have no effective legal recourse for debt sold under local (esp. Greek) law. This seems to be the most likely and the least disruptive solution. The national central bank could then allow the currency to decline in value in an orderly fashion (assuming it has any reserves left), create inflation to reduce debt burdens for private and public debtors, and allow nominal wages to rise (maybe).

3. A peripheral redenominates and repudiates its debts. This is unlikely because not only would it cause a punitive backlash from the EU (expulsion, tariffs), but also because it would wreck the Greek banking system (although the Greek banking system is pretty dead under all scenarios except hyperinflation).

Let’s take this thought experiment to the next step. If we accept scenario #2 (unilateral redenomination) as the most likely, what are the consequences for the global capital markets? We are really going out on a ledge here, but it is worth the brain exercise.

The day that Greece exits the euro, and redenominates its currency and all contracts into drachma, what happens?

Spreads on the rest of the indebted peripherals (the PIIGS) would skyrocket, irrespective of their finances at that moment. (The other peripherals would at this point dust off their own exit plans. Once one goes, can the others hang on? Spain? Italy?)

European bank spreads would gap out by hundreds of basis points, and the European interbank market would shut down. The ECB would fill this gap with massive free liquidity, such that banks would not fail immediately due to the shock. That will be a bad day for the president of the ECB (who is going to be a hard-money German!).

If, as and when the other PIIGS go to Plan B, then the crisis morphs into a 1931-style debacle: every man for himself; the strong win and the weak go under. Nations act to protect their banks. The interbank market just evanesces; it’s gone.

Banks in the redenominating nations would receive unlimited local currency liquidity from their revived central banks. The defaulting banks’ euro and dollar denominated debts to European banks and the ECB would be unilaterally redenominated into local currency by law. (Remember Latin America in 1982?)

You would then be looking at a European banking crisis. If additional PIIGS go under, the banking crisis becomes a meltdown. The immediate liquidity issue can be addressed by the ECB (unless the top German starts channelling Andrew Mellon); but the solvency issue must be addressed by the national fiscal authorities. [The EU cannot and will not recapitalize banks.] Government bonds can be swapped for peripheral bonds, or there could be temporary accounting forbearance (remember that?). But anyway, it’s awful, and worse than Lehman. Bad for stocks, good for the dollar, treasuries, and gold.

What happens to the redenominators? Well, they immediately lose access to all international credit including the ECB. They go cold turkey. But they can still finance their fiscal deficits and banking systems by using their unlimited ability to create local currency. So, they face inflation, drastic depreciation and a depression that is probably less severe that what they would have gone through under the euro. Over time, they would regain competitiveness, and perhaps even credibility if they avoid hyperinflation. Or, they descent into Zimbabwean chaos.

What does this mean for the euro? Initially it depreciates, sending a deflationary shock worldwide (the ECB can do nothing to stop this--besides raising interest rates!). The ECB will also have to face a big writedown on the bonds it bought from the peripherals (which is why it resisted this policy for so long).

How much the ECB can do to stem deflation depends on the degree to which the Germans will allow it to engage in unconventional policies (QE). Germany will be in the cockpit with respect to both rescue and monetary policy.

I think it’s inevitable that Germany will exit the eurozone and restore the Deutshe Mark within the next two years (yes, an extreme prediction, but is the alternative more credible?). Is that the end of the euro? Hopefully.

As the euro goes down, the dollar, the yen and the RMB go up. Treasury and JGB yields go down, unless the BoJ and the FRB lean against the wind and expand their money supply to offset what is happening in Europe. This could be inflationary in Europe, the US and Japan, which is not a bad thing. The Fed will resist any deflationary shocks coming from Europe.

What happens to global aggregate demand under such a scenario? Who knows? Can the Fed engineer domestic prosperity when Europe is hurting global confidence and investment? It is worth positing that a burst of worldwide inflation is just what the doctor ordered.

The indicator to watch is Greek and Irish bond yields, not the euro.

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