Saturday, December 18, 2010

Is there a "muddle through" scenario for Europe?

I may have been too confident that the eurozone will inevitably break up.

It may be that Germany and France will indeed “guarantee” the peripheral countries, such that maturing government debt will be backstopped by the EFSF, and maturing bank liabilities will be funded by the ECB on the basis that the banks are backstopped by their governments which are in turn “guaranteed” by the EFSF.  Then, as the peripherals balance their budgets, market access would resume.

If the markets remain closed to the peripherals and their banks, the next step would be fiscal union and the issuance of union debt. There is a body of opinion (in Europe) that this is exactly what will happen, because the alternative is supposedly worse. The French fall into this category, but Germany does not, not yet.

Fiscal union will require a new eurozone treaty, and a national debate in Germany on this issue.  Fiscal union is unpopular with German voters, but if it becomes necessary to save the euro, it is possible that that the two main parties will bite the bullet.

So what I am saying is that there is the possibility that the euozone will muddle through without default or redenomination. It is difficult to predict which outcome is more likley, because they are both hard to imagine. And the “muddle through” scenario only works if the peripherals implement their austerity plans to Germany’s satisfaction. That will be hard. Given the degree of pain that these countries suggests that their voters may give up before Germany does.

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