Sunday, September 9, 2012

Pathology Of The Eurozone Crisis

I have been asked a number of times “How did the eurozone crisis happen, and how did it grow so big before it was discovered?”

The crisis happened because European Monetary Union was poorly conceived, badly designed, and poorly executed. It grew so big because, like other such bubbles, it worked beautifully so long as it expanded.

EMU was conceived mainly for political reasons, namely to further cement “Europe”, and to further Europe’s desire for a restoration of its “world power” status. Instead of first creating a functioning political union with a government, a legislature and fiscal revenue, Europe put the cart before the horse and created a currency union without a nation, without centralized government, and without fiscal revenue or fiscal sharing.

The "Two Europes"
There is a lot of literature about the ideal conditions for a monetary union, and suffice it to say that the eurozone meets none of them. Europe is a geography, not a nation and not a culture. To be more specific about the differences, the northern part of Europe is more developed than the southern part. The north has stronger political institutions, greater national cohesion, disciplined labor markets, and a competitive private sector. Specifically, the northern European countries have been successful at maintaining international competitiveness despite having hard currencies. Unit labor costs are controlled in such a way that currency devaluation is not necessary.

By contrast, southern Europe is less developed than the north; it is more “Latin,” in the negative sense of the word. Political institutions are weaker, national cohesion is less evident, regionalism is more pronounced, and labor markets are inflexible. Southern Europe has never been successful at maintaining competitiveness with a hard currency. Southern Europe has historically dealt with poorly controlled labor costs by devaluation. Devaluation permits countries to avoid having to control labor costs.

This is why I say that EMU was poorly conceived: it was unsuitable for the heterogenous mix of countries involved.

Furthermore, the eurozone was badly designed. If, ex ante, one had wanted to create a European monetary union, one might have taken a close look at one of the world’s most successful monetary unions, the dollar zone. The dollar zone has three features that have been crucial to its success: (1) a national banking system which is nationally regulated and nationally guaranteed; (2) complete insulation of banks from the creditworthiness of their respective state governments; and (3) the absence of state-level convertibility risk.

The eurozone has none of these crucial features. It lacks a national banking system, national deposit insurance, and national bank regulation. Its banks are highly exposed to their respective governments, and they depend on these governments to guarantee their deposits. And depositors in eurozone banks are exposed to the risk that their deposits could be frozen or redenominated by their respective governments.

The Wrong Central Bank
The eurozone has another design flaw, an almost fatal one. That is that it chose the wrong model for its central bank. A monetary union which contains countries that rely upon a weak currency to remain competitive should not have chosen the Deutsche Bundesbank as its model. The eurozone’s central bank should have included Latin design elements, such as a higher inflation tolerance and a full-employment mandate. In other words, the ECB should have been modeled on the Banca d’Italia, a more forgiving institution.

By choosing the Bundesbank model, the solons had decided that it would be easier to change the nature of southern European society than for the Germans to accept the lira as their currency. That was a mistake: thirteen years of monetary union have not changed southern Europe. Unit labor costs are still uncontrolled, and the tolerance for deflationary policies remains low. Indeed, instead of the south changing, it is the ECB that will now have to change if EMU is to succeed.

The Bubble Economy
Now, given the foregoing flaws, how was the eurozone bubble able to grow so big for so long?  The answer is because it acted as a Ponzi-scheme. When EMU was embarked upon in the mid-nineties, a euphoric mania began in which, as if by magic, southern European countries lost their historic country risk. The magical word on everyone’s lips was “convergence”, the idea that somehow the creditworthiness of the southern countries would converge with the AAAs of the north.

The “convergence trade” meant that one could stop obsessing over southern budget deficits, secure in the knowledge that they were all on an inevitable path toward compliance with the Maastricht fiscal criteria (<3% deficit, <60% D/GDP). The thinking was, ignore the inevitable bumps, and ride the credit spreads down to zero. Overnight, these countries became magnets for capital inflows: their returns were high while their risks were low. A virtuous cycle began in which success fueled success and all the metrics pointed in the right direction. (All the metrics except the current account, but that was now “irrelevant”.)

This bubble started growing in 2002, and it was still growing when the great recession hit in 2008. In such a steep recession, it was natural for countries to run temporary budget deficits, so there was little concern over red ink in 2008 and into 2009.

Greek Perfidy
However, what ultimately poked a hole in the euro bubble was the discovery in late 2009 that Greece had been cooking its books for years, and had never been in compliance with the Maastricht criteria. (Imagine, a country knowingly publishing false statistics! Who had ever heard of such a thing?)

All of a sudden, Greece got hit with a big bucket of cold water. A country which had enjoyed much higher concentration limits than it deserved now began to discover what happens when your limits are reduced. Greece quickly lost market access and required a bailout.

At first it appeared that Greece would only need temporary liquidity support to tide it over until it could get its budget back in balance. Then it appeared that Greece would be unable to repair itself quickly and would be out of the market for a long time, requiring Europe to refinance its maturing debt. When it became evident that not only could Greece not balance its budget, but also that its debt levels were unsustainable, Europe began to realize that fixing Greece was going to be time-consuming and costly.

It was at this point that Europe made its next major mistake. This was to announce that, if Europe were to continue funding Greece, its debts would have to be reduced to a manageable level. And, if the European taxpayer were to have to rescue Greece, its bondholders would have to contribute (what is known in credit circles as "default").

That might sound perfectly reasonable to a politician, but it sounds perfectly unreasonable to a bondholder who has been repeatedly told that default by a eurozone government was “unthinkable”. Overnight, the unthinkable became not only thinkable but a fait accompli. Greece was rescued at the expense of its bondholders and, more importantly, at the expense of the eurozone’s credibility in the bond market. The eurozone minus credibility equals the end of euro mania.

Had Greece been quietly cleaned up, it would have been a manageable problem. But when the doctrine of  “bondholder bail-in” was proclaimed, that meant that every eurozone government instantly became a “credit” once again, to be evaluated on a stand-alone basis.

When the world’s credit analysts turned their microscopes onto the eurozone, they discovered a lot of ugly credits squirming around which were quickly named the “PIIGS”, for Portugal, Ireland, Italy, Greece and Spain. These countries then got hit with their own buckets of cold water, were declared personas non grata, and lost market access. This probably would not have happened if Greek bondholders had been protected (which would have cost very little in the scheme of things).

Ultimately, of the five PIIGS, two have been bailed out once (Portugal and Ireland), one has been bailed out twice (Greece), Spain is in the process of receiving multiple bailouts, and only Italy has survived on its own. And now Cyprus has been added to the list, even though it doesn’t fit into the acronym.

We have just now entered the next phase of the EMU crisis, in which the central bank has begun to develop Latin characteristics. But even now, it isn’t yet Latin, and it will need to be before this is over.

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