It is seemingly clearer and clearer that with the current structure and membership, the Euro does not work. The market seems to be driving the change in the direction of membership changes (via restructurings and temporary devaluations - e.g. GRE CDS and WI Drachma) while the euro-zone-'management' seem prone to structural changes (i.e. EFSF umbrella, Euro-bonds, and fiscal union). While the cost of either approach is likely extremely high, some research from early Summer by ESCP Europe suggests a non-trivial approach that reduces aggregate debt for the European sovereign complex by almost 64% is possible. The solution:- bi- & tri-lateral netting, and free-trading.
Clearly, there will be winners and losers in this 'free exchange', and the game-theoretical bargaining process of 17 self-indulgent, self-interested career politicians is unlikely to resolve in an optimal direction. However, if nothing else, it is evident just how Gordian-knot-like any resolution is likely to be.
Europe's Web of Debt (as it stood in May 2011)
After three rounds of 'bargaining' including bilateral netting, trilateral netting, and then free-trading (in order to manage different maturities), the complexity reduces dramatically - leaving it very evident where the debt really lies.
The main results were as follows:
The EU countries in the study can reduce their total debt by 64% through cross cancellation of interlinked debt;
Six countries – Ireland, Italy, Spain, Britain, France and Germany – can write off more than 50% of their outstanding debt;
Three countries - Ireland, Italy, and Germany – can reduce their obligations such that they owe more than €1bn to only 2 other countries.
Around 50% of Portugal’s debt is owed to Spain;
Ireland and Italy can write off all of their debt to other PIIGS countries, and Ireland can reduce its debt from almost 130% of GDP to under 20% of GDP;
Greece can reduce their debt by 20%, with 60% owed to France and 30% to Germany;
Britain has the highest absolute amount of debt before and after the write off (owed mostly to Spain and Germany) but can reduce their debt to GDP ratio by 34 percentage points;
France can virtually eliminate its debt (by 99.76%) – reducing it to just 0.06% of GDP;
The authors summarize their findings thus:
This exercise does not solve the problem of the EU debt crisis, and raises more questions that it answers in terms of data reliability. However the revelation about how interlinked debt might net out (possibly even to zero) is a policy option. And indeed if this exercise leaves some countries with a large remainder it points to where the real problems are. Either way, it sheds light on the issue and uncovers information.
The fact that so much debt is interlinked presents a real opportunity to solve the problem. The web of interlinked debt is too thick to be dusted away by classroom games, however policymakers should attempt to replicate this study, and they may find that instead of spinning further webs they might get out a duster to clean things up.
The bottom line for us that while breaking up the Euro will be extremely expensive and potentially dramatically destabilizing from more than a simple market-perspective (as monetary-union disruptions have historically tended to end in civil hostility), this study provides a simple way to see how a fiscally-joined and central Treasury-based system 'could' come out stronger. However, the path to that 'potential' strength will be littered with the bodies of financial and non-financial equity holders, senior- & sub-debtholders, CDS traders, and FX jockeys thanks to risk-free rate re-adjustments, subordination, ringfencings, forced recapitalizations, and implicit austerity.