A fantastic overview of all the game theory aspects embedded in the European crisis, from Joachim Fels, head of Euro research at Morgan Stanley.
- Somewhat paradoxically, the show of solidarity for Greece by other euro area members and the ECB raises the risk that the euro will break apart eventually.
- Seceding from the euro area to devalue is very costly and risky. But seceding to revalue and introduce a harder currency is easier. Germany might opt to do so one day.
- The road to such a break-up scenario leads through even more fiscal profligacy and divergence in the euro area, a politicisation of monetary policy, and a weaker currency. Recent events suggest that the trip down this road has started.
A pyrrhic victory… The joint euro area/IMF financial backstop package and the ECB’s recent climb-down on its collateral rules have clearly reduced the short-term liquidity risks for Greece. However, as our European economists have emphasised, long-term solvency risks remain firmly in place. More broadly, and more worryingly, recent developments significantly raise the (long-term) risk of a euro break-up, in our view.
… which gives rise to moral hazard: The bail-out and the ECB’s softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time. If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union. And because the Maastricht Treaty does not provide for the possibility of expelling euro area members, the only way how Germany could achieve this would be by leaving the euro to introduce a stronger currency.
Seceding to revalue is easier: It has been our long-standing view that such a break-up scenario – where a country or a group of countries want to leave to introduce a stronger currency – is more likely than a scenario where a country wants to leave to devalue. The reason is that the costs of leaving to devalue are extremely high.
- First, borrowing costs for the seceding country would likely rise significantly as investors will demand a currency and inflation risk premium.
- Second, while contracts between parties in the seceding country could by law simply be redenominated in the new currency, redenomination would not easily apply to cross-border contracts. Foreign creditors would still demand to be repaid in euros (‘continuity of contract’). Thus, a country that secedes and devalues would still have to honour its foreign-held debt in euros and would thus face a rising debt burden. If it decided to default instead, it would, at least for some time, be totally shut off from foreign financing.
- Third, a country that decided to leave the euro to devalue would immediately face a bank run by domestic depositors who would want to shift their funds into banks in other euro area member countries. This would provoke a financial meltdown which could only be prevented by a freezing of bank deposits and the imposition of strict capital controls.
By contrast, none of these costs would apply for a country that wanted to secede in order to revalue. Its borrowing costs would likely fall rather than rise as it would attract an inflow of funds
How it all started... None of these deliberations are new. In fact, we first started to worry about a potential euro break-up along these lines in 2003-04 in a series of notes (see, for example, Euro Wreckage? January 22, 2004, and Debating ‘Euro Wreckage’, February 9, 2004, with a reply by Noble laureate Robert Mundell). Back then, it had become increasingly clear that the move towards political union in Europe had stalled, partly because the EU has simply become too large and diverse a club due to successive enlargements. Moreover, the old Stability and Growth Pact (SGP), which was meant to ensure fiscal discipline within the euro, was effectively buried in late 2003 when both Germany and France kept violating the 3% budget deficit limit. It was later ‘reformed’ into a toothless tiger that allowed for much more fiscal flexibility. Thus, we worried about an increasing divergence of fiscal policies with widening bond yield spreads and increasing political pressures for an easier monetary policy stance, which could make the monetary union unpalatable for countries like Germany.
…and why it has become more likely now: Obviously, we have not reached the end-game yet. However, with the recent developments, such a break-up scenario has clearly become more likely, for two reasons. First, the lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation. Fiscal slippage in other countries has now become more rather than less likely.
Second, the ECB’s climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures.
Don’t get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire. However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.
What are the signposts that would indicate our break-up scenario is in fact unfolding?
- First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments’ resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.
- Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.
- Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound. If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.
Bottom line: To be clear, we neither advocate a euro break-up, nor is this our main scenario. However, the risk that it happens is far from negligible and the consequences for financial markets would be very severe. Hence, investors ignore the euro break-up risk at their own peril.