The Euro-Zone Becomes the Twilight Zone

Rod Serling is not doing the narration for the e-Zone unravel. And he will never turn the control of your television set back to you. It’s just going to start getting weird and keep getting weirder. Events in the euro Zone have taken on a strange twist. It’s not that Greece’s problems are not unanticipated. Indeed, when Greece secured its bailout, the stepwise doling out of funds anticipated just such an event in Greece; that the dominant parties might be ejected for what they agreed to putting minor players in control –players who did not sign on for austerity and will not sign on for it. So we may be in some odd place but it is hardly unexpected to anyone who has been thinking ahead. But thinking ahead isn’t enough… Seeing this impasse in train is not the same as having a solution for it. Even Europe is at odds seemingly with itself. Thinking about blocking the next €5 billon payment that is supposed be squeezed in a ahead of Greece agreeing to post any more austerity measures is one of the odd twists that someone somewhere in euro-land thinks makes sense. It is odd because the bulk of this payment is supposed to service debt at the ECB. So if this payment is withheld Europe would apparently cause Greece to default on its payments to the ECB. How when Greece has not done anything wrong (yet) Europeans would justify this is beyond me. I think it’s just a bunch of knee-jerk chain jerking. Without a government Greece has no way to respond to or deal with such threats. More to the point what would such a thing accomplish? It would ‘prove’ to Greece that the bailout was about funneling monies to save banks and that in the end Europe never intended to give Greeks any opportunity to manage their own affairs, cutting them off before they could even make a decision on their own future. Agree or not with my take on this, it’s one of the odder threats since while it would put Greece in default it would deprive the ECB of payments that previously had been all-but secured. This brings us to another reason why this whole episode that may be leading to EMU disintegration is so strange. The German target2 claims represent a huge slug of funds at risk. But that pile of funds may not be quite what you think. And target2 is hotly debated. The Bundesbank’s Weidmann has said this about those balances: “As I see it, the Bundesbank’s Target2 claims do not constitute a risk in themselves because I believe the idea that monetary union may fall apart is quite absurd. Whether and to what extent losses arising from liquidity provision actually impinge on the Bundesbank’s balance sheet does not depend on the volume of the Bundesbank’s Target2 claims. This is also true for the hypothetical scenario, which has sparked much public debate, of a member state with a negative Target2 balance potentially exiting monetary union. Even in such a case – which I consider to be highly unlikely – the risk remains rooted in the nature and volume of the liquidity provision. This might result in partial defaults on the ECB’s claims. However, any losses sustained by the ECB would have to be borne jointly by all Eurosystem central banks, irrespective of the size of their Target2 balance.” Extrapolating from that, Weidmann sees the loss of net liabilities by a departing member as THE loss to the system that would be shared by member banks regardless of each country’s target2 position. The Bundesbank’s target 2 balances are not at issue. Should a net liability holder leave, the EMU it would foist losses on the members that remain in EMU. That suggests that as long as the euro leavers are few and their net liability positions on target2 balances are small enough, EMU secession is tolerable. To Weidmann what matters is the size of the balances on the balance sheet of the bank that leaves the Zone. This puts a new dimension on Greece’s problems. And it puts a new dimension on the risk or costs of knock-on effects. If Greece left and if enough other members followed (with negative target2 balances) that could shift a large burden back onto not just Germany but all remaining EMU members. One wonders if there is not some calculation here whereby the burden of staying in the euro and accepting the distribution of these losses would make leaving a more viable option. Put another way we wonder if there is a systemic instability in EMU? Is it something akin to the Titanic hitting the iceberg that just could not exist and could ever do that kind of damage to such a wundership? In retrospect the safest thing would have been to sleep in a life boat...but only the right lifeboat. What is the analog for the e-Zone of the right lifeboat? I have for some time been captivated by this analogy of EMU to the Titanic. When something that can’t happen does happen it is a true regime change. And just as I would point out that there was no safer cabin on the Titanic when it sunk, is there a safe place to hide in the euro-Zone if it is going to split apart? If it splits will the cracks magnify or not? We see this tradeoff immediately in the FX market. With all the troubles in Greece surely the euro should go lower (as it has finally been doing). But if the euro losses its weakest members won’t the ‘euro’ that remains be stronger? So shouldn’t this news, perversely, be ‘good’ for the euro? Well not if leaving the Euro destroys the strong and pushes huge losses onto even the financially strongest EMU members. For those opting for bunds as a safe haven remember that there have been several instances of bund yields so low that the German offering was undersubscribed. At the end of the day if the damage to the Zone is bad enough the financial burden will be borne by those with financial resources. This is a bit like the market axiom that explains why in a market panic good asset prices fall along with the bad. You sell what you can. In the e-Zone you will get support where you can. While some look at the Germans as preparing their own backstop fund for banks as evidence that they would leave, Germany leaving the Zone would not be possible- there would be nothing left. Angela Merkel is variously described as controlling the e-Zone and setting its austerity agenda and surely she is under pressure at home to stop the excesses of the ECB which come back to haunt the German taxpayer one way or another. But in truth I think she has been more desperate than many of us realize. Germany’s financial strength is not up to the pressures of the Zone’s demands. Just like the Titanic was not up to the stress of hitting that iceberg. Germany is desperate and trying not to sound so. It helped to engineer a system that it could dominate in trade but it took a lot of financing which Germany was happy to provide. But when you lend customers the funds to buy your goods and they can’t pay you back that business model fails. I don’t think we know yet how failed this model is in Germany and elsewhere in the Zone. Greece was only part of the problem. I have argued for some time that basic inflation, and now price-level differences, and basic differences in unit labor costs within the Zone have become unsustainable. The idea of having enough austerity to reset the various price levels to previous parities is turning out to be comically stupid. Anyone who has used the terms ‘internal devaluation’ should have their mouth washed out with soap. It’s deflation; deflation, pure and simple, deflation. And it’s so painful no one will stick around to do it long enough to make it work. Ironically, while Bern Bernanke is doing all he can to prevent it in the US Europeans made deflation the snake oil of choice. When the IMF imposes such programs on countries some of the return of discipline is achieved by depreciating the exchange rate. That works though market forces and leaves no clear finger print on the ‘creative destruction’ it wreaks. But in this instance politicians are being asked to sign in their own blood and leave their own fingerprints on every single revenue raising act and each cut in the budget. That is a world of political difference. Indeed, if Greece blows out of EMU it will have the same austerity forces on it this time from market forces and prices will shoot up as the new Drachma plummets and energy and food costs soar through the roof. Then who will they blame? You can impose austerity for a year or two… But not for a generation. In that sense Europe has no plan for Greece, or Spain or for Portugal. Its attempt to bully Greece by withholding funds it already agreed to advance them is act of desperation. It is an admission I think of how dangerous dissolution of the euro would be. Since there are no rules no one knows how it would go. You can be sure that given the risks, the remaining EMU members would make things as hard as possible on Greece to make them an example that would keep others from leaving. And that is the sort of power-geopolitics of it all. But with such vast differences in price levels and in competitiveness and in unit labor costs even with a big stick how do you keep the rest of the Zone together? You don’t. And that is the conundrum. Having it come apart will be a disaster Europe will try to avoid. But keeping it together is impossible.