We have often discussed the temporary and tenuous nature of any and all government-suggested solutions so far to the European crisis on the basis that the 'model' is broken. Following the decision to go for PSI, and the possibility of a sovereign leaving the Euro-zone (Greek referendum ultimatum), money is no longer fungible in and across European banks (deposits) and sovereigns as it seeks the stability of a narrower and narrower core. Arnaud Mares, of Morgan Stanley, who wrote the initial and definitive Greek story long before most others, brings up this very point; questioning the fungibility of Greek Euro deposits with French Euro deposits, for example, and interpreting the situation as a 'run on banks and governments'. His view that without a clear path to a fiscal lender of last resort - or a true fiscal federalism across a united Europe - which ensures solvent governments will never go illiquid, then the December 9th decisions mark a bifurcation point of critical import.
If governments choose to engage on the route to fiscal federalism, we believe that this does not mark the end of the crisis. It could, however, mark the beginning of the end of the crisis, as it would be a decisive first step towards stabilisation and a European federation. The alternative could well be the beginning of the end for the European confederation.
Europe has to choose between debt assumption (enhanced federal control of national budgets accompanied by centralised funding of governments) and a debt jubilee (wide-scale debt repudiation), with all the social, economic and political consequences this entails. Mares' framework for considering the words and deeds of December 9th is critical, though complex, reading to comprehend the tipping point we are at.
On Europe's Hamiltonian Moment:
One year ago, we wrote that Europe was heading fast towards a crossroads where it would have to choose between a debt jubilee (wide-scale debt repudiation) and debt assumption (a form of fiscal federalism with enhanced control over national budgets accompanied by centralised funding of governments). We think this bifurcation point has now been reached.
By December 9, heads of state and government ought to outline how they intend to amend the constitutional arrangements under which Europe – or at the very least the euro area – operates. Should they set out a clear, consistent and workable policy orientation, which includes both fiscal control and a mechanism to keep compliant governments fully funded, this can in our view constitute a decisive first step towards stabilisation. Should they fail to deliver a credible framework encompassing both these dimensions, we would expect that the ongoing ‘run’ on governments and banks will accelerate, and it is seriously to be feared that it can no longer be stopped. The economic, social and political consequences could be unfathomable. The next few weeks are therefore a critical moment in European history, in our view.
On the growing cracks in the fungibility of money:
Money in a fiat money system is a liability of a bank: of the central bank for banknotes and other forms of central bank money; of a commercial bank for commercial money (deposits).
If one or more countries can leave the euro, or at the extreme if the euro can break up altogether, this raises questions as to whether these different forms of money are fully fungible. Is one euro of deposit in a Greek bank still fully fungible with one euro in banknote form? Is one euro of deposit in a Greek bank still fully fungible with one euro of deposit in an Italian bank, and is the latter still fungible with one euro of deposit in a French bank, or a German bank, etc.?
Pursuing this reasoning leads to the inescapable conclusion that the more plausible it is that a country can leave the euro, the greater the incentives for depositors to move their deposits from the banks of almost all countries towards those of the country that remains the safe haven by convention if for no better reason: Germany. We believe that such behaviour, in turn, would (and judging by anecdotal information received from our clients, does) increase funding pressure on all banks, intensify incentives to accelerate the de-leveraging of the banking system and raise further the spectre of a credit crunch.
And on a topic we have repeatedly discussed - that even if the ECB were to print print print, this would not solve the problem:
The limitations to ECB intervention are not technical, they are political: The problem with the ECB acting as a lender of last resort in this context is that it has no control over the fiscal stance of European countries, and that the constraints that were embedded in the Maastricht Treaty and the Stability and Growth Pact have proved neither binding nor permanent. If the ECB were to provide unlimited funding backstop to governments in the absence of any strengthened control on fiscal policy, it could not therefore credibly dispel the notion that it is funding the potentially runaway debt of potentially insolvent governments. Doing so would lead eventually to backdoor and unsanctioned fiscal transfers through either: i) mutualising sovereign credit risk on the balance sheet of the central bank; or ii) inflating debt away (which would affect different countries asymmetrically).
What is needed is utlimately Fiscal Federalism:
What we have described here has obviously little to do with expanding the size of EFSF, leveraging its action or augmenting it by drawing on the resources of the IMF or any other sources of funds. What we have described in one sentence is fiscal federalism, meaning:
- Full and permanent control from the union of governments – the federal level – over the fiscal stance of each member state, combined with;
- A permanent mechanism to ensure that all governments that submit to this federal control are fully funded on fair and equal terms.
The critical issue is to balance fiscal control with funding. Control without funding is fundamentally unstable or require systematic and arguably infinite ECB intervention and that could lead to the same path as no balance at all.
And finally, how do we judge the December 9th statements? Here are four questions that need to be answered affirmatively:
A sequential decision tree for roadmap: If the argument presented here is correct, then it provides an interpretation grid to assess the conclusions of the ongoing discussions between European governments. This interpretation grid can be thought of as a sequential decision tree, based on the following questions:
1. Can fiscal federalism defined as above be achieved in a sufficiently simple and practical way (in particular as regards the constitutional changes it requires, both at the federal and national level) as to be a credible outcome at all?
2. If so, will governments commit Europe clearly enough to this objective by December 9?
3. If so, will their choice be ratified by their own people, according to whichever ratification procedure is applicable?
4. If so, how long will the ratification and implementation process take? This, in turn, informs the question of whether there exist transitional support mechanisms that are sufficient to keep governments and banks funded throughout the ratification and implementation process.
Evidently, a negative answer to any of these questions ought to lead to the conclusion that the run will resume, accelerate and cannot be stopped, with all the consequences this entails.
Mares' full article below: