Tuesday, November 29, 2011

Europe..again the trade-offs

Europe: Irresistible farce meets the immoveable subjective

As we look at the assessments these are the polar opposite arguments. One group argues that Europe cannot come apart. The other holds that Europe must come apart. The euro-unity camp argues that it is nothing short of the future of Europe that is at stake (they are right but for all the wrong reason). The EMU-breakers argue several facts ranging from the high and different debt levels, cultural differences, differences in work ethic, the inability to make austerity work and the severe loss of competitiveness that has been suffered within the Zone.

As we look at these two cases and consider some of the arguments about how painful a break up would be, we need to look only at the Greek episode to see how little thinking has gone into the e-Zone analysis. There are many more than two possible cases here.

In the recent case of Greece, it negotiated a default that was not a default and did not trigger credit default swaps to pay. Granted Greece is now back at it, asking for an even larger haircut, but that is a separate issue (as well as part of the main issue, of course). The point is that when push comes to shove the rules change. It’s like the final seconds of a basketball game when the referees all but swallow their whistles (and with the NBA is set to play again we may get to witness more of that). Suddenly, you are playing under different rules. We should have no misconception that if the Zone is under stress and needs to blow out a few members that it will be done under existing rules without any changes. That, in fact, seems the least likely result to me.

What we may need to consider is a break up that keeps Europe together. That is a novel concept.

First of all if a nation goes bankrupt it is not certain that it would have to leave the Zone. But in a number of countries the problem is not only debt, it is competiveness. Let them declare bankruptcy and write down their debt and they are still uncompetitive. I see a lot of proposals for EMU-bonds and other financing devices but these are putting the cart before the horse. Greece has lost some 25% in competitiveness to Germany, Spain has lost about the same. Portugal has lost a bit less. Italy has lost about 10%- all since EMU has been formed and the outlet of currency depreciation has been removed.

These are competitiveness losses that would be hard to make up if the Zone stays together. If it breaks up, then countries could form a second block and try to regroup within that framework and to maintain a link to the rest of the zone depreciate their currency and restore their competitiveness.. They might even get assistance since they could all remain in the same EU mechanism and thereby have a split that is in currency terms only.

The countries that left the Zone would then be able to regroup, try to reestablish their competiveness under a new currency basis and possibly reenter the Zone at a later date. Greece and Spain and Italy and Portugal could issue a new common currency or each could to retreat to its own former unit.

It is important is to realize that all these arguments that are made about the Zone are less than resourceful – some are made by ideologues rather than argued from the facts. It is highly likely that once faced with the eventuality of break up that the Zone rules would change to allow the dead weight to leave on modified terms. It is also likely that the countries that left would get some aid and would leave on ‘good terms’ with either an option or a mandate to return to the fold in due time.

Ironically, a break-up may simply be the best vehicle for Europe to stay together.

It may not be too tidy and it would cause some trouble and legal issues. Imagine contracts written in terms of euros in a country that adopts its own and former unit. What are the grounds for altering that contract or not? Magnify that thousands of times. You might not be able to keep the contract in euros but neither could you redenominate it ‘as is’ since a local currency did not previously exist and one could not assume that two parties would have agreed to the same deal on different currency terms. For example, one assumes that there would be more inflation, at least initially, under a new unit as debt problems were inflated away and as the new unit sunk to a point that reflected the true parity for the new currency relative to the euro (since we are assuming here that the least competitive countries leave EMU).

So yes break up has a lot of technical issues that will become clearer if Europe goes down that path. If it does not, maybe it is not the end of the world either, despite all those arguments to the contrary.

Maybe the lost competitiveness in the South is not an issue because they simply will have industries that will not compete with Germany, the low cost EMU member. Maybe the Zone will come to specialize more. The US, after all, does not have the same industries uniformly spread across the nation. We have farming states, natural resource states and industrial states and all sorts of specialization. We also have high-cost states and low-cost states. If Europe is willing to reorganize itself along those lines maybe ‘not coming apart’ can work.

But I do not see how Europeans stay together and pretend that the lost competitiveness regions are going to catch up. Economics rules out miracles.

If Europe becomes more of a single economic unit we will not have to worry about the structural trade and current account imbalances that have developed within the Zone. Italy Spain, Portugal and Greece are running persistent balance of payments deficits; that will not be an issue when/if EMU finances are blended with the countries that run chronic surpluses. In this view Europe will move to a model of regional specialization instead of a model of free-standing countries sharing a currency but with independent financial issues each trying to run a balanced economy.

It should be clear that the choices Europe is about to make will have far reaching consequences.

This is why having a new treaty with voting makes sense. Most euro-leaders do not want to do it because there are factions at home that want to claw-back rights from ‘Brussels.’ But Angela Merkel has pushed for a new treaty vote for good reason. As the above discussion demonstrates, what is being contemplated- whatever road Europe takes- has far reaching consequences. It is important that all members are truly on board. It would be a really bad choice if the ‘euro-leaders’ were to gin together some deal that would bridge the financing issues without coming eyeball to eyeball with the broader socio-economic issues which lie at the bottom of the Euro-imbroglio.

Let me emphasize that coming up with a check to fund Europe near term, as difficult as that has proved to be, is a much easier thing than having Europe come face to face with what its identity will become. Pretending that you can stretch out financing and not dealing with what that time will buy is absolute nonsense. And that is why the German position has been so hardline. Germans want their money to buy results: a harder reality.

The Germans are the most solvent of the European nations and Germany has the most solid bond market. Germans are in the euro-cat-bird seat. But they are not out of danger. And that is why they shoot down one harebrained scheme to finance things after another. The Germans want financing to lead to a stable end game. And most of the financial schemes do not do that because many of them take a lot of the pain out of the process and without pain there will not be the kind of enduring progress that is needed.

I think this is a much more productive way to think about Europe, than heads it’s unified, tails it’s busted up. Europe needs to decide its identity that is the issue.

It is not about financing. It is about Europe deciding what it will be when it grows up. Heck people get divorced and then remarry! What can’t the Zone break-up over currencies and keep other common elements and plan to relink under better-understood circumstances in the future? What is so sacred about keeping the currencies fixed when it is so clear that the fix has gone bad? Who is looking at this and thinking about what it means to stay fixed in one zone instead of being flexible in one union?

In a piece on the future of the euro-Zone written by Niall Ferguson, the British historian, he, interestingly, has the UK pulling out of the EU and being joined by Ireland. He has Greece staying in. Then, years on, Greeks would still be undergoing high unemployment and still muddling through with huge transfer payments to support their lifestyle underwritten by Germans! Science fiction is one thing, but Greek political fiction is something else.

It’s not a result that I can see happening (sorry Niall); but it is consistent with what could happen if the Zone is kept together without a clear view of what that means for everyone. Would the Germans give in and support high unemployment in an uncompetitive Greece? Or would they force a long, long, period of austerity on Greece? And if that were done, would Greece have the staying power to stick it out within the Zone or would it choose to leave? This is why a treaty vote is so crucial and why those who would change the game must also change the vision so people know the consequences of their vote.

But Europe is also a place where leaders are used to leading their people by herding them into certain situations. Some it seems would prefer to kick the can down the road in a certain way to make the eventuality of a certain decision more likely. This is contrivance and manipulation. I am opposed to this path for Europe. Horse first. Cart second. It should not do it the other way around. The choice and its implication should be made clear.

Those are the thoughts that lurk behind any analysis of where the Europe is going. Europe must decide first what it wants, then arrange to finance that identity. It should not finance staying together for a while longer while they all try to figure it out. That time has passed.

Euro-procrastination makes no sense to me. It’s not buying time, or renting time; it is squandering it. Time to step up and pick your future.