The Euro appears to be in a death spiral: what are the likely outcomes?

Great Debates
1

Italian 10 year bond rates have now breached the 7% rate, with a bond auction today having interest rates on 10 year bonds reach 7.17%. For other Southern European nations 7% was untenable, forcing bail outs, but the general consensus here is that Italy can withstand closer to 8%. Still, it seems that there’s now nothing that can hold back the feedback loop, with Italian rates set to continue rising indefinitely, and they’re already precipitously close to a disastrous magnitude. Further, there’s a gigantic Italian bond auction in February, a month before the Eurozone treaty for stabilising the current mess is set to be held.

The credit ratings agencies are set to downgrade most of the Eurozone’s sovereign and bank ratings soon. France is rumoured to lose its coveted AAA status in the next few days, as everybody is panicked over how much exposure French banks have to bad Italian debts.

Italy is well known to be “too big to bail out”. Several non-Eurozone nations, including the US, Canada, the UK and Japan, have ruled out any new contributions to the IMF to affect a Eurozone bailout.

Eurozone politicians are literally clueless. Nobody has shown any sort of leadership during this mess. Germany has consistently let the perfect get in the way of the good. France has been desperate to avoid having its banks take a haircut on bad debt. Berlusconi looks not just to have fucked his country over, but half of the Western world. Eurozone politicians have consistently been working on month long timescales whilst the markets have been reacting by the hour. Britain has become an object of hate for every clown on the Continent for not going along with the latest set of stupid ideas.

What happens now? If Italy goes under are we really looking at financial Armageddon? Will France be dragged down with Italy, setting off a chain reaction across Europe and the wider developed world?

2

Italy is too big to bail out but it is also too big to fail, because if it goes Spain goes also. At least. And we see how traders react to the enforced austerity.

About the only solution I can see is for the Central Bank to start effectively printing money (not as easy as the Fed doing it) to cut the legs out from under the bond speculators, which should drive down the prices and stop the feedback loop. But the cluelessness you mention makes that seem unlikely.

This is the OP I really wish I could disagree with.

3

The Milan stock exchange is in freefall. What’s telling is that large Italian banks appear to be completely uninterested in investing in Italian government bonds even with 7% interest rates and virtually no borrowing costs.

This isn’t going to happen, not without a new treaty anyway, which will take months. The ECB and the German central bank have consistently said that this is illegal. In fact it seems that Merkel and the German central banks are completely at sixes and sevens. Merkel announces one thing, only for the Bundesbank to declare that it’s not going to happen two days later.

4

Like I said, I wish I could disagree. Though the cases aren’t exactly similar, this looks to me disturbingly like what would have happened in 2008 if the Bush Administration adopted what was the mainstream Republican position and let the banks fail.
The ghost of Herbert Hoover is smiling.

5

I don’t think there are any bond speculators as such. At least not in the sense of people shorting bonds and such. There are merely banks and pension funds that prefer to invest their money in other places. Italian bond traders sometimes enable private investors to buy Italian bonds free of charge. You can invest your pension savings there if you want to bypass your pension fund.

Anyway the solution is not to settle the taxpayers with debt to dysfunctional economies until they have showed the willingness to effective reforms. Italy can live with 7% or even 8% for a short while, until their reforms start to kick in.

6

We had a thread just recently on the worst-case scenario. That’s a bit easier to talk about than likely outcomes in general, because you just assume that they will consistently do everything wrong. Although maybe that’s a safe bet, because they continue to do everything absolutely wrong.

For situations that are better than rock bottom, someone in Germany has to finally realize that they’ll be eating a bit of inflation one way or another. They can do it before the eurozone collapses, or they can do it after. I can’t say how likely it is, though. The eurozone balance of payments is not sustainable. Contractionary policy in the periphery is not sustainable. But if they pursue the present course and everything falls apart, then right now, they have the convenient scapegoat. They can blame spendthrift Italians instead of examining their own policies.

Yes. See the other thread.

Eventually, the core money folks will decide to save their own banks. This will be either before or after the crisis. It would be nice to do it before.

It’s new money or bust. If you say new money is politically impossible, then “bust” is the only other option.

However, the mother of all bank runs could begin at any time. It’s one thing to say Germany won’t allow help if Italy’s banks are failing. It is potentially another story, though, if the crisis hits everywhere at once. They will, eventually, step in to stop it in their own country regardless of what they think the law says. The question is how many dominoes have to fall before that happens? As for that, I have no idea.

7

It’s always nice when the ignorant reveal themselves. The thing about facts is that they get to stay the same regardless.

Now, as far as inflation, the issue is that it should never have happened. WHen forming the Euro, everyone gave the Germans control for that very reason: avoiding inflation. They swore up and down the Germans could basically run it as they pleased, hence the current problem.

And at that, you’d need to run big inflation, fast in order to fix this, and that would cause other issues. It might crumple Germany’s economy, which is heavily dependant on exports and the low-value Euro currency.

8

Actually, wouldn’t Germans see deflation, as their currency outside of the Euro likely would be more valuable?

9

No. Inflating currency would make it less valuable. If they had their own currency, they would probaly see deflation immediately, until it was at a price which hurt German exports.

10

She said either way. If the Euro crashes and burns, I would expect deflation in Germany.

11

You have to admit that what’s happening is going precisely the way the Euro’s original critics said it might; the crisis, and, most importantly, the political inability to address it are due to the individual members not having independent monetary policy that suits their individual needs.

I guess we should’ve listened.

12

Sure, if Germany goes off the Euro. But that wasn’t the scenario under consideration.

13

Well, in America, it possibly/probably/certainly (take whichever you like) means a Republican president in a year…

14

The current crisis could be resolved tomorrow, literally, if the ECB pledged to buy sovereign debt. This does amount to monetization but would not necessarily result in inflation.

That is the normal, simple scenario which does not appertain any more in the Eurozone than it has here in the US over the past 3 years. With more quantitative easing operations than there are Rocky sequels, we now have a huge overhang of about $2Trillion in excess reserves held by the major banks.

Under normal conditions, that money would be lent and via the multiplier effect inherent in our fractional reserve banking system, the economy would be smoking hot in fairly short order. But that hasn’t happened for a variety of reasons. There is less demand for loans from clients who are able to meet the new, stricter underwriting requirements. There is no decrease in the gnawing uncertainty of what may come next so businesses don’t hire, don’t pursue high risk, high return projects. It’s not hard to come up with a long list.

The point is that having an extra $2T available to the economy doesn’t mean anything if no one either wants it or is able to get it. And that’s where we are right now.

If the ECB were to follow the US Fed model and buy IOUs written on toilet paper, there would be no financial crisis. There also wouldn’t be any inflation - at least not anytime soon.

However there is a catch both for our Fed and the ECB when (not it) it goes down that road. At some point, confidence will come back into the equation and economic activity will accelerate - perhaps dramatically. At THAT point, all that extra liquidity becomes fuel for inflation. The ultimate success of the technique depends on draining the right amount of liquidity at just the right time. That is a dangerous game, but it seems to be the only one in town for either of our economies.

15

I distrust any such magic solution that doesn’t address the underlying causes. There’s only one strategy that works: work harder and live within your means. The Polish finance minister was in Denmark for some reason yesterday, he had this to say on how Poland was doing comparatively well (4% growth): deleverage (don’t borrow so bloody much), stay cost-competitive and have well functioning public institutions. Pretty much the same message of the Swedish finance minister (another economy also doing fine in a bad market) Funny how all the successful finance ministers have the same message: work more, spend less, borrow less – while all the shitty economies all say: we need to borrow more. He added the key to breaking the crisis is to overperform. If the market expects reforms to x%, double it. Do more than expected. The problem with e.g, the Italian and Greek reforms have been that, while fine as far as they go, they’ve always been just a little less than what was expected.

16

QE just buys you time, though, surely? It doesn’t address any of the underlying problems. That is, a currency union between massive exporters and manufacturers like Germany and tourist hotspots like Greece is completely unworkable without masses of money flowing in virtually one direction. The Germans are loathe to do this, as they quite rightly see themselves as Germans and not as Europeans bailing out other Europeans.

Further, the idea that we need more time is strange. The last year has shown that, given ample time to address the problem, the Eurozone politicians will just throw it all away, until the situation gets to be so critical that they’re forced to act. None of this should ever have happened in the first place. During the boom times it was perfectly obvious that the likes of Greece were spending like there was no tomorrow, yet the problem was not addressed. Further, even now, with the threat of imminent economic collapse we have a meeting last week to try to sort the problem out, which turns into a circus about Tobin taxes and not about fixing the Euro (quote from a British Conservative politician: “Sarkozy had the choice of saving the Euro or regulating the city. He chose to regulate the city.”), with another follow up meeting four months later. The whole thing is a joke. The politicians have never seemingly grasped how critical this situation is from the start of the crisis.

17

Rune and Mon Capitan - you’re both absolutely right. Some sort of fiscal union has to be crafted. IF that can be done, and I have my doubts, that will bring back some sense of stability and address the underlying issues - at least in the long run.

My only point is that the liquidity crisis is more profound and urgent than dealing with the implementation of austerity measures. Most will call this ‘kicking the can down the road’. And to the extent the opportunity to reform is wasted, then that will in fact be all it accomplishes.

What I find interesting is the fact that the ECB has already indicated its willingness to monetize by loosening the requirements for the collateral it will accept from Eurozone banks. Presumably that includes sovereign debt. If so, then the only issue is not that they will lose their financial virginity by sucking up sovereign debt. That ship has sailed. At this point it is only a matter of degree. Granted, its a pretty huge change in terms of the volume involved, but despite their protestations of not being the lender of last resort, they in fact already are.

My personal speculation is that Drahgi sees what the two of you see - a vacillating and ineffectual collection of useless bureaucrats. So he deliberately allows a certain amount of panic to keep the heat on. I think it’s a little like playing chicken on a dark country road. I just hope he makes the right choices and has a godlike sense of timing.

18

I’m talking endgame. There could be deflation in Germany, but not for long. Inflation would be the final response. I’m looking at the Depression as precedent.

If a country breaks off from the euro, their new currency will devalue sharply against what remains of the eurozone. That is equivalent to a sharp appreciation inside the eurozone, which absolutely means deflationary pressure, exactly as you say. But the eurozone can’t take any more of that. They need their aggregate demand, their NGDP, to expand and return closer to their pre-crisis trend line.

Deflationary pressure will cause more breakage. One country flopping could lead to the domino effect. If it followed the pattern of the death of the old gold standard era, it would be one country after another abandoning the euro. Eventually, the core would be all that is left. And all that deflationary pressure would build in Germany itself, until it is finally their turn to devalue/depreciate. They would be the last.

In the 1930s, France was the last to go. They suffered deflation until they couldn’t take it any longer. Then they dumped gold with everyone else, the last big domino. This time, Germany will be the last in line, and they similarly will have no choice. The deflationary pressure will build until they finally break down and accept higher prices. They’re way too reliant on exports (fixed exchange rates inside the eurozone) for them to tolerate the loss of their European customer base to devaluation. They will follow suit. It will be inflation, eventually, even in Germany.

My big “hope” about the eurozone right now, if you can properly call it a hope, is that the process does not play out like dominoes. I would prefer everything threatening to go into the shitter simultaneously, in Germany as well as Italy, so the ECB has to save everyone together. (This assumes, of course, that it would still be possible to save everything. I can hope, anyway.) We would have our Credit-Anstalt moment in Italy instead of Austria, a big bank failure or series of failures, and then instead of Italy dropping out and causing crisis, the eurocrats could finally decide to backstop the system. Unlike gold, there is no physical limit to euro creation. They would do this if German banks are perceived to be in just as much danger as Italian ones, that is, if the entire system were on the brink and not just one scapegoat country.

At this point, the world is basically just waiting for the first big Italian bankruptcy. After that, the possible deluge. We will see.

19

Why? Because our economy will probably drop into a recession as well?

-XT

20

I do not see the ECU lasting-it is likely that the nations that are in good fiscal shape (Germany, the Netherlands, Sweden, Austria, and France (possibly), will stay on the euro, while the PIGS will revert to national currencies. Either the Germans permit monetary expansion (which Merkel will not allow), or the PIGS nationa will have to devalue their debt, somehow. For example, Greece can never pay down their debt (as it is presently structured).
Of course Germany will then face a dilemma-they are scared of inflation, but also face a collapse of their export bsiness, unless this can be fixed.