Sunday, December 18, 2011

Europe - no disasters in the waiting but little hope after that!

There are two parts to the Europe question.
1. Will the Euro survive?
2. What happens to Europe in the medium term in case it does?
The caveat in the second question is because it is terribly difficult to predict what happens to Europe if Euro does not survive. Predictions range to as much as 25% loss of output across Europe.

To me, the first question seems moot, especially in the light of the rather widely known fallout of Euro's failure and the fact that the near term survival of Euro is actually pretty much on tap for the policymakers in Berlin, Paris and Frankfurt (where ECB is based out of). I believe that contrary to popular belief and most scenarios of doomsday, Euro as a currency is far from failure. Sure it is under threat and is beseiged from many sides. However, for Euro to fail, Germany and France will have to lose market access or the cost of saving Euro in terms of bailouts has to go way beyond their current and future bond market-funded balance sheets. Either of these is remote scenario.

What is Germany upto really? Angela Merkel has been painted black and grey and white in the last few weeks by analysts around the world. But what the Germans are really trying to get out of the rest of the Eurozone is actually a commitment to lead fiscal lives similar to Germany's. This in turn is based on a more productive workforce, longer hours, higher retirement age, less state doles and so on. In the bargain the peripheral countries get to enjoy being part of the Euro - certainly a privilege in the times of crisis. Italy would have lost market access long back had it not been for its currency i.e. Euro. Of course one can argue that it might not have been lent to as much as it has been if it had not been for the Euro. Very true. Precisely the sort of thing that Germans want to avoid in future. They seem to have correctly concluded that bond market investors are not as well informed and choosy as they are made out to be. They will lend to seemingly sound but actually bad credit in much the same way American banks lent to sub-prime individual borrowers. Greece was a major case in point for this. Post facto, it seems ridiculous that anyone lent to Greece - Euro-denominated bonds or otherwise! Presumably everyone was counting on the rescue or explicit underwriting by Germany and France - which was never really there and which never happened when the time came. Having seen the inability of bond investors to rein in fiscally imprudent countries, Germany has correctly understood that the future of Euro depends on a "no-bailout covenant". And hence, if the suppy of money is going to be there in the lax times (from over-enthusiastic investors), Germany wants the demand curbed at the source - through fiscal deficit limits and gross public debt limits. Prudent if you ask me!

Why do I believe that Euro does not have that much of survival threat? For one, rescue is one round of QE away! Very much as the Americans have been shouting from the rooftops to the Eurozone leaders for a while now. Eurobonds have been talked about enough by now for even an implicit acceptance of the same by Germany to send the bond market investors into risk-on mode! Lastly the leaders of the rest of the peripheral countries seem to be complying with the demands of fiscal prudence - which most realize are in their own interest even if Euro does not survive. Germany and Euro-saving are good outside factors to blame to overcome any internal resistance for most of these countries. Push is unlikely to come to shove and even if it does, a combination of ECB, IMF, EFSF and maybe even the Fed will figure out a good way forward. It is in Germany's interest to keep things muddling through rather than conclude them very positively in a sudden stroke of brilliance. The most that sort of heroism will achieve is massive risk-on trades around the world, positive sentiment all round and in effect loss of another chance for the well managed economies of Eurozone to establish some displine amongst the rest. Since it seems more or less coordinated brinkmanship, the only danger is that of an unforeseen financial accident. In absence of that Eurozone worries will eventually go but probably drag on for another couple of quarters - as the economies sort out the fine print of greater fiscal union and iron out inevitable differences.

Disaster hence is unlikely. That does not mean that the proverbial "aaaal" is well though! The reason Eurozone went into this crisis is fiscal profligacy of its peripheral economies and the loss of confidence amongst bond investors for the debt issued by those countries. The confidence may slowly return to make investors take some cautious bets. However, the fundamental productivity challenges of Euro-area economies will not go away. If anything the battling with the crisis has only diverted the attention of the economic policy makers from them. Last but not the least the unfavorable and worsening-by-the-year demographics of most of European countries is not helping at all in boosting productivity. While Spanish unemployment may come down and Irish banking sector may after all be restored to half decent health and the clouds over most of Europe's banks may go away, the painful process of adjusting to a new economic environment where money is neither cheap nor abundant, governments are not the welfare states they used to be and where everyone is required to work longer and more productively will take its toll on growth. Europe may lose its own decade a la Japan. That is a far bigger disaster - however slowly it bites!

No comments: