The Euro Crisis: No More Safe Havens

Josh Rosner - July 2012

As the global financial and economic crisis drags on, European regulators and policy-makers continue in their attempts to find a path from crisis toward stability while balancing the public interests of independent sovereign nations with the desire to forge a deeper financial, economic, political and fiscal union.

While the media and government officials in the core of Europe continue to characterize the crisis as the result of profligate borrowing and reckless spending by peripheral economies of the EuroZone this picture ignores the larger and more significant reality of the crisis – this crisis is, at its core, the result of structural weaknesses built into the original design of the European Monetary Union. This theme further ignores the economic realities that faced the core states, particularly Germany and France, at the time of their entry into the EMU and also the reality that these economies, driven by asset growth as their banking sectors funded domestic exports, enjoyed almost a decade of growth. This growth, particularly in Germany, came not from any meaningful improvement in productivity but, rather, on the back of reductions of real wages for households, increased unemployment and reforms in their labour market – such as the Hartz reforms – which transferred wealth to those sectors of the economy. (which sectors?) It was these reforms in the post-reunification period of austerity, that prevented the profligate levels of domestic household consumption that were witnessed in the peripheral economies.

While there is a rationale basis for anger and contempt by German and French taxpayers it appears the anger has been largely misdirected. Rather than embracing the false narrative that “we don’t want to be responsible for bailing out Ireland, Greece, Spain, Portugal, Italy, Cyprus” (in other words – borrowers) the anger should, more rightfully be directed at:

  • Designers of the European Monetary Union who, at the creation of the EMU, ignored regular and repeated warnings, from noted academics, analysts and policy advisors, that structural weaknesses would lead us to the crisis we now face;
  • Banks, in the core, who, in a search for yield, were profligate lenders, with weak internal controls and excessive leverage, to weak private, corporate and sovereign creditors in the peripheral countries;
  • Those officials and technocrats who failed to properly regulate the domestic banking industry;
  • Allowed bankers to push the Basel Committee to treat all sovereign debt the same regardless of the differing debt-service capacity of the issuer;
  • Rating agencies who failed to offer meaningful analysis of sovereign debt service capacities and also assumed that too-big-to-fail financial institutions ratings should reflect an implied or explicit guarantee by their home country;
  • Political leaders who, since the beginning of the crisis, downplayed its ultimate costs and, thus, delayed its resolution and increased the ultimate costs to taxpayers;
  • Political leaders who continue to refuse to properly highlight that their efforts to support the periphery are little more than a transfer of taxpayer wealth to their own domestic banking industry.

It is our conclusion that Germany, in an effort to protect its banking sector from under capitalization and further insolvencies, has already committed its population to a back-door recapitalization of its own banks. As a result, German debts will rise markedly and German economic expansion will meaningfully deteriorate. These are facts.

The specific scale of these outcomes will be determined by the approach employed. Each path will be costly, even on a global historic scale. The longer it takes for political leaders to offer their constituents full disclosure and transparency, instead of choosing to obfuscate the scale of the crisis, the need to restructure un-serviceable public and private peripheral debts and to recapitalize their own banking system, the more costly any solution will be. These incremental costs could be avoided through decisive actions.

The choices of decisive actions are numerous and we will not, in this note, suggest a particular plan. Rather, we prefer to make it clear that the constraints on choosing a path forward are the result of a lack of political will, not economic will. That lack of will is the ultimate display of a failure of leadership by politicians and technocrats who do not want to deliver the unwanted, but necessary news to their populations. In Germany, where real wage declines early last decade robbed households of consumption opportunities and represented a transfer of income to domestic exporters and banks, the news that they will have to bail out these same firms and accept reductions in their national sovereignty will be a particularly bitter pill to swallow. Whether through the wiping out of bank equity and bailing in of bank creditors or other paths the costs will be astounding.

Given rising nationalistic sentiment in several European countries, that threaten to increase the chances of a disorderly collapse of the Euro project and an outcome far more costly to those core countries than a full recognition of loss, recapitalization of financial institutions and the mutualization and integration of the EuroZone economies so that sustainable growth can restart, it seems worth reviewing:

  • Why, in the wake of unification of East and West Germany, Germany was uniquely poised to benefit from a monetary union;
  • The role that Germany and its banking sector played in setting the stage for a crisis in the periphery;
  • Germany’s current economic and fiscal condition and existing commitments to the periphery;
  • The possible German GDP implications of various crisis management approaches;
  • The likely chances that German bond yields will not continue to remain detached from fundamentals; and
  • A fair basis on which to consider its obligations to the periphery.

The longer leaders wait and the less decisive their approach, the greater the risk that German bunds and German banks will lose their status as the “safe haven” assets of Europe. These risks are already on the rise as witnessed by recent the deterioration of global investor appetite for German government and bank obligations.