Sunday, 18 December 2011

The Euro Drama

After several false starts, Europe’s leaders failed, yet again, to come up with credible steps to solve the euro crisis.  The markets are getting weary and as investors lose faith and patience, the task of saving the single currency will become a lost cause. Sooner or later, the euro will be beyond saving. The way things are headed; this may be sooner than most people think!

In the run up to the Summit, the ECB has been extending its support to euro-zone banks—in effect lending them unlimited cheap money. That will help the banks and might in theory feed the demand for euro-zone sovereign debt. But it hardly counts as the “big bazooka” investors want, if only because the banks are wary of taking losses on ever larger stashes of government debt. What is required is not more liquidity but more capital for the banks.  Further, the ECB cannot intervene as the lender of last resort to euro-zone sovereigns.

In light of the above, the main objective in Brussels was to draw up a plan to save the euro. Governments needed to commit to credible fiscal rules that provided incentives for good fiscal governance. In return, the solution was expected to be in the form of joint liability for debts, with only the conforming countries benefiting from the purported Eurobonds. The European Central Bank (ECB) was to support to all solvent members. In addition to that the government’s were expected to announce measures to strengthen the banks and plans to drive economic growth.

But none of that happened.  Instead what we got was a British veto to a plan for ‘a plan’!  The proposal was to write fiscal discipline into national constitutions and enable the EU’s institutions to punish profligate countries and enforce fiscal discipline. The package focussed too much on austerity, and too little on economic growth.

Clearly, the leaders were hurtling down the wrong path. Forcing further austerity measures would further aggravate the recession and potential cause further civil disorder in most countries.  Besides, this could prompt a downgrade of most of the Eurozone’s credit ratings and cause economies to miss their deficit targets, increase borrowing costs — triggering still more austerity or sovereign default.  A downward spiral in the making!

Although the plan was greeted as a demonstration of European solidarity, it is more likely to provoke conflict. The summit rejected the idea of Eurobonds, in which all members would share some or all of the troubled economies’ debt burden.  Instead the pain is being imposed almost entirely on deficit countries, making it a bitter pill to swallow. If further austerity measures stir up civil unrest, the external enforcers from the EU will become a target for popular rage.

Already governments that agreed to the idea are warning that its ratification depends upon the detail and some countries may be pressured to hold a referendum. France and Germany, two of the major orchestrators can’t agree on the way to resolve the crisis, with France backing the Eurobonds idea while Germany is opposed to it.

Meanwhile the British government, having fallen out with its EU partners after exercising the veto, is promising that it will remain a central part of the union—and that London will remain Europe’s financial capital.  It must be conceded that an EU without Britain would be less liberal and Germany (and some of the smaller Eurozone members) recognises the importance Britain can play within the EU.

What is the hullaballoo about Britain’s veto

David Cameron’s plan was to seek safeguards for the financial sector and to subject some parts of financial regulation to unanimous approval, in exchange for backing a new treaty. When he failed to get what he wanted, he withheld his support.

Britain has real cause to worry about financial regulation. London is host to by far the biggest financial-services industry in Europe—in some areas it has as much as 90% of the EU’s business. The European Commission, encouraged by the French and others, has produced many ill thought out proposals to regulate it, as well as suggesting a financial-transactions tax a.k.a. ‘Tobin Tax’ named after the Nobel laureate economist James Tobin.

Mr Cameron’s veto was if anything symbolic as it fails to serve much more. He may have briefly basked in glory for his bold stance but if his aim was to protect the City and the single market, he has failed. Both are threatened more by Britain’s absence from the summits of up to 26 leaders that will now take place than by Britain’s participation in a treaty of 27 that placed no constraints on it. Britain could have achieved more by staying inside the tent that being outside.  After all, Britain has not been outvoted on a serious piece of financial-services legislation.

What next?

Germany has played down the significance of Britain’s veto and expects Britain to play an important role within the EU. As the balance of power shifts in Europe, there will be opportunities to mend the fences.  A compromise that gives Britain some reassurance about the financial sector and would let Britain return to the table may still be possible.

Ultimately, the euro zone faces tough choices. Its members could agree to deploy the ECB’s balance-sheet (much like the FED) and issue some form of Eurobond in exchange for fiscal integration. The question is not whether they can save the currency but whether some of them are prepared to pay the price for the profligate ones. This summit suggests not and it remains to be seen whether there will be a change of approach. Given the cultural, historical, political and historical divergences, this will remain a pipe dream.

It is more likely that some of the profligate countries may be forced out of the Euro and may only be readmitted post the criteria for fiscal rules are properly met.

But one thing is certain that this is not the last of the Euro Drama. Most certainly not!  In the coming weeks we will witness many more episodes of this epic!!!

What does this mean for global economy?

The unravelling of the Euro would impact the West severely denting growth and most definitely throwing the West into recession.  Already Europe is likely to face recession and the US would suffer recession should some of the Euro economies were to default given large exposure of US banks to Europe sovereign debt.

Rest of the world will experience a significant slowdown and overall global growth will falter.

While the drama plays itself out, in the interim brace for increased market volatility, further aggravating the poor economic outlook.


  1. Well written Sridhar. USA still struggling, if that was not enough we have some EU countries trying their best to jump on to the bandwagon of disastrous fiscal management. We heard chinese banks were being propped up, is there a story unfolding there. Indian banks seem safe though SBI did not get a grt rating but all we can say is 2012 might just prove right as per the Mayans for the financial world.....happy new year....Raj

  2. Very well written Sridhar. One thing the last 10 years have showed us is that Monetary Union, without Fiscal discipline is a receipe for disaster.
    Euro is dead mate, and the only people who are laughing about it are the Turks.


  3. Raj,

    Thank you. While the problems in the West is all too well known, what may shock most is when Chinese economy hits a road bump. That will make the global economy go into recession. The emerging trends from China are looking worrying.

    The Mayan prediction for 2012 may well have mean turbulence for the financial world!

    Meanwhile enjoy while it lasts and best wishes for a very happy new year. Cheers Sri

  4. Brat,

    Agree, monetary union without fiscal and political union is difficult to sustain. Fiscal discipline would still leave room for tensions among nations as locals will resist interventionist external institutions.

    Euro will cease to exist in its current form but we may well have a two speed euro, one for the core European economies and another for the peripheries. Keeping the single market is in everybody's interest else it could spiral into trade and currency wars!

    Turks will be thanking their stars, blessing in disguise for them. Cheers Sri