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Navigating the Eurozone Debt Crisis and Preparing for Greece’s Failure

Interest-Rates / Global Debt Crisis Oct 07, 2011 - 12:11 PM GMT

By: John_Mauldin

Interest-Rates

Diamond Rated - Best Financial Markets Analysis ArticleFolks, you hear a lot about the eurozone crisis, but what you don't run across very often is a coherent idea on how to move forward. My friends at STRATFOR, a private intelligence company, have done us all the courtesy of saying out loud what everyone else shies away from: Eject Greece from the eurozone.

It's not pretty. It belies the lovely concept of a unified and prosperous Europe. And the worst part: it comes with a big fat price tag, of the 2-trillion-euro variety. But it may be the only way to steer the train before it derails completely.


Today I have the privilege of sending you two pieces from STRATFOR. If you have a couple of minutes now, << watch this video on preparing for Greece's (inevitable) failure>>. Then check out the written piece below, a deeper dive into the crisis as a whole. If you're interested in following all of STRATFOR's geopolitical analyses, as an OTB reader you can get a hefty discount off their subscription rate, plus a free copy of the NY Times bestseller by George Friedman (my buddy, and STRATFOR's founder).

Your hoping the Rangers take it all analyst,

John Mauldin, Editor
Outside the Box

Summary

The eurozone's financial crisis has entered its 19th month. Germany, the most powerful country in Europe currently, faces constraints in its choices for changing the European system. STRATFOR sees only one option for Berlin to rescue the eurozone: Eject Greece from the economic bloc and manage the fallout with a bailout fund.

Analysis

The eurozone's financial crisis has entered its 19th month. There are more plans to modify the European system than there are eurozone members, but most of these plans ignore constraints faced by Germany, the one country in the eurozone in a position to resolve the crisis. STRATFOR sees only one way forward that would allow the eurozone to survive.

Germany's Constraints

While Germany is by far the most powerful country in Europe, the European Union is not a German creation. It is a portion of a 1950s French vision to enhance French power on both a European and a global scale. However, since the end of the Cold War, France has lost control of Europe to a reunited and reinvigorated Germany. Berlin is now working to rewire European structures piece by piece to its liking. Germany primarily uses its financial acumen and strength to assert control. In exchange for access to its wealth, Berlin requires other European states to reform their economies along German lines — reforms that, if fully implemented, would transform most of these countries into de facto German economic colonies.

This brings us to the eurozone crisis and the various plans to modify the bloc. Most of these plans ignore that Germany's reasons for participating in the eurozone are not purely economic, and those non-economic motivations greatly limit Berlin's options for changing the eurozone.

Germany in any age is best described as vulnerable. Its coastline is split by Denmark, its three navigable rivers are not naturally connected and the mouths of two of those rivers are not under German control. Germany's people cling to regional rather than national identities. Most important, the country faces sharp competition from both east and west. Germany has never been left alone: When it is weak its neighbors shatter Germany into dozens of pieces, often ruling some of those pieces directly. When it is strong, its neighbors form a coalition to break Germany's power.

The post-Cold War era is a golden age in German history. The country was allowed to reunify after the Cold War, and its neighbors have not yet felt threatened enough to attempt to break Berlin's power. In any other era, a coalition to contain Germany would already be forming. However, the European Union's institutions, particularly the euro, have allowed Germany to participate in Continental affairs in an arena in which they are eminently competitive. Germany wants to limit European competition to the field of economics, since on the field of battle it could not prevail against a coalition of its neighbors.

This fact eliminates most of the eurozone crisis solutions under discussion. Ejecting from the eurozone states that are traditional competitors with Germany could transform them into rivals. Thus, any reform option that could end with Germany in a different currency zone than Austria, the Netherlands, France, Spain or Italy is not viable if Berlin wants to prevent a core of competition from arising.

Germany also faces mathematical constraints. The creation of a transfer union, which has been roundly debated, would regularly shift economic resources from Germany to Greece, the eurozone's weakest member. The means of such allocations —direct transfers, rolling debt restructurings, managed defaults — are irrelevant. What matters is that such a plan would establish a precedent that could be repeated for Ireland and Portugal — and eventually Italy, Belgium, Spain and France. This puts anything resembling a transfer union out of the question. Covering all the states that would benefit from the transfers would likely cost around 1 trillion euros ($1.3 trillion) annually. Even if this were a political possibility in Germany (and it is not), it is well beyond Germany's economic capacity.

These limitations leave a narrow window of possibilities for Berlin. What follows is the approximate path STRATFOR sees Germany being forced to follow if the euro is to survive. This is not necessarily Berlin's explicit plan, but if the eurozone is to avoid mass defaults and dissolution, it appears to be the sole option.

Cutting Greece Loose

Greece's domestic capacity to generate capital is highly limited, and its rugged topography comes with extremely high capital costs. Even in the best of times Greece cannot function as a developed, modern economy without hefty and regular injections of subsidized capital from abroad. (This is primarily why Greece did not exist between the 4th century B.C. and the 19th century and helps explain why the European Commission recommended against starting accession talks with Greece in the 1970s.)

After modern Greece was established in the early 1800s, those injections came from the United Kingdom, which used the newly independent Greek state as a foil against faltering Ottoman Turkey. During the Cold War the United States was Greece's external sponsor, as Washington wanted to keep the Soviets out of the Mediterranean. More recently, Greece has used its EU membership to absorb development funds, and in the 2000s its eurozone membership allowed it to borrow huge volumes of capital at far less than market rates. Unsurprisingly, during most of this period Greece boasted the highest gross domestic product (GDP) growth rates in the eurozone.

Those days have ended. No one has a geopolitical need for alliance with Greece at present, and evolutions in the eurozone have put an end to cheap euro-denominated credit. Greece is therefore left with few capital-generation possibilities and a debt approaching 150 percent of GDP. When bank debt is factored in, that number climbs higher. This debt is well beyond the ability of the Greek state and its society to pay.

Luckily for the Germans, Greece is not one of the states that traditionally has threatened Germany, so it is not a state that Germany needs to keep close. It seems that if the eurozone is to be saved, Greece needs to be disposed of.

This cannot, however, be done cleanly. Greece has more than 350 billion euros in outstanding government debt, of which roughly 75 percent is held outside of Greece. It must be assumed that if Greece were cut off financially and ejected from the eurozone, Athens would quickly default on its debts, particularly the foreign-held portions. Because of the nature of the European banking system, this would cripple Europe.

European banks are not like U.S. banks. Whereas the United States' financial system is a single unified network, the European banking system is sequestered by nationality. And whereas the general dearth of direct, constant threats to the United States has resulted in a fairly hands-off approach to the banking sector, the crowded competition in Europe has often led states to use their banks as tools of policy. Each model has benefits and drawbacks, but in the current eurozone financial crisis the structure of the European system has three critical implications.

First, because banks are regularly used to achieve national and public — as opposed to economic and private — goals, banks are often encouraged or forced to invest in ways that they otherwise would not. For example, during the early months of the eurozone crisis, eurozone governments pressured their banks to purchase prodigious volumes of Greek government debt, thinking that such demand would be sufficient to stave off a crisis. In another example, in order to further unify Spanish society, Madrid forced Spanish banks to treat some 1 million recently naturalized citizens as having prime credit despite their utter lack of credit history. This directly contributed to Spain's current real estate and construction crisis. European banks have suffered more from credit binges, carry trading and toxic assets ( emanating from home or the United States) than their counterparts in the United States.

Second, banks are far more important to growth and stability in Europe than they are in the United States. Banks — as opposed to stock markets in which foreigners participate — are seen as the trusted supporters of national systems. They are the lifeblood of the European economies, on average supplying more than 70 percent of funding needs for consumers and corporations (for the United States the figure is less than 40 percent).

Third and most importantly, the banks' crucial role and their politicization mean that in Europe a sovereign debt crisis immediately becomes a banking crisis and a banking crisis immediately becomes a sovereign debt crisis. Ireland is a case in point. Irish state debt was actually extremely low going into the 2008 financial crisis, but the banks' overindulgence left the Irish government with little choice but to launch a bank bailout — the cost of which in turn required Dublin to seek a eurozone rescue package.

And since European banks are linked by a web of cross-border stock and bond holdings and the interbank market, trouble in one country's banking sector quickly spreads across borders, in both banks and sovereigns.

The 280 billion euros in Greek sovereign debt held outside the country is mostly held within the banking sectors of Portugal, Ireland, Spain and Italy — all of whose state and private banking sectors already face considerable strain. A Greek default would quickly cascade into uncontainable bank failures across these states. (German and particularly French banks are heavily exposed to Spain and Italy.) Even this scenario is somewhat optimistic, since it assumes a Greek eurozone ejection would not damage the 500 billion euros in assets held by the Greek banking sector (which is the single largest holder of Greek government debt).

Making Europe Work Without Greece

Greece needs to be cordoned off so that its failure would not collapse the European financial and monetary structure. Sequestering all foreign-held Greek sovereign debt would cost about 280 billion euros, but there is more exposure than simply that to government bonds. Greece has been in the European Union since 1981. Its companies and banks are integrated into the European whole, and since joining the eurozone in 2001 that integration has been denominated wholly in euros. If Greece is ejected that will all unwind. Add to the sovereign debt stack the cost of protecting against that process and — conservatively — the cost of a Greek firebreak rises to 400 billion euros.

That number, however, only addresses the immediate crisis of Greek default and ejection. The long-term unwinding of Europe's economic and financial integration with Greece (there will be few Greek banks willing to lend to European entities, and fewer European entities willing to lend to Greece) would trigger a series of financial mini-crises. Additionally, the ejection of a eurozone member state— even one such as Greece, which lied about its statistics in order to qualify for eurozone membership — is sure to rattle European markets to the core. Technically, Greece cannot be ejected against its will. However, since the only thing keeping the Greek economy going right now and the only thing preventing an immediate government default is the ongoing supply of bailout money, this is merely a technical rather than absolute obstacle. If Greece's credit line is cut off and it does not willingly leave the eurozone, it will become both destitute and without control over its monetary system. If it does leave, at least it will still have monetary control.

In August, International Monetary Fund (IMF) chief Christine Lagarde recommended immediately injecting 200 billion euros into European banks so that they could better deal with the next phase of the European crisis. While officials across the EU immediately decried her advice, Lagarde is in a position to know; until July 5, her job was to oversee the French banking sector as France's finance minister. Lagarde's 200 billion euro figure assumes that the recapitalization occurs before any defaults and before any market panic. Under such circumstances prices tend to balloon; using the 2008 American financial crisis as a guide, the cost of recapitalization during an actual panic would probably be in the range of 800 billion euros.

It must also be assumed that the markets would not only be evaluating the banks. Governments would come under harsher scrutiny as well. Numerous eurozone states look less than healthy, but Italy rises to the top because of its high debt and the lack of political will to tackle it. Italy's outstanding government debt is approximately 1.9 trillion euros. The formula the Europeans have used until now to determine bailout volumes has assumed that it would be necessary to cover all expected bond issuances for three years. For Italy, that comes out to about 700 billion euros using official Italian government statistics (and closer to 900 billion using third-party estimates).

All told, STRATFOR estimates that a bailout fund that can manage the fallout from a Greek ejection would need to manage roughly 2 trillion euros.

Raising 2 Trillion Euros

The European Union already has a bailout mechanism, the European Financial Stability Facility (EFSF), so the Europeans are not starting from scratch. Additionally, the Europeans would not need 2 trillion euros on hand the day a Greece ejection occurred; even in the worst-case scenario, Italy would not crash within 24 hours (and even if it did, it would need 900 billion euros over three years, not all in one day). On the day Greece were theoretically ejected from the eurozone, Europe would probably need about 700 billion euros (400 billion to combat Greek contagion and another 300 billion for the banks). The IMF could provide at least some of that, though probably no more than 150 billion euros.

The rest would come from the private bond market. The EFSF is not a traditional bailout fund that holds masses of cash and actively restructures entities it assists. Instead it is a transfer facility: eurozone member states guarantee they will back a certain volume of debt issuance. The EFSF then uses those guarantees to raise money on the bond market, subsequently passing those funds along to bailout targets. To prepare for Greece's ejection, two changes must be made to the EFSF.

First, there are some legal issues to resolve. In its original 2010 incarnation, the EFSF could only carry out state bailouts and only after European institutions approved them. This resulted in lengthy debates about the merits of bailout candidates, public airings of disagreements among eurozone states and more market angst than was necessary. A July eurozone summit strengthened the EFSF, streamlining the approval process, lowering the interest rates of the bailout loans and, most importantly, allowing the EFSF to engage in bank bailouts. These improvements have all been agreed to, but they must be ratified to take effect, and ratification faces two obstacles.

Germany's governing coalition is not united on whether German resources — even if limited to state guarantees — should be made available to bail out other EU states. The final vote in the Bundestag is supposed to occur Sept. 29. While STRATFOR finds it highly unlikely that this vote will fail, the fact that a debate is even occurring is far more than a worrying footnote. After all, the German government wrote both the original EFSF agreement and its July addendum.

The other obstacle regards smaller, solvent, eurozone states that are concerned about states' ability to repay any bailout funds. Led by Finland and supported by the Netherlands, these states are demanding collateral for any guarantees.

STRATFOR believes both of these issues are solvable. Should the Free Democrats — the junior coalition partner in the German government — vote down the EFSF changes, they will do so at a prohibitive cost to themselves. At present the Free Democrats are so unpopular that they might not even make it into parliament in new elections. And while Germany would prefer that Finland prove more pliable, the collateral issue will at most require a slightly larger German financial commitment to the bailout program.

The second EFSF problem is its size. The current facility has only 440 billion euros at its disposal — a far cry from the 2 trillion euros required to handle a Greek ejection. This means that once everyone ratifies the July 22 agreement, the 17 eurozone states have to get together again and once more modify the EFSF to quintuple the size of its fundraising capacity. Anything less would end with— at a minimum — the largest banking crisis in European history and most likely the euro's dissolution. But even this is far from certain, as numerous events could go wrong before a Greek ejection:

  • Enough states — including even Germany — could balk at the potential cost of the EFSF's expansion. It is easy to see why. Increasing the EFSF's capacity to 2 trillion euros represents a potential 25 percent increase by GDP of each contributing state's total debt load, a number that will rise to 30 percent of GDP should Italy need a rescue (states receiving bailouts are removed from the funding list for the EFSF). That would push the national debts of Germany and France — the eurozone heavyweights — to nearly 110 percent of GDP, in relative size more than even the United States' current bloated volume. The complications of agreeing to this at the intra-governmental level, much less selling it to skeptical and bailout-weary parliaments and publics, cannot be overstated.
  • If Greek authorities realize that Greece will be ejected from the eurozone anyway, they could preemptively leave the eurozone, default, or both. That would trigger an immediate sovereign and banking meltdown, before a remediation system could be established.
  • An unexpected government failure could prematurely trigger a general European debt meltdown. There are two leading candidates. Italy, with a national debt of 120 percent of GDP, has the highest per capita national debt in the eurozone outside Greece, and since Prime Minister Silvio Berlusconi has consistently gutted his own ruling coalition of potential successors, his political legacy appears to be coming to an end. Prosecutors have become so emboldened that Berlusconi is now scheduling meetings with top EU officials to dodge them. Belgium is also high on the danger list. Belgium has lacked a government for 17 months, and its caretaker prime minister announced his intention to quit the post Sept. 13. It is hard to implement austerity measures — much less negotiate a bailout package — without a government.
  • The European banking system — already the most damaged in the developed world — could prove to be in far worse shape than is already believed. A careless word from a government official, a misplaced austerity cut or an investor scare could trigger a cascade of bank collapses.

Even if Europe is able to avoid these pitfalls, the eurozone's structural, financial and organizational problems remain. This plan merely patches up the current crisis for a couple of years.

By John F. Mauldin
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Comments

Geoff
08 Oct 11, 06:32
Banking collapse

A well thought out analysis putting succinctly what most of us have concluded for a while. From the analysis it is apparent saving the Euro and Europe as it now exists would seem highly improbable marking the end of the experiment.

We do know that when an end comes it is often very quick but the point at which it happens is unpredictable.

The danger today, which has not existed before is most sovereign states are overburdened by debt of such size to pose a serious threat to even safeguarding the bank deposits of its people.

Serious adjustment in spending, entitlements and standard of living expectations are on the way which will undoubtedly lead to instability. This is the true threat that has to be addressed. I am not optimistic instability can be mitigated.


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