spotfxtrader

After a pro EU piece the other week, (and by pro EU I mean anti Europe – his suggested most favourable outcome for the crisis being the introduction of a debt union, i.e. an outcome which would amount to the crushing of any democratic opposition to the EU Superstate), Mr Münchau appears to have seen the error of his ways….

As we’ve been saying all along, the ‘system’ is non-linear, and as it has now become totally unstable, the chances of the crisis being resolved in anything approaching an orderly manner are extremely slim. After considering his earlier piece pretty contemptible, I do like his description of EU decision makers as ‘serially incompetent’. I would venture that that description universally applies to the political classes throughout Europe and the US, with very few exceptions.

Ultimately he suffers from the delusion that the whole edifice could be managed if only good decisions could be made. The only good decision would be not to have attempted the creation of a superstate founded in subterfuge in the first place.

By Wolfgang Münchau

Published April 24 2011, 19:51

I was uncharacteristically optimistic last week, and had planned to end my informal series on eurozone crisis resolution with a benign scenario. The eurozone would survive in one piece; there would be no blood on the streets, just a once-and-for-all, albeit reluctant, bail-out, accompanied by a limited fiscal union. But as several readers have pointed out, my scenario is prone to a very large accident. I accept that point. Last week, we caught a glimpse of how such an accident may come about. My benign scenario looks a lot less certain today than it did a week ago.

The week began with the strong showing of two parties in the Finnish election, which are advocating a partial Portuguese debt default as a condition for a rescue package. The results triggered a renewed outbreak of the financial crisis, as eurozone spreads rose to near record levels once again.

The most disturbing news, however, was a revolt within Angela Merkel’s increasingly fragile coalition. It looks as though the German chancellor is on the verge of losing her majority over the domestic legislation of the European Stability Mechanism (ESM), the long-term financial umbrella for the eurozone. She may have to rely on the opposition to ratify the ESM, which may come at a heavy political cost. The Bundestag already postponed the vote on the ESM until the autumn, hoping to keep it clear from the controversial decision to pass the Portuguese rescue programme in May.

As opposition to the ESM mounted, German officials fell over themselves to be quoted by various newspapers pronouncing that a Greek restructuring was inevitable. Even Wolfgang Schäuble, finance minister, talked about the possibility of default. Some wily speculators unleashed the rumour that Greece would spring a surprise debt restructuring. The rumours prompted a criminal investigation. Another week in the eurozone’s debt crisis!

A monetary union is at a natural disadvantage when it comes to the handling of crises. There is no central government that takes decisions, which makes communications hard to control. What is less forgivable is the serial incompetence of the eurozone’s decision-makers, as exemplified by the perpetual eagerness to declare the crisis over the very second financial market pressure subsides. Not only do they know little about financial markets, they have surrounded themselves with policy advisers who know little too.

Their ignorance is an ideal breeding ground for quack solutions. One such is immediate default. German Christian Democrats and Finnish isolationists spent the last week trying to convince themselves that a Greek debt-restructuring would save them a lot of money.

That belief is premised on two false assumptions. The first is that a voluntary restructuring could solve the Greek debt problem. It can work in limited cases, but not when countries are insolvent. Greece, however, faces no short-term liquidity squeeze, because it is supported by the European Union and the International Monetary Fund. There is no need for any restructuring, voluntary or involuntary, right now. But Greece may need to impose a “haircut” in the future to ensure debt-sustainability. The ideal moment would be when the country achieves a primary surplus, probably in 2013.

The second wrong assumption is that the Greek banking sector would survive a restructuring unscathed. This is a conditional error. If you believe that a voluntary restructuring would be sufficient, then the Greek banking sector would indeed survive. But it would surely not survive a large and involuntary haircut. The European Central Bank would face a haircut on its direct investments of Greek government bonds, and, more importantly, much of the collateral posted by Greek banks would vanish. On my calculation, the cost of a Greek default to the German taxpayer alone would be at least €40bn ($58bn), including recapitalisation of the ECB. A bail-out would be cheaper.

A premature Greek default would change everything. As would the failure by the EU and Portugal to agree a rescue package in time; or an escalation in the EU’s dispute with Ireland over corporate taxes; or a ratification failure of the ESM in the German, Finnish or Dutch parliaments; or a German veto for a top-up loan for Greece in 2012; or the refusal by the Greek parliament to accept the new austerity measures; or a realisation that the Spanish cajas are in much worse shape than recognised, and that Spain cannot raise sufficient capital.

Then there is the downgrade threat for French sovereign bonds. I recall asking a French official about this, and getting the smug answer that the rating agencies could hardly downgrade France if they maintained a triple A rating for the US. That was before last week. By extension, France must also now be in danger. A downgrade would destroy the logic of the European financial stability facility. It is built on guarantees by the triple-A countries. Without France, the lending ceiling of the EFSF would melt down further.

The list of potential accidents is long, but they share a joint theme – serial political crisis mismanagement. We saw another glimpse of that last week. If we go down the route of premature default, and allow the True Finns and the true Germans to run the show, the eurozone as we know it will be finished.