This is how European union ends

 I never held much truck with analysts like George Friedman, who believed that the European Union is doomed. Unfortunately, new facts have caused me to change my mind.

 

One new fact, actually: the European decision to charge the Irish government a market rate on its “bailout” funds. WTF? Here is where I want to go out and shake a German: the IMF is the good guy in this story! You heard me right. The IMF suggested that Ireland basically default on the debt incurred to rescue the banks. That would be fine. Cut everyone’s debt level, let firms and individuals escape via bankruptcy. That would make it much easier to slash prices and wages without squeezing living standards. “Internal devaluation,” in other words.

But the German government, the same government that (sensibly) wants private-sector haircuts after 2013 nixed the idea because its own banks are too exposed, and Berlin does not want to admit that its banks were as caught up in the foolishness as Irish ones. Instead we get a non-bailout bailout that does nothing to improve the situation and forces the Irish public to transfer 10% of its income to the rest of Europe for the foreseeable future.

Maybe as the possibility of disastrous disorderly defaults looms ever-larger, German politicians will get their act together. A European version of the Brady bond is one possible solution. A raise in the ECB’s inflation target would help. Low-interest E.U. loans are a great idea. And a complete unification of European banking regulation (I suggest they just adopt Canada’s rules and be done with it) is long overdue. Internal devaluations made as easy as possible, reforms in the places that need it (of which Ireland is not one), and the dream of European unity held together.

That looks ever-less likely. Instead we may get collapsing banking systems, chaotic defaults, German taxpayers bailing out German banks at high cost, and a reckless euro-breakup with horrible consequences for the world economy. It would also, as best as I can see, leave a residue of massive anger aimed, rightly or wrongly, at Berlin.

The problem seem to be the German government’s unwillingness to explain that Germans benefit more than anyone from the eurozone. Break it up, and German banks go kaplooie, German exports become uncompetitive, German wages become unsustainable, and the German people get blamed. Instead, though, it seems that the narrative of hard-working Germans selflessly sustaining the rest of Europe is too good to resist. And so, we slouch towards catastrophe. (The optimist in me says that it will turn out much better than the 1930s! The pessimist says, yeah, so did the 1980s in Latin America.)

I hope that I turn out to have been right the first time. Can somebody talk me down?

Comments

[Omar Serrano]

I agree that somebody should explain German voters that they have benefited-and quite a bit-from having the Euro and that German banks are so exposed that there is nothing altruistic about supporting Greece and now Ireland (and tomorrow probably Portugal and maybe even Spain). But as it happens this is a two way street and the Irish also benefited from entering the Euro at a relatively low exchange rate which basically meant anchoring a low rate and giving Ireland a fine competitive advantage. I'm not saying that this was the only reason for Ireland's impressive economic record over the past years (low corporate taxes certainly did their part too) but it surely helped. Now as in Spain, it fuelled a housing bubble with the effects we all know. But still. In the end it seems to me the problem is the unique experiment that Europe has become. While currency unions are not so rare (at least historically) you don't see a lot of currency unions pooling sovereignty as EU Member States do. So my take is that the EU won't break. The euro, well I'm still betting on it, though probably some way of defaulting will be eventually found as seems to be now the aim of the Franco-German duo. So I'm in for a bet, since we both like cigars that could work. My take is that after a lot of squabbling and only after things get even more nasty politicians in Euroland will come to accept the sort of painful measures you suggest. But these are my two cents...

[Noel Maurer]

Sir, you're on! OK, here's the bet. If the euro makes it to 2013, I fly to Switzerland and owe you an evening of port and cigars. (Plus, possibly, steak.) If the euro collapses before then, you fly to Boston and we do the same. Deal?

It's a bet I'll hope to lose.

[Omar Serrano]

All-right then! It's a bet. I like the idea of Boston (or Switzerland) with port, cigars and a good stake (need to check on a nice Argentinian restaurant around here... just in case).

[Doug M.]

Can I get a piece of this?

Doug M.

[Noel Maurer]

Sure! Which side? (I win if any country leaves the euro. I don't want to win.)

N

[Doug M.]

[sucks teeth] /any/ country? No, that I wouldn't take.

The original language was "if the euro collapses". If Greece and Portugal leave, but everyone else stays put, that's not exactly "collapse".

My definition would be "at least 90% of the population that are using the Euro now, still are." The current population of the Eurozone is about 330 million, so it could eat a loss of 33 million.

Spain alone has 46 million, so if Spain leaves, you win.

Also, we didn't say when in 2013 -- Jan 1, December 31, fiscal year? I'd propose the 25th of March, which is the date the EEC treaty was signed back in 1957. Does that work for you?

(Also, why would you not want to win? If Spain leaves the eurozone, but everyone else stays put, the consequences will be complex -- but not, ISTM, obviously catastrophic.)

Doug M.

[Noel Maurer]

I clarified because I know you well enough to know that you'd misinterpret it. You want me to buy you a dinner.

But okay. Spain is the big one. It's a different bet, but I'm happy to exclude Ireland, Portugal, and Greece. The new wager, then, is on any of the original EEC six or Spain. And I do like using March 25 instead of January 4th. (The difference is Belgium.)

I hope to lose because the withdrawal of even a small peripheral country will be accompanied by a massive economic contraction, even if the Eurozone politicos then do what they must to keep the Zone together. I don't like to profit off suffering, although I clearly don't dislike it that much. I also hope to lose because I like the idea of a madre patria integrated into Europe. But the latter is emotional.

So, are we on?

[Doug M.]

Tch. I don't care about the dinner.

In fact, it doesn't make much sense if we're on different continents. So: dinner and drinks if we're living within a couple of thousand miles of each other, or have a trip scheduled within a few months. Otherwise, loser sends the winner a $100 bottle of the tipple of his choice.

Belgium doesn't count if it breaks up before then! (Unlikely but possible.) Otherwise, okay -- EEC-6 or Spain.

Massive economic contraction: possible, certainly! But I'm not sure why that would be the most likely outcome.

Doug M.

[Noel Maurer]

No, no, the idea is that the bet was made with people on different continents! I go to Europe if I lose, Omar comes to Boston if I win. Higher stakes ... and more fun either way. Think of the conversation! Plus, cigars. (I have the steakhouse and cigar bar in Boston all picked out already.) Still in?

Why wouldn't an exit from the euro result in a massive economic contraction?

[Doug M.]

I see the fun part, but it's a bit harder for me to flit off to another continent. "Claudia, watch the kids by yourself for a week? I lost a bet."

But if you'll accept 'best efforts to make it to dinner, and a bottle of good cognac if I can't', then yes, still in.

Why wouldn't it: say Spain leaves and... and /it is awesome/. Foreign debts redenominated in pesos, which promptly lose half their value: yeah! Exports suddenly become ferociously competitive: woo! Imports rice in price, and that's inflationary... and hot damn, that's good too, because there's nothing like a hot dose of inflation to get the wheels turning again. A rosy scenario, sure, but not an obviously daft one.

Now, this could lead to all sorts of knock-on effects. But I'm not sure why it leads to "massive economic contraction" either in Spain or in the rest of the EU.

Doug M.

[Noel Maurer]

I understand your point about switching continents, but bear in mind that I'll be in the same situation by 2013. It's what relatives are for. Help me out here with "best efforts."

Or you could buy my ticket to Switzerland if I win ... that's an option!

As for the rosy scenario ... it's pretty daft.

What happens in the run-up to leaving the euro? Massive bank runs and large-scale bankruptcies.

What happens at the moment of de-euroization? A bank holiday, followed by a massive increase in the debt-income ratio for Spanish firms. Spain would also need to impose capital controls or face a massive monetary contraction, at which point it's tossed E.U. law out the window. It could reduce the sudden shock to Spanish borrowers by forcibly pesifying all debts, but that introduces even more legal uncertainty.

Then you run down the J-curve for a while, as import costs spike. More businesses go under as they find that they can't survive in the increase in the cost of imported inputs, even with lower labor costs.

Eventually you see a recovery. And, if the banking system had already been allowed to collapse, then you might even see a relatively quick one.

The scenario fits Argentina to a T ... but then you have the knock-on effects for the rest of Europe, which didn't apply to Argentina.

First, French and German banks reel from their exposure to the Spanish economy.

Second, both countries take a big hit to their net exports. This punches the German economy right in the nose.

Third, contagion wrecks Belgium, Italy, and possibly France, which start to see severe bank runs (if they haven't already).

Finally, uncertainty takes its toll. After all, if the entire Notorious Six follow Spain, then the German economy is going right down the tubes. The increased possibility will cause panicky people to run for the hills --- save your euros! Don't spend!

This is a massive economic contraction. The rosy scenario is daft. The only way it could possibly apply is if the Eurozone was crazy enough to allow the entire European economy to dip over into something resembling the Great Depression.

Convinced?

[Doug M.]

No. But let it bide. I suspect we're going to know the winner of this bet well before it's time to pay up.

Doug M.

[Noel Maurer]

I really would not want to let this bide. Why are you not convinced?

Explanation: This is along the lines of two people discussing whether the sky is blue or green. If I'm color-blind, then I want to know.

[Doug M.]

I'm in the West Bank now, confronting a rather astonishing legal tangle. Distracting!

Would you have any objection to me putting this up at the Fistful?

Doug M.

[Noel Maurer]

Cross-post?

What's the tangle?