France Reappears To Support Greece?

From the very beginning of our posts on the Euro, dating back to 2011 we have talked about the fundamentally divergent interests of France and Germany. For a while, French President Sarkozy made a concerted effort to have arms outstretched for his partner, Chancellor Merkel.  Since the next regime, things have become somewhat aloof, if not frosty.

We noted in a recent post, that French President Hollande was not visible as Chancellor Merkel was playing the despotic aunt, refusing to finance her profligate nephew, Greece.  The Wall Street Journal reports that President Hollande is visibly counseling about the risks of continuing to play hardball with Greece and a consequent default and Grexit.

It comes down to the original conception of  the European Union, which dates back to 1950-51 and initiatives championed by French foreign minister Robert Schuman, whose work we studied in our European economics seminar at the University of York, which I attended as an overseas student during my junior year of college. Here is a quote ascribed to Schuman,

• "Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity."

Customs union, currency union, free movement of capital and labor, harmonization of regulation, abolition of non-tariff barriers, and the unspoken political union.  It was a grand vision, to be sure, but more than half a century later, its defects and limitations continue to show.  

Looking at the history and origins of the two world wars, one would be very hard pressed to make a case for the notion of 'solidarity' across national boundaries, when solidarity within those same boundaries is becoming more questionable.  

Greece and its vaunted talent bank of American-trained economist/politicians have been irresponsible, but their actions are rational responses to the sometimes perverse incentives built into the whole currency union operations.  If money and credit are being given away, why not take it?  

We may now see the consequences of that strategic gambit. 

The EU and Greece Share a Cup of Hemlock

Since 2012, we have written about the inevitability of the events the European union are facing today, a Greek sovereign debt default, an exit from the euro currency zone, political chaos at home, and a fundamental failure of the grand European experiment.

To reach this conclusion, no complex economic models are needed.  The design of the system and the notion of divergence, along with the history of relationships within the zone, point the way.

To be sure, along the way, there were many false dawns, as European politicians do what they do best summit meetings and consultations with smiling faces and bowed heads, walking in some countryside.  Hedge fund managers used their tools to call a bottom in bond prices and got involved.

Fast forward to today, and there are no financial markets to impose any discipline on Greece.  Hedge funds have gone home chastened with their losses, and Greek sovereign debt is owed to the IMF and to the ECB, with the biggest chunk being owed to Germany.

For all the Ph.D.s among the Greek expat intelligentsia, for all the worship of game theory and Nash equilibria, Greek politicians have gone beyond brinksmanship to simple economic lunacy.  Asking the EU to wait for a Greek national referendum was irresponsible. Greek government pensioners don't want any changes in the status quo and blame outsiders, like the IMF, for their problems.  A "No" to acceding to further fiscal discipline may be a vote against the EU, but it is also a repudiation of failed Greek political parties.  It does no one any good, except to save face for the Tsipras leadership failure.

For Germany, not how French President Hollande is no longer at the Chancellor's side, as they were inseparable a few years ago, co-leaders of the European experiment, along with the IMF, now led by a French national too.  Chancellor Merkel is now by herself forcing Greece over the cliff.  Of course, she has no real choice.

The Greek alternative to fiscal austerity has been a plan in which, for example, pension payouts were guaranteed, and a plan dependent only on revenue raising through taxes on small businesses, with no more fiscal austerity.  No Ph.D. is needed to see how this plan would turn out.  So, any rational observer has to realize that Greece is no longer serious about reforming its economy to meet substantially higher growth targets.

But, since the Maastricht Treaty is silent about unilateral exits and the mechanics thereof, a Grexit really calls into question the whole value of the euro, the ECB, the ESM, and all the bureaucratic empire that has been created in Brussels.  Which peripheral member would be the next to take bitter medicine?

Although Plato took liberties with the poisoning of Socrates, in terms of describing symptoms and a drawn out death, it probably applies well to Greece and to European Union.  If Greece takes its bitter medicine and defaults, leaving the Eurozone, there will be great economic weeping and gnashing of teeth.  But, Greece will have made Europe pay a price too, finally exposing the emptiness and futility of the eurozone as it has been laid out and administered so far.

A Greek Exit May Be the Lesser of Two Evils

One of my favorite financial commentators, Professor John Cochrane of Chicago Booth pooh-poohs talk about a Greek exit from the euro, saying essentially that we are used to sovereign defaults and this issue is separate and distinct from a decision by Greece to exit the euro.  He writes,

"Greece no more needs to leave the euro zone than it needs to leave the meter zone and recalibrate all its rulers, or than it needs to leave the UTC+2 zone and reset all its clocks to Athens time. When large companies default, they do not need to leave the dollar zone. When cities and even US states default they do not need to leave the dollar zone. A common currency means that sovereigns default just like large financial companies."

But, unlike the U.S. dollar which gained wide acceptance after the detailed architecture of the United States of America had been put in place and operating, the euro was created as a common currency without a political union in place, so I would argue that John's comment misses an essential political difference. Finance, more often than not, turns on politics, which is logical since markets are themselves social constructs in which the rulers of the nation-state have an intense interest.

Going back to 2011, we wrote, "...a paralyzed Europe has to come to terms with the failure of the notion of their common currency union."  

In 2012, we wrote, "Meanwhile, the economic and social  costs of the adjustment to the weaker EU members will be genuinely painful."

I can't believe that it's taken four years for the financial press to wake up to the realities as opposed to covering EU press conferences. The Greek government played chicken with Germany, and Greece blinked. Cash was found, debt repayments were made, but they were made with prior loaned amounts found laying around, lent by the IMF/ECB. This was a cruel joke, and the charade continues, but at what cost?

Greece is a sovereign state, and it should have the freedom to make its own foolish economic decisions and to run itself into the ground, if there is no domestic political will.  Instead, its economy is chronically mismanaged, but more so than Italy or France?  And, though its electorate expressed revulsion at the euro scenario by bringing in a reform party, the people's will continues not to be carried out because of the eurozone's fiscal and economic reform requirements.  Sooner or later, this lack of political freedom is a genuine cost of belonging to the euro zone.  

The contagion issue is a technical red herring, in my opinion.  Policy pundits have argued about this before, to no real conclusion or benefit.  Greece needs to confront its own economic and social mismanagement and deal with monetary issues through its own elected representative government.  If Greece were to reissue the drachma, try to prohibit capital flight, and the drachma rose to 500 drachma/euro, then a rather painful adjustment process would begin and a new equilibrium found. But this process might be less destructive to the Greek polity than the slow bloodletting under the ECB/IMF/ESM, Whatever path chosen, it would be chosen by the Greek voters, without outside pressures, other than by market price signals. 

Greece would also being doing a favor for the rest of Europe by exposing the economic fraud which is the EU, that shouldn't have allowed most of the periphery to join the eurozone had it enforced its own rules.  

Greece Finds Some Cash

Even though we've been out of the blogosphere for a while, nothing has really changed in the drama between Greece and its creditors. Despite some last second posturing through Finance Minister Varoufakis being photographed with Russian President Putin, Greece really had no cards to play and miraculously found $450 million euro for a scheduled debt repayment to the IMF today. Answers: Greece blinked.

No good can come from extending this drama further.The longer the charade goes on, the more the politicians and their weary voters will come to feel that there is either (1) no real crisis and the drama has all been brought on by outsiders, so no need to change anything; or, (2) there is no hope for Greece except to be Europe's indebted beggar, and therefore no need to strive for growth or improvement. Neither reaction helps the nation in the long-term.

 Despite the dire consequences of a Greek exit from the euro currency, it can be handled and indeed we believe that were once contingency plans for doing just this.  27% plus unemployment rates for two years running, the uncertainty of meeting April government payrolls, the capital flight and the growing lame-duck feel to the current government all point to the benefits of Greece taking the bitter medicine and going it alone.

The euro itself will be less damaged that if the system were to countenance a "slow bailout" of Greece.

The Bank of England's recent Fiance Committee minutes show that UK banks' net exposure to Greece comprised less than 1% of the Common Equity Tier I (CET1) Capital, and bank counterparties as a whole had about a 2% exposure.  Were an exit to hit other heavily indebted countries in the eurozone, the exposure are significantly greater, but Greece itself can be ring-fenced by current capital cushions. JPMorgan Chase CEO Jamie Dimon has said that his bank has been working on a Greek exit for some time, through its risk management simulation exercises.

European stocks smugly reach new highs, while the ongoing complexion of the European experiment continues to look wan.

Who Blinks First: Greece or Germany?

Some of my most widely read posts, both by numbers and by geographical dispersion, relate to the Euro and the Grexit, dating back to 2012.  This particular one, "Revisiting the Euro and the Grexit," hit it all right on the head.

Today, even the Guardian seems to waking up out of a fog when it writes,

"A month ago, such an outcome(economic collapse or exit) to the Greek crisis looked highly improbable. It now appears far less unlikely, which is one reason why the euro has been under such pressure on the foreign exchanges. At some point, the 35% depreciation of the single currency against the dollar is going to lead to strong exports and a much-needed growth boost."

Bailing out Greece, or Germany blinking, puts another nail in the European experiment.  The EU violated its own rules when it admitted Greece (and others) into the currency union, and a bailout (or other euphemism) is the ultimate practical repudiation of both economic principles and rules.

The multi-year charade that has brought us to this point can't continue by just accepting more austerity: for the economic well being of the people and for the political self interest of its politicians, Greece needs to undertake fundamental structural reforms in taxation, labor market and public pension reforms.  Without some outside representation by the EU machinery in providing technical assistance or monitoring, it's hard to see how blank checks can be written.

If the bitter pill were accepted, how could the current Greek government, elected on a sham platform, continue to hold the confidence of the electorate?

Taking the euro down to stimulate exports helps Germany much more than it will help Greece in the short-term, without labor market and regulatory reform in, for example, Greek ports and shipping.

All eyes may turn to Mario Draghi, but his tune is already tired and won't be enough.

Klaus Adam Sees It Our Way on Greece

Professor Klaus Adam  writes,

"This unfortunate outcome must be blamed on the inability of the Greek political elites to deliver the structural economic changes that are needed. Salary cuts and tax increases alone simply cannot re-establish the competitiveness of the economy. And if true economic reform cannot be delivered, then a euro- area exit remains the only other available option. This is a sad and unavoidable conclusion, and it follows from the simple fact that Greece cannot go on borrowing forever."

"A Greek debt default and a simultaneous euro area exit would achieve all of these goals, virtually overnight. Obviously, the adjustment would be rough and turmoil would probably prevail for a number of months, but the adjustment would take place."

We've written about this possibility since 2011, when the markets were oblivious to anything but rosy scenarios for the euro experiment.  However, given years of the dithering by European leaders and their enablers like the ECB and the IMF, a Greek exit alone won't end the issues within the EU.  It may resolve the pain for the Greek population and perhaps allow some real reforms under the leadership of its own politicians.  The broader issues within the EU and the fissures between France and Germany will only intensify.

Euro Bunds Not A Rational Option

Today, we know that the young, photogenic Greek leftists were full of bluster but no bite.  Instead, they are now going in search of traditional political support for a combination of Euro bonds, debt write downs, and traditional bailouts with "other people's money."  Meanwhile, French socialists are behaving no differently from the deposed conservatives in trying to paint Germany in a corner as the obstructionist force to progress.  IMF Director Lagarde has joined in on cue, as the WSJ writes the "campaign for join Euro bonds gathers pace."  The pace may not be sustained.

No German politician of any stripe, Social Democrat or otherwise, would be able or willing to cede political and economic sovereignty to the extent triggered by issuing a Euro bond instrument.  France may be "jousting" with the Germans about Euro bonds, but aside from rhetoric and public relations, the Republic has no leverage.

The BBC did a series of walk around interviews with German citizens about the Euro crisis this morning, and I was amazed at the thoughtfulness of all the answers.  Certainly nobody offered a solution.  But, I would describe the sentiment as being (1) we wouldn't like the European union/currency/experiment end, but (2) Germany certainly can't be expected to write blank checks or to carry the burden for Greece and others.

There has never been any doubt that a euro zone fracture or breakup would be costly.  An economist at the University of Cologne mentioned something that I wasn't aware of: Target 2 funds of the European Central Bank.  (I regret not being able to credit his name because it wasn't very audible on my feed) These funds were, in his words, meant to slosh around European central banks to ease short-term liquidity crises without triggering public concerns.  He calculates that there are 240 billion euros issued under Target 2, with no clear requirements for repayment.  He estimates a Greek exit would wipe out repayment prospects, costing Germany almost thirty percent of this amount, which was its contribution.

Spain's issues are within the purview of a traditional central bank: a real estate bubble.  It has already put some of its smaller institutions under central bank control, and it just needs to act quickly and decisively.  The sooner it does this, the sooner the rest of Europe can own up to where some of the bad Spanish paper lies. 

As some of the German citizens interviewed by the BBC said, it would be a shame if Greece, at 2% of EU GDP could call the day for the end of the euro.  The Greeks don't seem ready to march off the cliff today.

More Euro Agonistes

We've always believed that resolution of the euro crisis had to include a Greek exit from the currency union. Now, many the consensus-driven financial community are busy hedging towards a similar position.  For example, from the Wall Street Journal, we read:

"Citigroup on Monday raised its estimate of the likelihood of a Greek exit from the euro area over the next 18 months to 50% from a prior range of 25% to 30%, according to the bank’s latest “Global Economics View” analysis by economists Willem Buiter and Ebrahim Rahbari." (Wall Street Journal)

The Jerome A. Chazen Institute of International Business at the Columbia Business School recently sponsored a panel discussion on the euro crisis.  A video of the forum, along with pdfs of the presenters slides is available.

The foundational issues are good, old fashioned issues of international economics.  The European currency union was put together with members whose economies were too diverse in size and character.  The entire theoretical framework of the currency union  put together by Robert Mundell, Roland McKinnon and Peter Kenen required a basic assumption that inflation rates among the members were similar.  The entire model, like most international trade models, requires factor mobility (labor and capital), and no economic rigidities in labor markets, for example.  The creation of the customs union was a backdrop for the currency union.

However, the elephant in the room was always "harmonisation" of fiscal policies in the language I read in the economic literature when studying in Europe. That harmonisation was supposed to magically lead to integration of fiscal and political policies.  There never was a harmonisation of fiscal policies,  and there surely will never be an integration.  The geographical and politicial balkanization of Europe has settled that issue. 

The current situation has also introduced significant economic distortions in Europe, as Professor Beim's slides show. Germany was the first to rationally remove labor market rigidities, regulatory burdens, and to provide financial incentives for its export-oriented sectors.  Subsequently, German industrial output showed rapid growth, while those of large economies like Italy fell, from the date that the euro exchange rate was fixed.  Greece fared far worse. 

European politicians are skilled diplomats, unlike our own rough-and-tumble media brawlers, and so they will put a better face on the crisis.  More importantly, they will stretch out the meetings, summits, communiques and public lectures so that any exit will be relatively orderly.  Meanwhile, the economic and social  costs of the adjustment to the weaker EU members will be genuinely painful.