Source: Business Insider
A Quote From Merkel That Pretty Much Guarantees ThSlow growth is embedding itself solidly into the US economy and the bond mayhem in Europe continues. The external environment for China is getting worse. This will almost certainly make China’s adjustment – when Beijing finally gets serious about it – all the more difficult. With still weak domestic consumption growth, and little chance of this changing any time soon, weaker foreign demand for Chinese exports will cause greater reliance than ever on investment growth to generate GDP growth.
Europe’s travails in particular can’t be good for exports. What’s worse, it’s now pretty much official that the euro will fail soon enough. We have this on no less an authority than Angela Merkel. Here is what Thursday’s Financial Times says:
"Angela Merkel, German chancellor, declared on Wednesday that “the euro will not fail” after the country’s powerful constitutional court rejected a series of challenges to the multibillion-euro rescue packages agreed last year for Greece and other debt-strapped members of the eurozone.
In a passionate restatement of Germany’s determination to defend the common currency, the chancellor welcomed the court’s judgment as “absolutely confirming” her government’s policy of “solidarity with individual responsibility”.
No, I didn’t misread the article. I just have a very different understanding of the logistics of a denial. Last year, for example, I wrote on my blog about ferocious denials by both Spain and Portugal that they would need any official help in funding themselves. But according to one of my favorite British television comedies, Yes, Minister, an official denial means something very different from what is intended. “The first rule of politics,” Sir Humphrey, the wily civil servant in the show, insists is: “never believe anything until it is officially denied.”
That’s why, citing Sir Humphrey, I was pretty sure that both Spain and Portugal would need to be bailed out. As long as they remained within the euro, I was convinced that there was no politically acceptable adjustment mechanism that would allow them to continue funding their debt in an orderly way. One way or the other they would have to be bailed out or default, and probably both, with the first happening a few times before the second. In the end the denial confirmed the bail out. Sir Humphrey usually knows how such things actually work.
So of course Merkel’s denial struck me as especially interesting. I don’t want to sound too glib or too jokey, but I wonder if there has ever been a forced devaluation that wasn’t preceded by ringing assertions from presidents and central bank governors that under no circumstance would the currency ever devalue.
What is all the more interesting is that I recently discovered that the quote “never believe anything until it is officially denied” doesn’t originate with the writers of the British TV comedy. Apparently it can be traced to at least as far back as Otto von Bismarck, who was born not too far from where Angela Merkel grew up. Never believe anything until it is officially denied, the Iron Chancellor warned us.
An interesting proposal
So if Germany’s Iron Lady is now denying that the euro will fail, can its failure be far off? It depends I guess on what we mean by failure. If any important reversal in the structure and membership of the euro is a failure, then it will almost certainly fail, but I suppose there are many ways the euro project can be transformed without quite calling it a failure.
At the end of last month Hans-Olaf Henkel, for example, the former head of the Federation of German Industries, had an interesting OpEd in the Financial Times. In his piece he says:
"Having been an early supporter of the euro, I now consider my engagement to be the biggest professional mistake I ever made. But I do have a solution to the escalating crisis.
…Instead of addressing the true causes, politicians prescribe painkillers. The euro patient suffers from three discrete diseases: as a result of the financial crisis, many banks are still unstable; the negative effects an overvalued euro has on the competitiveness of the “south”, including Belgium and France; the huge level of debt of some eurozone countries. It would be misleading to proclaim there is an easy way out. But it is irresponsible to maintain there is no alternative. There is.
The end result of plan “A” – “defend the euro at all cost” – will be detrimental to all. Rescue deals have led the eurozone on the slippery path to the irresponsibility of a transfer union. If everybody is responsible for everybody’s debts, no one is. Competition between politicians in the eurozone will focus on who gets most at the expense of the others. The result is clear: more debts, higher inflation and a lower standard of living. The eurozone’s competitiveness is bound to fall behind other regions of the world.
As a plan “B” George Soros suggests that a Greek default “need not be disorderly”, or result in its departure from the eurozone. But a Greek default or departure from the eurozone implies risks too high to take. First in Athens, then Lisbon, Madrid and perhaps Rome, people would storm the banks as soon as word got out. A “haircut” would not improve Greece’s competitiveness either. Soon, the Greeks will have to go to the barber again. Anyway, we now talk also about Portugal, Spain, Italy and, I am afraid, soon France.
That is why we need a plan “C”: Austria, Finland, Germany and the Netherlands to leave the eurozone and create a new currency leaving the euro where it is. If planned and executed carefully, it could do the trick: a lower valued euro would improve the competitiveness of the remaining countries and stimulate their growth. In contrast, exports out of the “northern” countries would be affected but they would have lower inflation. Some non-euro countries would probably join this monetary union. Depending on performance, a flexible membership between the two unions should be possible."
I think Henkel is right, although I think the likelihood of Europe’s adopting his Plan C is pretty small. Still, it is interesting to consider why he might be right.
As I see it, we cannot continue with the existing currency arrangement. Countries like Spain (I am reverting to my habit of calling all the deficit countries “Spain” and all the surplus countries “Germany”) simply will not adjust quickly enough as long as they maintain the euro, and we are going to watch their economies contract and their debts grow until finally the electorate has had enough and forces a radical change in strategy
Much if not most of peripheral Europe will then leave the euro and default, and Germany will have to eat the losses on its outstanding (and growing) loans. But why wait? The longer we put off the reckoning the worse it will be for peripheral Europe and the greater the losses that Germany will have to swallow. So shouldn’t Germany simply force Spain to leave the euro now?
Damned either way
The problem is that if Spain leaves the euro and returns to the peseta, it will be caught in a downward currency spiral like the ones suffered by Mexico in 1982 and 1994 and Korea in 1997. In both cases the currency plunged by far more than the amount of its theoretical overvaluation. This happened because a substantial portion of Mexican and Korean debt was denominated in foreign currency. Of course once Spain revives the peseta, it will be in a similar position – with a lot of its debt denominated in euros, which will become a foreign currency.
What does external debt have to do with the extent of the devaluation? Quite a lot, it turns out. Mexico and Korea (and a host of others examples) remind us that when a country is forced to devalue, the amount of the devaluation is not necessarily in line with estimates of the amount of overvaluation.
I would argue that Spain probably suffers from 15-20% overvaluation, but once Spain returns to the peseta the peseta will not devalue by that amount. It will devalue by at least 50%, and probably a lot more. Why? Because of the self-reinforcing relationship between the currency and external debt.
It always works the same way when a country with a lot of external debt devalues its currency. As the peseta devalues, Spain’s external debt will rise in tandem since it is denominated in the appreciating currency. Since Spain is already believed to be overly indebted, as the debt rises relative to domestic assets, Spanish credibility will decline quickly and financial distress costs will rise.
But of course as credibility declines and defaults rise, the peseta will drop even more as investors flee the currency and as domestic borrowers with euro-denominated debt try to hedge the currency risk. This will go on in a self-reinforcing way until the currency has been crushed. In the end, for Spain to leave the euro would probably cause its external debt to more than double – perhaps even triple – as the peseta falls. Of course it will be forced into default within days or weeks.
This, by the way, is not an argument for Spain to stay in the euro. If Spain stays in the euro we will still arrive at default, but much more slowly, and mainly at first through a grinding away of wages and economic growth over many, many years and a gradual building up of debt as Germany refinances Spanish debt at interest rates that exceed GDP growth rates. The default will occur anyway, but only after years of high unemployment.
This is why I think Henkel’s proposal makes sense. Rather than have Spain leave the euro, Germany can leave the euro. The new German currency would automatically appreciate and the euro would depreciate, but without the terrible debt dynamics, the adjustment in the currency value would be much closer to the theoretically correct adjustment. The relative adjustment would probably be in the 20% range rather than in the 50% range.
Of course German banks would still have a problem. Their deposits would be in the form of the new German currency, and a lot of their loans – all those to Spain, for example – would be in the depreciating euro, and so they would take large losses. But at least the losses will be less – and more importantly the process will be more orderly – than if Spain simply leaves the euro and defaults.
One way or the other Germany is going to take a pretty big hit. It is a complete waste of time trying to figure out how to avoid it. It would be far more constructive to resolve the problem as quickly as possible in as orderly a manner as possible, and as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics. That’s why I think Henkel’s proposal is an interesting one.
Of course the really interesting thing about Henkel’s proposal (at least to me) is to figure out what decision France would make if something like this happened. If France remained within the euro (i.e. “peripheral” Europe in Henkel’s scenario), the possibility of a United States of Europe would be forever dashed, but it would almost certainly be replaced with a two-entity Europe – the United States of Germany and the United States of France, or perhaps, for those who like 19th Century monetary history, the new Zollverein and the new Latin Union.