Can the EU survive?

Just for once, this is not a question best left to the Poli Sci. Because the main forces will be money/macro.

For nearly two years now, I've been worried that one or more of the Eurozone countries might do an Argentina. I've been asking whether the Eurozone could survive. I think it's time to change the question. Can the EU survive?

I don't know the answer. But I think there's a serious risk that it won't. And I think the EU would have a better chance of surviving if the Eurozone were killed off quickly.

The whole purpose of the EU was to stop the European countries fighting one another. That's certainly a laudable purpose. But good fences make good neighbours. And a big argument over which neighbour owes how much to which other neighbours is not conducive to a peaceful neighbourhood. And there's going to be a very big argument if and when some Eurozone countries and their banks cannot pay their debts to other Eurozone countries and their banks. Not to mention their debts to the ECB.

Relations between the UK and Iceland got rather sticky when Iceland and its banks defaulted. This will be much worse: because there's much more money at stake; because there are more players involved; and because everybody owes everybody money, so if A can't pay B then B can't pay C, and so on. So it's much more complicated, and everybody will be justified in blaming everybody else.

It's not just an argument about debts and defaults. It's an argument about who is responsible for unemployment, austerity, and recession. Each country will blame other countries for its economic troubles. It's already started of course, but the argument can get much worse than what we have seen already.

It doesn't really matter if the UK and Iceland get mad at each other, because they don't have much to do with each other anyway. But the EU countries are all part of the common European project.

If a firm defaults, you can: arrange a takeover; close it down and sell off its assets; write down its debt; or convert its debt into equity. If a country defaults the first and second options are unlikely. Most commenters are talking about debt write-downs.

A debt write-down raises a number of questions. How big a write-down? Would it be the same for Greece as for Ireland? Should private debts all be written down by the same amount, and by the same amount as sovereign debt? Who decides? How long will it take to decide? How many other countries and banks go bust while they are trying to decide? It would be a very nasty argument.

A better option would be to convert the country's debt into equity. That is essentially what happens when Ireland (say) re-issues the Punt, and converts its Euro debt into Punt debt.

(For "Ireland" read "Greece, Portugal, Spain, Italy, whoever" throughout.)

Sure, the law says it has to pay Euro debt in Euros, not in Punts. But the law also says the debt must be paid in full. And if we are talking about write-downs, we have already admitted that the law will be broken.

The debt to equity (Euro to Punt) conversion is simpler, because it provides a natural focal point for agreement. What is the natural focal point for agreement on a write-down, 10%, 20%, 33.3%? All Irish debts, both sovereign and private, would be converted from Euro into Punt debts.

The debt to equity (Euro to Punt) conversion also gives Ireland a better chance of recovery. Because Ireland will once again have control over monetary policy. No country in a disinflationary recession and control over its own monetary policy would allow interest rates of 9% on its sovereign debt. And the better is Irish recovery the greater the returns to its bondholders. The punt will of course devalue, so the debt will not be paid in full. But it won't be paid in full anyhow, with a write-down. If re-establishing control over monetary policy promotes economic recovery and increases debtors' ability to pay, the creditors will probably get more real value in devalued Punts than in written-down Euros.

The best hope for the survival of the EU is the non-survival of the Eurozone.

Comments

[Bob Smith]

"If a firm defaults, you can: arrange a takeover; close it down and sell off its assets; write down its debt; or convert its debt into equity. If a country defaults the first and second options are unlikely."

Well, the Germans have tried to do hostile takeovers of their neighbours before. Twice. A third time would probably go over better if they hadn't downsized the populations of their neighbours the last time they tried.

[Just visiting from Macleans]

This may seem like an easy question to answer to most. But, since Ireland's great economic success has been attributed to attracting foreign investment through its low CIT rates, how would investment be affected by the reintroduction of the punt, and the related exchange rate risk? Would one expect capital flight?

[finance]

The ECB, the European Parliament, the German government and the German population all have different objectives. Those who run the EU institutions have worked their entire life on the Single Europe dream, and few, who saw the success of their enterprise only a few years ago, can stomach what is happening now. The European parliament is driven by the same "federalist" idea: "there is still too much nationalism, what we need is more centralized decision making".

The German government has been brought to the table kicking and screaming, Angela Merkel and here government have resisted the entire way, either in speeches, even yesterday when the president of the ECB said that they would double the size of the emergency fund, the German Minister of Finance, said: "no way will we increase the fund", they could not even coordinate such a simple message!

Finally, the German people are realizing that not only did they not benefit from the Euro, the party largely bypassed the average German citizen -- house prices in German are largely unchanged for the past decade, but they also figured out that it is they who will pay the bill.

Finally, it has dawned on Europe's population that its the banks, and their shareholders that are being protected here. How quickly we forget the European bank test which deemed all Irish banks sound... was in fact one big lie.

No the Euro is doomed (at least for Ireland, Portugal, Spain and Greece), but the continued stupidity of the EU institutions may even result on the failure of the whole enterprise. By June/September 2011 the whole thing will be over

[Kosta]

Re-denominating the debt into local currency (be it Punts, Drachmas, or so forth) certainly has an appeal. One of the downsides, however, is that the ultimate write-down from such a move is not known from the onset. I imagine that some parties would prefer a straight up write-down, with 'certitude' that x% of the debt will be repaid, to a situation where the repayment rate depends on how quickly the debtor's new currency devalues.

The re-denominating the debt into local currencies is a "plastic" solution, compared to the more transparent (and fragile) "glass" solutions presently being proposed.

[Andrew F]

"Finally, the German people are realizing that not only did they not benefit from the Euro, the party largely bypassed the average German citizen -- house prices in German are largely unchanged for the past decade, but they also figured out that it is they who will pay the bill."

Shouldn't that have been predictable? Isn't this what happens when you run large current account surpluses, paying for someone else's party?

Which is also to say, isn't China in for a similar rude surprise when their de facto shared currency with America falls apart?

[Patrick]

The morality play story works both ways. If those Germans where so virtuous and clever, then why did they keep supplying the booze when the party was clearly out of control? If we're capitalists, don't lenders who make bad decisions loose their money?

Ireland in particular, and to some degree Spain where actually playing by the rules. They did everything the serious people told them to. In Ireland, gov't finances only went really pear shaped when the bankers put a gun to the Irish economy's head and said "bail us out or we pull the trigger".

[Phil Koop]

You have cause and effect reversed - the money / macro problems are consequences of underlying political problems, not the other way around.

"Economics is a different science in Germany than in the rest of the world. There is no space here to explain why that is, but we can observe the toxic implications of this in the current debate": http://www.eurointelligence.com//index.php?id=581&tx_ttnews[tt_news]=2967&tx_ttnews[backPid]=901&cHash=a5ba4bd647.

[Kosta]

Patrick: if we're going to do the morality play, how does one lay blame when the politicians get in bed with the developers and bankers? I believe that sums up Ireland's situation, with their present situation resulting from poor choices of elected leaders. If we're going to play the morality game, doesn't this blame then devolve to the electorate?

If we're going to do the morality play, I think Spain's the country which most played by the rules, including proactive bank capital requirement increases at the top the bubble, and as far as I know, more limited corruption/political interference in the housing and banking sectors.

[Patrick]

Kosta: So the entirety of the population of Ireland for generations to come is supposed to suffer because some politicians - for whom not all Irish voters voted - are some combination of short sighted, stupid, and corrupt. Uh huh.

[Richard H. Serlin]

"And there's going to be a very big argument if and when some Eurozone countries and their banks cannot pay their debts to other Eurozone countries and their banks. Not to mention their debts to the ECB."

Another reason to support default or reorganization.

[Guillaume]

I mostly agree with this: "The best hope for the survival of the EU is the non-survival of the Eurozone." The only thing I would add is that it is mostly a function of how messy the Eurozone breakup is. If it's a disorderly mess with electronic bank runs, countries defaulting and exiting at different times, I wouldn't give the EU a big chance to survive. If it's more like "Dagen H" (look it up), I'd say there's a very strong chance it will survive and maybe even thrive.

I must say that I like how my guest post from May is holding up now.

[Nick Rowe]

http://en.wikipedia.org/wiki/Dagen_H

Dagen H (the day Sweden switched to driving on the right) was very well publicised in advance. I don't think that could happen here. It would be very hard to coordinate. The banks would need to be closed for some days, then re-open under the new rules. I wonder if Ireland still has the old punts locked in a basement somewhere? Probably not. It won't be clean; it will be very messy. But default and haircuts would be even messier.

Phil: "You have cause and effect reversed - the money / macro problems are consequences of underlying political problems, not the other way around."

It's both. In one of my old posts, I argued that the money/macro problems are indeed a consequence of the fact that the Eurozone is not a nation. There is no central fiscal authority. So I agree with you. But now it's time to look at the reverse question: the feedback from the money/macro problems on the political structure.

[Kosta]

Patrick: Isn't that how modern democracy is supposed to work, that is the elected leaders make decisions and the country lives with results? I don't want to hijack this thread with another morality play argument, so let's just admit that democracies often elect new gov'ts which quickly disavow previous policy.

Oh, and there's plenty of blame to go around in Europe. Here's a blog that claims that German bankers contributed to the bankruptcy of Ireland by completing deals in Ireland which weren't permitted in Germany (regulatory arbitrage). Of course Irish law makers contributed by allowing this regulatory arbitrage to take place http://golemxiv-credo.blogspot.com/2010/11/who-bankrupted-ireland.html

[OGT]

Good summary. There is obviously a tremendous resistance to a break up in European elite circles, perhaps analogous to France's 'Gold Bloc' in the 1930's.

Here's link to Michael Pettis's take on the Euro, which is mostly along the lines you outline, though he seems to think a break up of the Euro would be bad for the European Union, primarily I take it because of the inevitable mess and recriminations:

http://mpettis.com/2010/11/chinese-inflation-and-european-defaults/

[Mark_dowling]

Iceland are EEA members, so the relationship is a bit different to if the UK was having a beef with a non-EEA country, say Tunisia.

[Guillaume]

I'm extremely worried about how the media is reacting in Europe. The French-language press is in denial about the possibility of a Eurozone breakup (I just read les Échos, France's business paper). It's easy to be caught up in the noise of the Financial Times and Paul Krugman, but the fact is that the discourse is very different in other languages. Most Europeans voices seem to believe that it will all work out (not that they're happy about the way it's done...) and perhaps that this crisis will lead to greater European integration.

Irish newspapers have moved to anger, not quite bargaining yet. My Greek is not good enough to figure out where they are now, but my guess is that it's probably still bargaining. Depression and acceptance are still ahead...

I'm not sure our media are covering the crisis very well either. I'm hearing lots of comments about how the problem is "centered on Europe", that there is little risk of contagion because "we don't export very much too Europe" etc. We have an awfully short memory about the severity and virality of financial crises. FT Alphaville had two interesting posts this week about the interconnectedness of European markets (http://goo.gl/3C0bB and http://goo.gl/HXFZy). Spanish banks (mostly BBVA and Santander) are extremely important in Latin America; it remains to be seen how they would respond to a shock at home. At this point I don't see how we could avoid a crisis smaller than the Asian financial crisis. And I agree Nick, it will most likely be very messy.

[JP Koning]

"That is essentially what happens when Ireland (say) re-issues the Punt."

Right, with a click of its fingers, *presto*, new currency. Not that easy. A country that's about to default on its debts can't magically conjure up a new currency. If no one trusts its debt, who's going to trust its other paper? Because trustworthy euros already circulate in Ireland, most attempts by Irish authorities to re-issue funny Punts will probably meet very limited success. An Ireland that takes the punt/default route may end up like many South American countries, somewhere between partial and full dollarization (or in the Irish case, euroization). So forget about monetary control, Ireland is already a satellite around planet Euro. This lack of control wouldn't necessarily be bad, central banks are mischevious beasts; dollarization/euroization help castrate them.

[Sina Motamedi]

Yup, I'm with you on this one Nick. Fiscal and monetary power need to share the same zone.

[mark]

"And there's going to be a very big argument if and when some Eurozone countries and their banks cannot pay their debts to other Eurozone countries and their banks. Not to mention their debts to the ECB."

I will try on the contrarian pov for fun. Isn't this the exact reason it will/could/should (see how committed I am to the argument!)? Now no doubt they are really in the muck of it now and, like you say, default dominoes won't make for happy neighbours. But it would make for unhappy neighbours whether they were bound via the EU or not. And, while they clearly did not have their act together in time for the GFC, shouldn't the Euro Zone be more attractive as it is a means to establish greater regulation and consistency (whether through formal regulation or moral suasion) that limits the likelihood of things default dominoes in the future?

[TGGP]

Does anyone actually think there would have been another war if not for the European Union? Seems to me that a heavy American troop presence balancing the Soviets sucked up most of the oxygen for decades, by the end of which Sailer's "dirt theory of war" was going strong:
http://isteve.blogspot.com/2006/08/woody-hays-chair-of-national-security.html

[tjfxh]

NIck: There is no central fiscal authority.

That's the crux of it. They rushed into an ill-advised currency union without due regard for regional asymmetry, or the shock of a financial crisis. In addition, the Maastricht Treaty set unrealistic standards. They are now boxed in and either have to move forward to address the shortcomings or else back out as gracefully as they can before social unrest becomes intolerable as austerity bites. The longer this festers, the more it going to become every man for himself and that does not bode well for political union, which monetary union was supposed to underlie and support, but is now undermining. No muddling through this one.

See Bill Mitchell, "Doomed from the start," for the gory details of misconstruction.
http://bilbo.economicoutlook.net/blog/?p=7909

[George J. Georganas]

The whole difference seems to be that people in Germany are prepared to reduce their aspirations to material well-being themselves, while people in Ireland prefer to have their aspirations cut via devaluation. Is that reason enough to break up the EU ? It makes precious little difference to the people concerned.

[Luis H Arroyo]

A very good post, with which agree. I don´t see ow the Euro could survive. The net account of its short live is too sad. now the problem is how to exit much or less ordely -if we can.
AS Chulchill once said, "Never was So Much harm Owed to So Many Idiots Who Received So much power"...

[wjd123]

When will we learn that financial services have to be closely regulated. Make them take a very sever hair cut and save the majority of people in the Eorozone from substantial pain. It is the banks which have caused the damage, and it is the banks which should suffer the pain. For example, Goldman Sacks helping the Greek government to hide it's loans as swaps.

The Eurozone is an elected body. If it wants to last it will do what is politicaly expedient and what is right.

[Determinant]

Would we have considered breaking up Canada in 1890 if Ontario or Nova Scotia had defaulted on their provincial debts? The same sort of cross-subsidization applies, and the British North American colonies had no fiscal relations with each other until 1867. In fact the BNA Act transferred most of the debt of the Province of Canada, New Brunswick and Nova Scotia to the new Government of Canada. We all paid for each other's actions through a common tax framework, right from the beginning.

Europe's problem is that they tried currency federalism without political and fiscal federalism. The European Parliament can't set an independent income tax and issue bonds in its own name. If the Euro is to survive, that's what needs to happen.

In our own federations we do this kind of cross-subsidization and bailout without so much hassle. We call it being a country.