Clearly, there are two parts to the Europe question.
1. Will the euro survive?
2. If it does, what happens to Europe in the medium term?
The caveat in the second question is because it is difficult to predict what will happen to Europe if the euro does not survive. Predictions range up to as much as 25% loss of output across Europe.
To me, the first question seems moot, especially in light of the rather widely known fallout of euro’s failure and the fact that the near-term survival of the euro is actually pretty much on tap for policymakers in Berlin, Paris and Frankfurt (where ECB is based out of). I believe that contrary to popular belief and most scenarios of doomsday, euro as a currency is far from failure. Sure, it is under threat and is besieged from many sides. However, for the euro to fail, Germany and France will have to lose market access, or the cost of saving the euro in terms of bailouts has to go way beyond their current and future bond market-funded balance sheets. Either of these is a remote scenario.
What is Germany up to really? Angela Merkel has been painted black and grey and white in the last few weeks by analysts around the world. However, what the Germans are really trying to get out of the rest of the Euro-zone is actually a commitment to lead fiscal lives similar to its own. This, in turn, is based on a more productive workforce, longer hours, higher retirement age, less state dole outs, and so on. In the bargain the peripheral countries get to enjoy being part of the Euro-zone –certainly a privilege in times of crisis. Italy would have lost market access long back had it not been for its currency, i.e., the euro. Of course, one can argue that were it not for the euro, the country would not have been lent as much as it had been.
This is precisely the sort of thing the Germans would want to avoid in the future. They appear to have correctly concluded that bond market investors are not as well informed and choosy as they are made out to be. They will lend to seemingly sound but actually bad credit in much the same way that American banks lent to sub-prime individual borrowers. Greece was a major case in point for this. Post-facto, it seems ridiculous that anyone lent to Greece—euro-dominated bonds or otherwise! Presumably, everyone was counting on the rescue or explicit underwriting by Germany and France. However, that was neither really there nor did it occur when the time came.
Having seen the inability of bond investors to rein in fiscally imprudent countries, Germany has correctly understood that the future of the euro depends on a “no-bailout covenant”. Hence, if there is supply of money during lax times (from over-enthusiastic investors), Germany wants the demand curbed at the source through fiscal deficit limits and gross public debt limits. Prudent, if you ask me!
Why do I believe that the euro does not have much of a survival threat? For one, rescue is one round of QE away, much as the Americans have been shouting from the rooftops at the Euro-zone leaders for a while now. Eurobonds have been talked about enough by now for even an implicit acceptance of the same by Germany to send bond market investors into risk-on mode! Lastly, the leaders of the rest of the peripheral countries appear to be complying with the demands of fiscal prudence, which most realize are in their own interest even if the euro does not survive. Germany and Euro-saving are good external factors to blame to overcome any internal resistance in most of these countries. Push is unlikely to come to shove and, even if it does, a combination of ECB, IMF, EFSF and maybe even the Fed will figure out a good way forward.
It is in Germany’s interest to keep things muddling through rather than conclude these quite positively in a sudden stroke of brilliance. The most that sort of heroism will achieve is massive risk-on trades around the world, positive sentiment all around, and in effect loss of another chance for well-managed economies of the Euro-zone to establish some discipline among the rest. Since it appears more or less a case of coordinated brinkmanship, the only danger is that of an unforeseen financial accident. In the absence of that, Euro-zone worries will eventually go but probably drag on for another couple of quarters as the economies sort out the fine print of greater fiscal union and iron out inevitable differences.
Disaster, hence, is unlikely. That does not mean that the proverbial “aaaal” is well though! The Euro-zone crisis can be attributed to fiscal profligacy of the peripheral economies and the loss of confidence among bond investors for the debt issued by these countries. The confidence may gradually return, encouraging investors to take some cautious bets. However, the fundamental productivity challenges of the Euro-area economies will not go away. If anything, battling the crisis has only diverted the attention of policymakers from it.
That said, the unfavorable and worsening-by-the-year demographics of most European nations are not helping to boost productivity at all. The Spanish unemployment may come down and the Irish banking sector may after all be restored to some degree of health and the clouds over most of Europe’s banks may go away. However, the painful process of adjusting to a new economic environment, where money is neither cheap nor abundant, governments are not the welfare states they used to be, and where everyone is required to work longer and more productively will take its toll on growth. Europe may lose its own decade a la Japan. That is a fat bigger disaster—however slowly it bites!
Swapnil Pawar
CIO-Karvy Private Wealth
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