By Data Diary:
Way back when the convergence trade was all the rage and the FX business was at the leading edge of the evolution of language, I wrote an essay contemplating the likely long term success of the Euro. It concluded that the weight of the experience was against the dream.
1) Economies move at different speeds and in different directions
Monetary unions fail more often than they succeed. Historical precedents suggest smaller scale arrangements have more staying power than the grand plan that generally can’t cater for the diverse interests of its member states
That is not to say that monetary unions can’t work for considerable periods of time. For example, the Latin monetary union (1865 to 1927 on the wide) struggled through the Papal States debasing their silver coins early in its term – the Vatican was tossed out – then, as a de-facto gold standard, held together reasonably well until the world went to war. Similarly, the Scandinavian Monetary Union was a gold standard fixed exchange rate that effectively bridged the same period.
It’s just that the trials and tribulations of economically distinct demographics tend to get it the way unless there is an overwhelming political cohesion to hold them together.
2) Political union is therefore necessary for monetary union
The major defining theme of successful monetary unions is that they are based on political solidarity. Consider the reunification of Germany with its vast wealth transfers from the west to the east – could this have been achieved without a single political will? The splintering of the USSR stands in stark contrast to the experience of the US. Even the Benelux union owes its primacy to the perceived benefits of scale that subsuming national interests into a fixed arrangement offer.
A monetary union needs an effective political structure to implement the ’singular’ vision. Institutions like the European Parliament are incapable of providing that simplicity. The somnambulistic circles of the Greece bailout have succinctly demonstrated this. Just as the Roman Empire ultimately crumbled under its own complexity, arrangements such as the Euro that are reliant on a myriad of rules falter when these rules are stretched beyond the practical.
A uniform political will is most necessary when the system is under stress. In the best of times, no one minds the risque behaviour of a few nude swimmers. When times are worse, populist politics matters and this type of politics panders to the local over the global.
3) The tipping point is reached when national interests dominate over commonwealth ones
So what happens when a member of a monetary union falls out of alignment with the group?
The main cost to a member state of belonging to a monetary union is the loss of nominal exchange rate flexibility – to state the bleeding obvious. This means that the only way to address external imbalances is by internal adjustment. As Latvia has demonstrated the cost to the ‘local’ population can be steep.
When trade imbalances become manifest as unsustainable debt loads then the end game for that arrangement is at hand. ’Internal devaluation’ presupposes that the debtor nation can flip into a trade surplus situation to repay its debts. Alternatively, and even less palatably, the population of the debtor nation can sell off all its land and chattels to repay the debts. Or the debtor nation can repudiate its debts.
This is an environment where the political imperative is more likely to be driven by the ‘local’ population. In need we can change the ruling elite so that they can repudiate the debts of the prior corrupt mob. This is the single simplest way to remove the debt overhang. It presupposes that the country is striking out on its own.
What then does a country like Greece stand to lose from departing the euro? When you get to the end of the rope, if it is more politically expedient to default, the country will. IMF and European Community be damned. Latvia might have taken the ‘internal devaluation’ route – and saved the Swedish banking system a mighty migraine – but the more countries that are pushed down this path, while the US takes a placebo of its own choosing, the less probable that this solution can be sustained.
It’s the opposite dynamic in the ‘benefactor’ states. As creditors, they must agree to debt restructures that have the propensity to transfer wealth to the profligate debtor nation. The alternative is that the debtor defaults. The tipping point for them comes when the perceived transfer payments outweigh the benefits – better to write-off the debt today than continue to build an even bigger problem.
(This is not to say that the tipping point has been reached today – the creditors still believe they can get their money back and will bend over in attempt to forestall a default. The purpose here to talk through the logic – with the aim of arguing against the viability of the Euro as a long term proposition.)
What’s interesting is that the market has grown somewhat accustomed to the Grecian drama – curve spreads for Portugal and Ireland remained stable while Greece’s blew out again last week (from Markit).
Greece CDS spreads have pushed back through 400 bps – that’s well into junk land. Yet the market doesn’t think this is a systemic problem. I’d beg to differ – it’s just a matter of time before some of the other debt-bearing sovereign states limp into the ward and the burden on the stronger balance sheets starts to show its effects. Over the next few years, we can expect shifts in the political currents, perhaps radical changes in leadership in some countries. The unravelling of the Euro dream may be resisted – but it’s the path of least resistance in a over-engineered and unstable environment.