More Thoughts on End Game Scenarios

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The euro zone finance ministers meet today and tomorrow. Approval of the next tranche of aid to Greece and an agreement on EFSF leveraging is sought. Yet the real deal is still a week away and that is the EU summit.

A year ago, we handicapped the likely end games to the European debt crisis. We attributed a 3% chance of a country leaving the union. Although there has been heightened talk of a country leaving and different systems have contingency plans or stress tests to ensure the ability to cope in such an event, no country has left and the knock-on effects of a country leaving, possibly sinking the entire project, do not appear to have been thoroughly thought through by the advocates.

We attributed even a lesser chance to closure through substantially faster growth (2%). A year ago we did not expect the ECB to hike at all, let alone twice this year, but reinforces the poor growth outlook. Growth recognizes the price of austerity.



Source: Bloomberg

We attributed a 7% chance of internal devaluation/deflation. Here is what the selected inflation performance looks like:

We attributed 79% chance to debt restructuring, arguing if sovereigns cannot devalue, grow, inflate or be forgiven, restructuring seemed almost unavoidable. The proposals for Greece seem to combine some debt forgiveness with debt restructuring. The jury is still out whether other countries will have to restructure. We suspect so.

It is also not clear at this late date how much the private sector debt forgiveness will amount to in Greece. We argued the initial 21% was too small. We argued the 50% was also on the low side and now it seems like on a net-present-value basis, it will be near 70%.

A year ago we attributed a 9% chance to a fiscal union. That seemed reasonable for most of the year. However, as the crisis has intensified and pressure has mounted, especially on France, the risk of a fiscal union have increased substantially.

In effect, if Germany is being asked not just to share the uber-mark with Europe and the anti-inflation (and low interest rates) with Europe, but now shares its balance sheet and credit, then there needs to be greater centralization and coordination of fiscal policy.

We have argued that the monetary union was an economic solution to a fundamental political problem: under what conditions could Germany be reunited. Now what is needed is a political solution to an economic problem (debt crisis and lack of competitiveness).

There are three essential components of fiscal union. There must be some before the fact (ex ante) function that could include some prior approval of budgets, especially if the deficit is projected to be in excess of 3% of GDP. There must be some surveillance of implementation and finally there must the capability of imposing after the fact (ex post) sanctions.

Just as it took fall of the Berlin Wall and the ERM crisis of the early 1990s to prod European countries (not all of course) to cede monetary sovereignty, it has taken the intensification of this existential crisis to get the same countries to consider ceding fiscal independence.