Deep Dive: Is EMU Irreversible or Not?

A jacket or shirt may be reversible.  The optical illusion posted here is reversible.  A man is evident even when looked at "upside down".  Time is unidirectional, we are taught and some things simply cannot be reversed, like  a hard-boiled egg.

However, science has once again pulled the rug out beneath our feet.  Earlier this week, ABC reported that scientists have discovered a way to un-boil an egg white. Apparently boiling an egg folds the proteins, and scientists have learned to unfold them. They can reverse the boiling process within a few minutes. 

In the most basic sense the question facing investors is whether European monetary union is like a hard-boiled egg.  Can it be reversed? 

The simply answer is of course it can be reversed.  A building can be knocked down; political agreements torn up.  Currency unions have been dissolved in the past.  They can be dissolved again. 

The answer then hinges on will.  Are the members committed?  Will alone may be insufficient as some historians teach us about the start of WWI.  Is there the institutional capacity to implement the will?  

The euro-skeptics' arguments have been well-publicized and are well known.  Even if a monetary union is desirable, which is not often a conceded point, it cannot be without fiscal union.  Some argue that Europe put the cart before the horse--political union has to proceed monetary union.  They argue that countries are too economically diverse to make an optimal currency zone.  Owing to the linkage of fiscal and monetary policy, there were agreed limits on deficits and debt that have been respected primarily in the breech. 

Such arguments had been quieted over the last couple of years, following ECB Draghi's pledge to do whatever is necessary to preserve monetary union.  However, the belief lurked just below the surface and has arisen anew, spurred by Syriza's victory in Greece.  

The US experience is instructive up to a point.  First, political philosophers going back to Aristotle and Plato through the mid-18th century argued it was not possible to have a representative form of government over a large territory.  It had never been done successfully.  It was a great experiment.  The great experiment of our time is the European Economic and Monetary Union.  

Second, the US was not an optimal currency zone when it was founded.  Some would argue it still is not because of the economic diversity.  While the rest of the country will benefit from the decline in oil prices, Texas, North Dakota, and Alaska will not.  Federal fiscal transfers can make up for the heterogeneous economy.  And yet, the states with the lowest incomes are still in the part of the country that tried to leave 150 years ago.  

Plans for EMU grew out of the fall of the Berlin Wall.  The problem it was solving was not an economic problem, but a political one that has vexed several generations.  As Kissinger put it, "Germany is too big for Europe and too small for the world."   Under what conditions could Europe allow Germany to be re-united? The solution was to tie German irreversibly to Europe.  The economic answer to the political challenge was two-fold:  Germany had to share the uber-mark, the super-Deutsche mark.  It is the euro. Germany also had to share the Bundsesbank's anti-inflation credibility, which means low interest rates.  It is the ECB, headquartered in Frankfurt, not far from the Bundesbank.  

Initially, a narrow union was expected.  Belgium, Luxembourg, Denmark, Netherlands, Austria, German, and France.  This was going to be facilitated by exacting, even if arbitrary fiscal requirements.  There were two problems.  First, several countries, including Germany and France, needed to have liberal definitions of the criteria.  Once the door was widened, others could squeeze through too.  Second, French leaders understood that a united Germany would be more powerful than it.  To strengthen its ability to tie the giant down, the Lilliputians needed to increase in numbers.  A broad union would be a better check on Germany that a narrow union.  

What many of the euroskeptics do not appreciate, which led them to anticipate a Greek exit a couple of years ago, and to suggest exit is the solution to any peripheral problem, is the strength of the political commitment to maintain the union.  Our understanding of the political commitment allowed us to anticipate correctly not only that the union would remain intact, but that it would actually grow. With Lithuania joining at the start of the year, the expansion of EMU is over for a few years until maybe Poland and the Czech Republic join towards the end of the decade.  

The Financial Times chief economics commentator Martin Wolf had a clever way to find some common ground with the euroskeptics.  He called creating a monetary union the second worst idea. The second worst, huh?  "Creating the eurozone is the second worst idea its members are ever likely to have.  Breaking it up is the worst."

The euroskeptics perpetuate a myth.  The myth is the periphery like Greece has been bailed out.  It is not true.  Even in the recovery Greece has enjoyed, unemployment idles one in four adults and one of every two young people.  The economy has contracted by at least a quarter while the swing in the external account from a large deficit to a small surplus implies something closer to a 40% drop in spending. 

Greece has most certainly not been bailed out.  It owes more money today than it did in 2010.  Its debt is roughly 227 bln euros (~125% of GDP).  Given the private debt restructuring, the bulk of the Greek's debt is in the hands of the official sector, ECB, EU, IMF, bilateral loans from EMU members.   

The myth that is propagated is that German tax payers are footing the bill.  This is factually not true. The bulk of the money that was loaned to Greece came from the issuance of bonds that were guaranteed by EMU members.  Germany is by far the largest economy, and its share of guarantees is the greatest. 

Where does the money go that Greece borrows?  To living high is what the myth suggests.  In reality, about 10% was used to finance Greek government activities.  More than 15% has been used to make interest rate payments on the debt.    Greece's official creditors have been kept whole. Most of the goods and services Greece bought, running up a 15% current account deficit at its peak, was from the creditors.  It was mostly producer financed consumption. 

The European project was based on a balance of power between creditors, represented by Germany, and debtors represented by France.  France has continued to lose competitiveness to Germany over the past quarter of a century, as Mitterand, (who struck the deal with Kohl to establish EMU) understood.  Because of this, Germany and the creditors largely persevered in the sense that their interests have been protected.  The creditors' DNA prevailed in the institutional carving out of EMU, and reinforced by the IMF.  

However, as we have traced, the tide has turned.  If the contest between creditors and debtors was a fine balance, the flag had moved in the direction of the creditors but is now being pulled back.  This is why Germany and those articulating the creditors’ interests feel besieged.  

First, the IMF officially recognized that it did not fully appreciate the multiplier effect of austerity. Second, the new EC announced a more flexible understanding of the fiscal discipline.  Third, the preliminary decision by the European Court of Justice favored broad discretion be recognized for the ECB, seemingly ruling in favor of Outright Market Transactions, that the Bundesbank testified against.  Fourth, the ECB announced a sovereign bond buying program over the objections of the German representatives (and a few others).  Fifth, the reforms at the ECB given its increase in members, means that the Bundesbank will not vote at every policy making meeting.  

Sixth, Syriza's victory in Greece is a setback for creditor interests.  This is the first time an anti-austerity party has won a national election.  Former Prime Minister Samaras was opposed to many aspects of the austerity program before he was elected.  During his years in Greek politics, and helping to topple more than one government, he had made enemies and weakened the New Democracy Party. He refused to make room for a different and more unifying candidate.  He ran a poor campaign, primarily characterized by the demonization of Syriza.   

Just like US railroad failures were a large emerging market debt crisis of the 19th century, Germany defaulted several times in the 20th century.  Even though, German economists eschew Keynes, they understand the Economic Consequences of Peace better than most.  Yet, it has repeated those mistakes now, albeit on a smaller scale.   The bleeding of Greece has political limits, and they have been reached.  

There are numerous areas and ways a compromise can be worked out between Greece and its official creditors that preserve the nominal value of the debt, while reducing the debt burden.  Maturities can be lengthened.  The debt is kept on the official books at face value.  They do not have to mark-to-market.  Does it really make a difference if the Greek bond the ECB holds is for five years or ten years?  Surcharges on some of the loans can be cut.  Where does the self-righteousness come from to seek to punish the debtor?  Some consolidation and re-organization of the debt can be achieved to smooth out the maturity profile and payout schedule.  Some of the debts can be converted into equity of a new development bank, for example.  There can be an extended moratorium on the debt repayment to give the Greek economy more time to heal.  

One element of the common ground between the new Greek government and its official creditors relates to the national elite.  Syriza's campaign was not simply against Germany and the official creditors though that is the way it was often portrayed.  Syriza also fought against the local corruption and tax evasion.  The official creditors and investors may be surprised by the full Syriza agenda.  It will include reforms and a superior tax collection effort..   

The first test of the new government will take place next week, not at the end of February when the current extension runs out.  Next week, Greece needs to roll over about one billion euros in T-bills.  Previously foreign investors were eager buyers.  When this dried up, Greek banks were relied on to buy the bills.  However, there have been a dramatic outflow of deposits.  There are estimates that as mush as 11 bln euro have left after a four billion drop in December.   There is 1.4 bln in T-bills maturing the following week (February 13).  

There is another date to keep in mind.  February 15.  It is when Hamburg holds its election.  Within Germany, the SPD has been largely neutered by entering the coalition government with Merkel's CDU and Merkel's support for the minimum wage that went into effect on January 1.  Merkel's main rival is from the AfD, Germany's own anti-EU party.  Although the AfD did not do well enough to meet the threshold to enter the national parliament, it has done well in a couple of eastern states, though it played down its anti-EU stance and emphasized its conservative social agenda.  Hamburg will be the first western contest for it.  

Merkel is the ultimate strategist.   She will not go into history as the German that lost Europe at the start of the 21st century.  A compromise will be worked out because EMU is irreversible, unlike a hard-boiled egg.