For Europe, Breaking Up Is a Hard Thing to Do

By: Vitaliy_Katsenelson

Everyone is looking with horror at Europe, waiting for the European Economic and Monetary Union to break up and for the PIIGS to start dropping like flies, taking the rest of the euro zone and the global economy with them. Unlikely!

European monetary union was a great experiment that made a lot of sense on paper. Europe, which had roughly the same size population and economy as the U.S., was at a competitive disadvantage, as dozens of currencies embedded extra transaction costs in cross-border trade and each currency separately had little chance to compete with the U.S. dollar for reserve currency status. Germany — the largest country in Europe and one of the world’s biggest exporters — was at a disadvantage too: The strong deutsche mark made its products more expensive and less competitive in the rest of Europe

There were also no-less-important noneconomic considerations. Germans were haunted by their past; they had started two world wars in the 20th century, and a united Europe was their way of lowering the chances of future European wars.

EMU sounded like a very logical marriage of all the significant powers of post–World War II Europe. But the arrangement was never really a marriage; it was more like a civil union. EMU members combined their currencies into one, the euro. They agreed to use the same central bank and thus implicitly guaranteed one another’s debts. They signed treaties that spelled out the rules of the union (the prenup), but unlike most prenups, in which the rules of divorce are spelled out, the EMU did not determine what would happen if a member fell upon financial hard times.

The grooms and brides never moved in together; their fiscal policies were never consolidated. Though treaties put limits on budget deficits (which, ironically, Germany was the first to break), each country went on spending its money as it wished. Some were relatively frugal (Germany); others (the PIIGS: Portugal, Ireland, Italy, Greece and Spain) went on spending binges like newly hitched college students who had just gotten their first credit card, with irresistibly low introductory rates and a free T-shirt.

Predictably, like many college students, the PIIGS went over their credit limit, but they had ceded control of their currency to the European Central Bank, so they could not arbitrarily increase their spending limits by printing more money. Governments that cannot afford to make their interest payments or roll over their debt and don’t have the key to the printing press are left with only one option: default.

EMU members were so eager to consummate the union that the issue of divorce was not addressed. To kick Greece out of the EMU, a new treaty has to be written and all the partner countries have to unanimously vote to approve it (which means Greece would have to vote for it too). For more on the economic and political costs of such a scenario, check out the terrific recent report by UBS Investment Research titled “Euro break-up — the consequences.”

It is very unlikely that Greece would leave the EMU of its own accord. All of its government and corporate obligations are in euros, and on the day it announced its departure from the European Union and a return to the drachma, its banking system would collapse. All depositors would run to their banks to withdraw their euro-denominated deposits. The drachma would trade at a steep discount to the euro, and while the government would be able to print drachmas at its leisure, the bulk of the corporate sector’s debts would be in steeply appreciated euros and its income in collapsed drachmas. The failure of the corporate sector would follow that of the banks.

Logically — though logic is a very significant assumption in this discussion, considering that politics is often emotional and illogical — Greece will not get out of the EMU on its own, and unless treaties are broken, which would set an enormous negative precedent for the rest of the EMU, Greece will not be kicked out of the union.

This brings us to a very probable solution: a full or partial bailout of Greece by the “strong” EMU countries (that is, Germany and France). It is in their best interest. Greece is a sovereign EMU nation, so German and French banks have not had to put up significant reserves (if any) against Greek debt, though they have more than $100 billion exposure to it. A disorderly (Lehman-like) collapse of Greece would send a profound shock through the European banking system, and instead of bailing out Greece, the German and French banks would need a bailout themselves. At the end of the day, someone will get bailed out. By bailing out Greece, Germany and France are indirectly bailing out their own banks, but with an added bonus: a preserved union.

A logical question comes to mind: Facing all these costs, not to mention a popular distaste for financing the exuberant, nontaxpaying Greek lifestyle, why wouldn’t Germany break treaties and get out of the EU itself? If Germany left the EMU, its economy would not be unscathed — the deutsche mark would likely skyrocket against an even-more-weakened euro. Germany’s exporters, which are vital to its economy, would lose competitiveness in European markets, and its economy would enter into a prolonged and very painful recession. The rest of the European economy would weaken, and Germany would have no one to sell its goods to. (This sounds a lot like the China-U.S. relationship.)

Yes, the pain the German economy would suffer would be a lot less than the pain that would be felt by Greece if it exited the EMU; however, schadenfreude would give the Germans little satisfaction. And although in today’s modern, civilized world, wars are not fought among developed Western countries, a broken Europe increases that probability.

Paraphrasing Rahm Emanuel, this is too good a crisis to waste, and over time it will bring the EMU closer and eventually push it toward the logical next step: marriage — a United Countries of Europe. Giving up one’s fiscal policy and sovereignty is very difficult, and national pride will require significant subjugation, but Europe will have little choice.

The Greek crisis will soon be yesterday’s news and forgotten, but in the meantime it provides the EMU with a wake-up call that the prosperity-only setup is not a sustainable long-term model. The EU needs a default bailout (TARP-like) mechanism to deal with adversity. The good news is that while Greece is by far the most dysfunctional economy in the EMU, it is the smallest of the troubled PIIGS.

Germany is paranoid about inflation. It suffered through one of the worst-ever inflations in the early years of the last century, but a centralized bailout mechanism big enough to deal with the PIIGS will likely leave the ECB no choice but to rev up the printing presses. Given the alternatives, Germany will have little choice but to accept that reality. Inflation (unless it is hyperinflation) will be a more democratic and more politically acceptable solution than Germany and France’s underwriting the PIIGS’ debt.

P.S. Watercolor "(Colorado) Governor's Mansion" is by my father Naum Katsenelson

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

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