Investors betting against the euro-area surviving its debt crisis in one piece may be overlooking one thing: the will of politicians to hold it together.
German Chancellor Angela Merkel is intensifying her defense of the currency. French President Nicolas Sarkozy says there’s no alternative to channeling aid to Greece without risking the kind of cataclysm set off by the 2008 collapse of Lehman Brothers Holdings Inc. Greek Premier George Papandreou this week proposed 6.6 billion euros ($8.7 billion) of fresh austerity measures in a recession headed into a fourth year.
The euro is “a political project,” said Erik Nielsen, global chief economist at UniCredit Group in London. “The market may not have believed them, but leaders have repeatedly said they will do whatever it takes to keep it together.”
Keeping the 17-nation region together means politics will have to remain the glue, challenging the argument of investors including Pacific Investment Management Co. Chief Executive Officer Mohamed El-Erian. He says the euro area may need to shrink to survive. That concern is highlighted by the swelling gap between the 10-year interest rates of Germany and Italy.
In a sign investors are questioning the longevity of the euro, the spread between German and Italian benchmark bonds reached almost 400 basis points, having held below 50 basis points for most of the last decade. Four in 10 respondents to the quarterly Bloomberg Global Poll said last month they expect a nation to leave the euro within a year and a further 32 percent said a member would exit in two to five years.
“Many global investors see Greece as a precedent for big Italy,” said Holger Schmieding, chief economist at Joh. Berenberg Gossler & Co. in London. “The test of whether European defenses are strong enough to prevent contagion from Greece to Italy could be made soon.”
It may come in the weeks before a Nov. 3-4 summit of Group of 20 leaders in Cannes, France, which international finance chiefs see as the deadline for European governments to devise fixes for turmoil.
That meeting “is likely to be a major point of inflection, which will either resurrect life or leave us in deep hibernation through the winter,” said Jim O’Neill, chairman of Goldman Sachs Asset Management in London.
Economists at Goldman Sachs Group Inc. yesterday revised their outlook to show the euro-area economy will expand 0.1 percent next year rather than the 1.3 percent previously anticipated with Germany and France suffering mild recessions.
‘Too Much to Lose’
Some investors still bet on euro-area leaders avoiding the worst case scenario. Kathleen Gaffney, co-manager of the $19.4 billion Loomis Sayles Bond Fund, says she continues to hold Greek debt and is buying sovereign securities from other European countries.
The European Union has “too much to lose” if Greece were to exit the euro, Gaffney said in a Sept. 28 interview with Lisa Murphy on Bloomberg Television’s “Fast Forward.”
The euro is also trading above its average since it was born almost 12 years ago, another sign that investors see little chance of a collapse as officials take on the crisis.
“Too much political and ideological capital has been invested into making the euro project work and bringing the continent of Europe closer together since the end of World War II to allow it to unravel now,” Thanos Papasavvas, the head of currency management in London at Investec Asset Management Ltd., which invests about $95 billion, said in a Sept. 20 interview.
Having once held out on aiding Greece, demanded investors play a greater role in bailouts and flatly rejected initiatives such as joint euro-area bonds, Merkel is changing gears to stress governments must hold the euro area together.
Deeper integration “is the only way forward for Europe,” she said Sept 9. On Aug. 21 she even agreed that sharing debt in the form of joint bonds might be possible in the “distant future.”
Sarkozy and Merkel will meet Oct. 9 to discuss speeding the euro area’s economic integration. Among the options: enacting a permanent rescue fund next July, a year earlier than planned. That would provide a 500 billion-euro war chest and provisions for sharing costs with bondholders for countries with “unsustainable” debt. Governments may also unpick a second Greek rescue agreed in July to increase the financial industry’s contribution and create a safety net for banks.
There’s “no credible alternative” to aiding Greece, Sarkozy said Sept. 30. “The failure of Greece would be the failure of all of Europe.”
Greece itself is trying to counter criticism over its failure to satisfy the terms of an international bailout. Papandreou pushed new cuts through his Cabinet this week and his finance minister, Evangelos Venizelos, rejected making his country a scapegoat for Europe’s policy failures.
Other governments are also taking steps to fortify their finances. France, Italy and Spain have entered German-style budget deficit limits into their constitutions. Italy last month introduced a 54 billion-euro package of austerity measures that included cuts in central and regional spending and a higher sales tax.
Politicians are likely realizing failure to keep the euro area together risks “threatening another Great Depression,” HSBC Holdings Plc economists Stephen King and Janet Henry said in a Sept. 30 report. They see the evolution of a “fiscal club” in which troubled countries get aid from neighbors, yet are required to temporarily sacrifice their fiscal sovereignty.
‘Costs of Failure’
“Ultimately the costs involved in fixing the euro’s manifest weaknesses are far lower than the costs of failure,” said King and Henry.
Politics as much as economics have lain at the heart of the euro project, born in part by the desire to avoid another war by bonding nations together. It is the offspring of an integration which began in 1951 with the establishment of the European Coal and Steel Community.
Former German Chancellor Helmut Kohl told Bild newspaper in 2010 that “there’s no alternative to Europe, especially in the question of war and peace.” It was Kohl who helped turn the euro from an economic tool into a political one as he pushed for the inclusion of “the greatest possible number of countries” rather than just those with the strongest economies.
Jacques Delors, a former president of the European Commission, once said “people forget too often about the political objective of European construction. The argument in favor of the single currency should be based on the desire to live together in peace.”
Still, as union grew from the six founders to 27 members today, it never had the political will to enforce its own economic rules and no plan for dealing with countries, like Greece, that threatened default. No nation was ever punished for violating deficit limits and in 2005, Germany and France led the push to water them down.
Some are questioning its ability to stick together. Nouriel Roubini, chairman of Roubini Global Economics LLC, said in an Oct. 2 interview in Dubai that Greece would be better off outside the euro and that in three to five years, there’s a “good probability that the euro zone is smaller than” now. El-Erian, who helps manage the world’s biggest bond fund at Newport Beach, California-based Pimco, says there is the potential for a “smaller, much better integrated, fiscally strong euro zone.”
El-Erian nevertheless sees hope that European policy makers “finally” understand the severity of their crisis. After four days of meetings in Washington, El-Erian said in Sept. 27 radio interview on Bloomberg Surveillance with Tom Keene and Ken Prewitt that “they recognize they have deep problems, and they recognize they need to do something about it.”