Ezrati’s Economic Outlook: More Muddle in Europe

As the Europeans meet and speak and summit, it becomes ever clearer just how intense and complex matters have become. Later in June, Greece will determine whether it will stay in the eurozone or perhaps even exit the European Union. In or out, Europe and Greece will have to cope with the aftermath of the decision. Even as Greek questions remain open, a broader drama has grown around recent proposals for the union to issue eurozone bonds that would draw on the generalized credit of all members in common. Though Berlin will likely block such efforts, the negotiations could put Germany in such an uncomfortable position that it will offer other forms of compromise, perhaps by softening its position on austerity or by contributing more generously to the European Stability Mechanism.

The Greeks will effectively decide on membership in a June 17 vote and then, no doubt, in subsequent parliamentary maneuvering. On the chance that the nation does decide to leave, European officials are already working on arrangements that will permit Greece to step out of the common currency but remain in the EU. The decision will almost surely be a Greek one. The rest of Europe does not want to throw Greece out, however troublesome it has become. They know that Athens, whether outside the eurozone or in it, will still owe the money in euros and still have trouble paying. But with Greece outside the union, the Germans and others would lose control. Since they cannot avoid dealing with a failing borrower, they surely would prefer a situation in which they have some control.

If Greece decides to stay and get aid from Europe's Stability Mechanism, it will, of course, have to abide by austerity measures. If Greece leaves, it will almost certainly repudiate the debt. Frightening as this second alternative seems on the surface, it may prove to be a non-event for Europe, if not for Greece. After all, the privately held Greek debt has already seen writedowns amounting to 70% of its face value. A loss of the remaining 30% would hardly break the European banking system, especially since Greek debt outstanding, even before the writedowns, amounted to less than 1% of all European bank assets. The remaining debt, held mostly by the European Central Bank (ECB) and the International Monetary Fund (IMF), would likely be renegotiated or, if repudiated, readily replaced by the ECB through its money-creation mechanism and by the IMF by drawing on its members, including the United States. The real risk of Greek withdrawal is that it might engender a run on Spanish and Italian paper. This kind of contagion could be very damaging, though chances are the European Central Bank (ECB) would disarm the worst effects with additional liquidity flows, including direct purchases of Spanish and Italian bonds, as it did last year.

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While the Greeks make up their collective mind, the rest of Europe recently has divided over the question of common eurozone bonds. France, under its new president, Francois Hollande, has pressed the issue, with support from Italian Prime Minister Mario Monti and others, including even World Bank chief, Robert Zoellick. Germany, still led by Chancellor Angela Merkel, has steadfastly opposed. Those in favor of the proposal claim that such bonds are the only way for the eurozone to raise sufficient funds to support its weaker members, which can no longer afford to borrow for themselves at reasonable rates. They argue further that such bonds will calm investors by reassuring them of the union's resolve to stand behind its indebted members. The German opposition claims such bonds will make it impossible to impose budget discipline on the zone's errant members. Behind these positions, no doubt, also lie narrower national interests. Germany, as Europe's largest and, arguably, strongest economy, has the best credit and, consequently, the lowest borrowing costs. If Germany were to become part of a Europe-wide borrowing plan, it would lose that advantage and possibly saddle itself with a potentially uncontrollable liability. Nations in favor of the bonds, of course, would benefit from German strength and get better credit terms than they can on their own.

This dispute would seem then to offer little more than a dead end. Because of the need for unanimity in EU decisions, the French and others cannot force the bonds on Germany. No doubt if Europe were structured differently and France, Italy and others could force the bonds on Berlin, Germany would leave the union. But since that cannot happen, a German departure is not in the cards. Because all the others need German economic and financial strength to make the bonds attractive, they have little or no incentive to try some form of organization separate from Germany. Nor can the ECB bridge these differences. Though it can legally take action without German approval, its charter forbids it to issue bonds.

If the proposed bonds, then, go nowhere, the politics surrounding the dispute may still bring some movement. The Germans, after all, have no desire to become the naysayers of Europe. They want to relieve the tension and surely also want to give Hollande, Monti and others something like a victory to take home to their constituents. Indeed, Hollande and Monti may have pressed an issue on which they already knew that Merkel was intransigent just to get compromise elsewhere. Such compromising might occur on four fronts:

Berlin might seek to relieve political pressure and also quell market fears by offering greater funding for the European Stability Mechanism. By reassuring investors that Europe has the resources to meet the obligations of its weaker members, a substantially larger fund, even if unused, would strengthen the market for all sovereign debt.
Berlin might also offer greater funding for the European Investment Bank (EIB). With enhanced resources, the bank could undertake more infrastructure projects across Europe, relieving some of the strains of austerity on member countries without encumbering government budgets.
Berlin might also give beleaguered Eurozone members more time to meet deficit goals. Such an approach would still give German policy its ultimate goal but in the interim relieve these nations of the need for especially intense austerity and so lift the worst political pressure on national leaders cooperating with the austerity regime.
Berlin could also broaden the criteria used to enforce austerity. By targeting spending growth, for instance, or regulatory burdens in addition to direct deficit targets, the beleaguered members could point to progress, and thereby encourage markets, even if improvement in the raw deficit figures were to take longer than originally planned.

A Lord Abbett colleague, Zane Brown, describes such German accommodations as replacing shackles or cables of austerity with more yielding rubber bands. Such accommodations would offer Europe's leadership a way around the eurozone bond impasse, give France and Italy's leaders something to offer their constituents, and still protect German taxpayers, to a degree. (At least they would escape a potentially unlimited liability.) Most importantly, they would also help relieve European political and financial strains, whatever Greece decides to do.