The prospect of a country leaving the Eurozone and its potential impact – Part 1 of 4

Why we are where we are:  An unlevel playing field

Before we explore the impact of a country leaving the Eurozone, we need to understand, and be quite clear, why, under current EMU treaties and arrangement the prospect of one or more countries leaving the Eurozone is not just a possibility but an inevitability.

Due to years of chronic economic mismanagement - multiple policy errors within the Eurozone and outside it - peripheral European countries are suffering from solvency problems that make defaults unavoidable and exits from the euro highly likely.  Not today, or tomorrow, but in time.

Short of Germany (and others) committing themselves fully to fiscal and capital transfers to the periphery in perpetuity the current structural, economic and social imbalances are simply incompatible with an enduring single currency and monetary union.  Without a change to the current rules regarding bailouts and fiscal transfers, the Eurozone can only break up.

The current policy of ignoring the underlying structural deficiencies and kicking the can down the road with ever more audacious and inventive conjuring acts does nothing other than to delay the inevitable, weaken faith and credibility in European policy makers and their ability to manage European economic and financial interests prudently and, ultimately, exacerbate the scale of  financial, social and economic costs by the time this monetary union breaks.

Like many a fixed exchange rate regime that preceded it in history, especially with so many diverse cultures and basic barriers to social and economic cohesion, it will break. It is no longer a case of “if”, but “when”.  The key for Europe will not be so much in the mechanics of an exit from the euro, but how to manage the process and the aftermath.

The economies of Greece, Portugal, Ireland, Cyprus, Spain and Italy have collapsed, and are mostly either still contracting or are having weak “technical” upticks (from extreme low data points) that, in reality, will not generate a GDP growth rate capable of dealing with these long term structural imbalances and the horrendous backdrop of ever-rising debt and unemployment.

Indeed, unemployment has reached shocking levels; 28 per cent in Greece, 26 per cent in Spain, 16 per cent in Portugal, 13 per cent in Ireland and 12 per cent in Italy.  Amongst the young, these numbers are utterly unconscionable (29% in Ireland, 37% in Italy, 38% in Portugal, 55% in Spain and 58% in Greece). This, over any length of time, will become socially unbearable.

Other than to refinance their unsustainable borrowings, little or nothing has been done to address the structural problems of these weak economies –– while committing them to a degenerative spiral with little or no possible redemption within a time scale that is socially realistic or manageable.

Policies have consequences:  A socially degenerative spiral


The wrong way: Mind the gap

01-02-ECU-retail sales

Flawed thinking: Theory versus practice

In short, the Eurozone has become in an insurmountable mess – financially, economically, politically and socially.  It is a political dream, based on theoretical ideology, which now has virtually no chance of survival in practice. Fixed exchange rates in history have had an appalling track record of durability at the best of times.  The Eurozone, where language and mobility of workforce barriers act as an impediment to social and economic cohesion and where cultures, ambitions, values and work ethics are in such stark contrast to one another, we doubt that this one will be any different.

Had the Eurozone architects undertaken proper financial, economic, political, fiscal and welfare reforms over the past 15 years and disciplined themselves to a strict convergence timetable towards a level playing field on all levels, then “maybe” there might have been a slight chance that this project could have worked for an extended period of time.
As it is, this hasn’t happened and the reality is that the entrenched disparity between some economies – especially of competitive grounds -  is simply too far gone to be able to recover.  Consequently, this crisis will rotate from a financial, economic and sovereign debt one into a political and then a “social” one, which is where, in a democracy, it all ends.

The major flaw in this political dream is in Europe’s politicians not appreciating that they remain in office for as long as “the people” are prepared to tolerate them or (the consequences of) their policies. It is self evident that “the swing of the pendulum” has already started to swing hard in a number of countries against austerity, against enforced erosion of cultural heritage and against “the one size fits all” monetary policy.

After all, not everyone in Europe wants to become a German – either economically or socially.

At this juncture, the only way to perhaps save the Eurozone in its present form would be for the introduction of euro bonds and an absolute “all-for-one and one-for-all” attitude and commitment.  Without this, it simply isn’t possible or credible.

Whilst joint euro bonds would not deal with the deep rooted cultural differences or economic divergences between Germany and the periphery, it would at least put an end to market pressures which, otherwise, will keep coming back again and again.  Markets exploit weakness and, unlike politicians, understand it well when something which is unsustainable.

However, since it seems clear that there will be no common fiscal backstop, as the Germans will not countenance such, it is inevitable that we are headed for a breakup sooner or later.  

In conclusion, whilst European policy makers have successfully, thus far, managed to kick this can a long way down the road, do NOT be fooled by this.  They will, eventually, run out of road.  If a structure is unsustainable, this means that it shall not be sustained.

Part 2: http://shorex.com/expert-opinion/item/42-the-eurozone-til-default-do-us-part-part-2

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Michael Petley

Michael Petley is ECU's Chief Investment Officer, Chairman of its Global Macro Team, and one of the three investment managers of ECU's Institutional Global Macro and Active FX Overlay Strategies. Michael founded ECU in 1988 and was CEO & Chief Investment Officer for 19 years.

He has 25 years of experience in managing FX mandates and presided over the highly successful management of all ECU's core currency products until November 2007. He returned to ECU in 2011.

Website: www.ecugroup.com


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