In instructing the Greeks as to precisely how to phrase their referendum question - stay in the euro zone or leave, Chancellor Merkel and President Sarkozy (the Merkozy as they have come to be known) crossed a highly symbolic threshold. They allowed the markets to imagine a scenario in which euro zone members that were not fiscally fit could take their leave of the single currency. This is a hugely significant moment since, as Brussels Eurocrats have never ceased explaining, monetary union could only ever be a one way street given that the treaty creating it contained no provision for a country to abandon the euro.
Such sentiment was important though, because just like placing bets on the likelihood of the Sun rising and setting, the euro was viewed as a sure thing, a reliable asset to hold, and once even had pretensions to become a world reserve currency like the dollar. In the same way that the currency was seen as virtually infallible, so too were those countries which adopted it and became euro zone members. The idea of a country which had the euro defaulting on its debt was impossible. Institutional investors around the globe believed the zero risk label and bought the bonds of euro zone countries, confident in the knowledge that while banks might go under, states never could.
Enter stage left, Greece and Italy. Now that the Merkozy have let the cat out of the bag with their shock revelation that membership of the euro zone does not have to be permanent, investors in sovereign debt are now saying to them through their refusal to buy Italian bonds – if you can’t prevent a tiny country like Greece (which represents only 2% of the euro zone's GDP) causing two years of political and financial turmoil, what possible chance do you have of saving Europe’s third largest economy, Italy!
No one realistically expects Italy to default anytime soon, given its huge economy. But then, this crisis is no longer about Greece or Italy. It’s about the survival of the euro itself and whether Frau Merkel and Monsieur Sarkozy are prepared to back it unreservedly. Of course, neither Germany nor France has the financial wherewithal to bail out Italy which is why we are now almost certainly seeing the beginning of the end of the euro zone as it is currently constituted.
The problem is that Germany and France, the axis which led the drive towards the single currency in the 1990s and which championed the cause of ever closer European integration for decades, cannot even agree on the degree of latitude which the European Central Bank (ECB) should be allowed in buying the sovereign debt of euro zone countries. Monetary union has proved to be a chimera and brotherly (or even sisterly love) from Paris and Berlin has been lacking as one of the founding members of the European Economic Community teeters towards financial oblivion.
On Wednesday the yields on Italy's ten year note rose to just under 7.5% - a new record for the single currency and in terms of the country’s borrowing costs, totally unsustainable. This immediately led to higher margin calls by one of the largest clearing houses for any institution trading in Italian debt. A similar margin call last year on Irish bonds prompted the Dublin government to go cap in hand to its European partners, and Italy now risks being shut out of credit markets entirely with potentially disastrous consequences for those financial institutions exposed to Italian sovereign debt.
If the mantra in 2008 was ‘too big to fail’ as governments bailed out institutions like AIG which were deemed to pose a systemic risk to the global financial system, the cry in 2011 as states run into trouble is surely ‘too big to save’. This time it is not CEOs like Dick Fuld of Lehman Brothers making frantic calls to competitors to save their banks from oblivion, it is European leaders trying to save their countries.
Unlike Ireland, Italy’s begging bowl is simply too large and even if European leaders were to act decisively and in concert (a sense of collective purpose which has so far eluded them) such a sovereign debt crisis would be difficult to manage. In reality, there is no sign of concerted action on the part of either the ECB, or its political masters – the European heads of government and especially the lady in Berlin holding the euro zone's purse strings.
Angela Merkel, all too aware of the dangers of huge deficits, haunted by the spectre of inflation from Germany’s turbulent history and reluctant to see her country’s AAA credit rating affected by the profligate countries in southern Europe, seems unwilling to do what the current crisis demands by giving the ECB and the European Financial Stability Fund (EFSF) the financial firepower to calm the markets. One of the reasons for the lack of success at the G20 summit was Germany’s refusal to allow its sizable gold reserves to be used to placate the markets. Unsurprisingly, far from being calmed or intimidated, the markets now recognise that there is neither the political will nor monetary muscle available inside Europe to save the single currency.
Even before Merkozy’s ill-judged advice to the Greeks regarding their referendum question, the euro zone's always reactive, hopelessly feeble handling of the Greek debt crisis for the last two years has revealed the vacuous truth about closer European integration. Having scented Italian blood, having seen the G20 summit end in failure without any commitment to increase the size of the EFSF and having seen the Chinese shun pleas to bail out struggling Europe, investors are now piling into perceived safer havens like the dollar.
More seriously, the inability of Europe’s leaders to tackle this crisis when it was manageable has now led to the erosion of one of the fundamental precepts which underwrites the entire global banking system – the principle of zero risk Western sovereign debt.
For the last few decades, the conventional wisdom has been that buying sovereign debt from countries like the US, Britain and Germany was the safest possible investment strategy since based partly on historical precedent, these countries were perceived to be so strong economically and politically that they would never default on their debt. The dollar became the world’s reserve currency, the deutschmark came to symbolise German resilience and steadfastness and the phrase ‘as safe as the Bank of England’ entered the lexicon as the ultimate measure of an asset or investment’s lack of risk. Whatever geopolitical turmoil was going on in the world, investors could be fairly sure that if they invested in these countries and other similar economies, then they would get their money back - the concept of zero risk in a nutshell.
Notice that I use the phrase 'similar economies'. Herein lies the fundamental flaw in the entire single currency project, and the reason why the principle of zero risk has been so damaged by the mishandling of the European debt crisis. Greece wanted into the euro because it gave its highly dubious economy (where one-third of tax goes uncollected and government bureaucracy strangles entrepreneurial endeavour at birth) the fiscal cover to borrow cheap money. What allowed Greece to get away with this for so long is that the markets figured that as a member of the euro, Greece could never default because to do so would strike at the principle of a zero risk single currency backed to the hilt by all the other members of the club. In the heady mix of financial possibilities open to institutional investors as they placed bets worth billions on the world's markets, they knew that in times of uncertainty they could invest more money in zero risk Western debt, and less in the higher risk sovereign debt of emerging market economies like Brazil, Russia, India and China. Last week’s events finally shattered that illusion, even if the previous two years of Franco-German muddle had not.
While markets do sometimes get carried away, their behaviour more often than not reveals fundamental truths that the political classes would rather ignore. The current unsustainable yields on Italian debt reflects the fact that Italy is hopelessly uncompetitive, its economy is stifled by crippling bureaucracy and outdated labour laws. Sitting on the third largest debt pile in the world, the markets doubt the ability of the country’s political elite to deliver the economic reforms necessary to repay those borrowings.
This crisis has revealed paradoxes and absurdities which explain why Western economies in general and European ones in particular have huge underlying issues surrounding their continued ability to pay for their over-burdened welfare systems, even as their productivity and growth rates decline. One absurdity was the idea that the Chinese, sitting on 3 trillion dollars of foreign exchange reserves, but still in their own words, ‘a developing economy’ would feel like bailing out the euro zone countries where per capita income is approximately eight times larger than their own. It is little wonder that the head of China’s sovereign wealth fund poured cold water on the idea of the Chinese riding to the rescue of the wealthy ‘indolent’ Europeans.
If a stronger, more credible euro is to emerge, it seems likely that the number of countries in the euro zone will have to shrink dramatically and those economies which have working practices and bureaucracies deemed too outdated and stifling to growth will be told to shape up or ship out. Given the speed with which this crisis has accelerated, even France will have to watch out, particularly given the huge exposure of its banks to Italian debt.
It seems likely that the world will once again have to go through another period of financial anxiety, possibly even worse than in the aftermath of the collapse of Lehman Brothers in 2008. If we emerge unscathed, Western economies will have to demonstrate that they have shed their indolent ways, by cutting their welfare states, improving their competitiveness and proving to the markets and the white knight Chinese that they are worth rescuing and that their sovereign debt is still worthy of the label 'zero risk'.
Posted on November 9, 2011