Thoughts on the euro

Ireland looks like they will be able to pass a budget that will allow them to pay down their international debt although Irish citizens will be paying the price. Greece still appears to be in denial with protests every time a politician even thinks about raising taxes (or enforcement) or cutting government transfer payments. Portugal is hanging on … just. Spain has a 20% unemployment rate and will find it difficult, if not impossible to pass a contractionary budget. Italy? Well, same story, different language.

Portugal will be the next country to need a bailout, and Spain won’t be far behind. Of the two, Spain is much larger and a much bigger threat to European stability. Angela Merkel, Chancellor of Germany, has rejected any notion of increasing the size of the bailout fund. What happens next?

First, Portugal accepts a bailout and the bailout fund runs dry. The cost of credit default swaps on Spanish debt, and Italian debt, starts to rise. The rest of the world starts unloading debt of the weaker European countries and, afraid to reinvest in France or Germany, move the money out. This puts downward pressure on the euro. This increased supply drives bond prices down increasing yields and further exacerbating Spain and Italy’s refinancing problems. A falling euro increases the cost of imports for France and Germany which slows their economies and kindles inflation. The European central bank must raise interest rates to fight the inflation, but at the same time needs to buy up sovereign debt to prevent a run on any particular country. The quantitative easing is, itself, inflationary.

Eventually, Spain can no longer refinance their debt and must seek assistance. German taxpayers will revolt at the thought of taking on the debt of Spanish taxpayers and Spain defaults. Negotiations will occur and Spain will refinance their debt at 60-70 cents on the euro with restrictions on fiscal policy. This will mirror Iceland’s solution wherein the bondholders are forced to bear some of the loss.

Spain’s banks will be some of the larger holders of Spanish sovereign debt as a form of reserves. A devaluing of the debt will reduce the asset side of their balance sheets and lower their capital ratios. Some may become insolvent. With any luck, the banks will have purchased credit default swaps and with a little more luck, the counter parties will be solvent. Banks in other countries will also be holding Spanish debt and these banks will also have reduced assets and capital ratios.

When Spain defaults, all the world’s banks will be in jeopardy. Spanish banks are linked to German banks which are linked to English banks which are linked to US banks all through the swaps market. It is the counterparty risk that will cause the contagion.

England and the US will be able to support their banks, in a worst case scenario, by guaranteeing the debts, just as the US did in 2008. The numbers will be staggering. England and the US can do this because their central banks have the unlimited authority to print pounds and dollars respectively. Germany and France, on the other hand, have no such authority to print the euro.

There appears to be no mechanism available to force the fiscally liberal nations to abide by the deficit-to-GDP and debt-to-GDP restrictions that they agreed to ten years ago, nor does there appear to be a mechanism to evict them from the euro currency zone. For Germany and France to save the euro, they will be required to guarantee the debt.

There is, however, a different scenario. France and Germany could voluntarily leave the euro and reinstitute the franc and mark respectively. Their debt would immediately be repriced in their own currencies. The remainder of the fiscally conservative countries could follow with the reinstatement of their own currencies. The remaining users of the euro could vote to inflate the debt away. Once the debt has shrunk to a manageable level in real terms, the euro is abandoned and so endeth the single currency experiment.