11 Feb 2010

Heading to Brussels on an epic day for the future of Europe

This is an epic day for the future of Europe. Most of the time such hyperbole is tossed around to describe the phony importance accorded to an arcane constitutional debate or unfathomable treaty.

Today is rather different. The euro is not going to collapse because it will not be allowed to do so. Nonetheless, in patching up the flaws of the euro system that have been laid bare by the ouzo crisis, European leaders may well be creating a quite different direction for the continent.

We have never been here before. We have never had a currency union of 16 sovereign nations trying to stave off a potential run on the sovereign debt of one of its members.

There are two ways to look at this. If Greece was outside the euro, it could have, as the UK effectively has, devalue its way back to competitiveness.

Yet over the past two years, had the drachma existed, its surely would have come under acute speculative attack already.

Now imagine that Euroland was actually a sovereign nation. What would happen? Well there wouldn’t be 16 separate sovereign debt markets for a start.

Euroland’s “sovereign debt”, though worse rated and requiring higher interest rates than Germany’s, but would still be manageable with Euroland’s gross debt at 84 per cent of GDP and deficit at seven per cent of GDP last year (half that of the US).

Yesterday the world’s biggest bond trader said despite this week’s problems he still rated German debt more of a buy than US debt. It’s worth noting that Greece’s total national debt is only equivalent to two per cent of Euroland GDP.

So Europe raises its money on the back of Germany’s fiscal discipline. Indeed that’s precisely what happened in Euroland up until Lehman Brothers collapse.

Ten-year bond yields, the interest rate governments pay on longer term debt, were only marginally higher for the PIGS (Portugal, Italy, Greece and Spain) as for Germany. That relationship has now broken.

A measure of the success of any rescue plan will be that the gap, known as the spread, closes. It already has, a little, thanks to the talk of a rescue plan.

Yet part of the bridging of that chasm is that Germany’s government debt has become marginally more risky in the markets. The financiers are betting on an epic transfer of risk from the PIGS to the farmer.

So just as the bank crisis saw an epic transfer of financial risk from profligate banks to their governments, so we have a transnational transfer in the offing.

So what will Germany, and France want in return? A strict IMF-style austerity plan. In fact, the IMF could be made to seem like a cuddly teddy bear compared to what’s in store for Greece.

Do too little and the Teutonic tendencies will be offended. Do too much and perhaps the Greeks will choose to abandon Euroland.

The frontiers of a nation’s sovereignty are determined by its ability to tax and spend and if the latter exceeds the former, to borrow.

It was always said by the theorists behind the single currency (the Optimal Currency Area theorists) that monetary union would require some sort of fiscal union so that tax transfers could be made to areas hit by “asymmetric shocks”.

We may well see the kernel of that today.