If you want to unnerve a European, the revelation of a secret dinner of New
York-based hedge funds conspiring against the euro is hard to beat. Europeans
are right to worry – but not about the collusion itself. They should be much
more concerned that some of the world’s smartest investors are convinced the
euro has only one way to go: deep down.
At first sight, this flies in the face of a previous consensus. In Europe, in particular, the predominant view has been that
the infidels at the Federal Reserve and the Bank of England will ultimately
inflate themselves out of their debt, while the European Central Bank will hold
firm. That scenario would be consistent with an overvalued euro.
So what has prompted some sophisticated investors to think the opposite? Greece? Probably not. This is a
story about what will happen to the eurozone beyond Greece.
Without political and legal constraints, this would be much easier. The
eurozone would prescribe itself a crisis resolution mechanism, a procedure to
manage internal imbalances, and perhaps move towards a common eurozone bond.
Several economists have made concrete proposals: Daniel Gros, director of the
Centre for European Policy Studies, and Thomas Mayer, chief economist of Deutsche
Bank, have argued
the case for a European Monetary Fund. Yves Leterme,
the Belgian prime minister, has proposed a European debt agency.
While all of this sounds sensible, none of it may ever happen because of
political and legal constraints. Some member states would argue that a new
European treaty would be needed to implement such proposals. The route to
getting the Lisbon treaty ratified was so
tortuous that Brussels
would rather go to hell and back than negotiate and ratify another treaty. In
any case, German constitutional law imposes such tight constraints that any
dilution of the no bail-out clause in the Maastricht
treaty or the price stability target of the ECB might trigger a forced German
exit. The most one can hope for during the next 10 years is improved voluntary
co-ordination in the European Council.
So the question then becomes: what economic adjustment mechanisms are
feasible against this political and constitutional backdrop? The options are
limited. The one policy response we can almost take for granted will be an
attempt to reduce budget deficits back towards the Maastricht treaty’s upper ceiling of 3 per
cent of gross domestic product. This will be achieved, if not by 2012, then a
year or two later. Meanwhile, Germany
has unilaterally prescribed itself a deficit-to-GDP ceiling of 0.35 per cent
from 2016. There will be some slippage here as well. But there can be no doubt
that the eurozone will try – and probably succeed – to consolidate its fiscal
position. The budget committee of the German Bundestag
started last Friday, in fact, by cutting the finance minister’s 2010 budget by
almost €6bn ($8.2bn, £5.4bn).
If we assume further budgetary consolidation as a given, how then will the
eurozone economy adjust? It is an economic fact that the sum of public and
private sector balances must equal the current account balance. So forcing up
public sector balances implies either an offsetting fall in private sector
balances, an offsetting improvement in the current account balance, or some
combination of the two.
In scenario one, the eurozone’s current account balance remains broadly unchanged,
and all the adjustment comes through a fall in private sector balances. In a
similar way, Greece
last week solved its fiscal problem by creating a private sector problem of
identical size. The Greek state – the sum of its public and private sectors –
is just as bankrupt today as it was a week ago. This means that, by following
the fiscal policy rules, the eurozone would risk a private sector depression,
which would almost certainly be concentrated heavily in Europe’s south. This
scenario would greatly increase the probability of a eurozone break-up at some
point in the future. Investors who believe in this scenario would be very
afraid to hold euros.
In scenario two, all the adjustment comes through the eurozone’s current
account balance, which would turn from slightly negative to strongly positive.
It is difficult to see how this could be done without a significant further
devaluation of the euro. The euro would join the long list of currencies that
have seen their problems solved through competitive devaluation. So the
consequences would be a significant devaluation of the euro against the dollar
and a reversal of its appreciation against sterling. It would make life more
difficult for the British. But, most importantly, it would contribute to a resurgence
in global imbalances.
Whichever scenario you choose, the euro is going to be weak. Even if the
eurozone were to allow more serious slippage in budgetary consolidation than I
have suggested, that would probably not help the euro either, as markets would
start to doubt the longevity of the currency union for political reasons.
We have always known that a monetary union cannot exist without political
union in the long run. Those smart New
York investors are betting that the long run is
closer than we thought.
This piece first appeared in The Financial Times.
The European Council on Foreign Relations does not take collective positions. ECFR publications only represent the views of their individual authors.