The Euro’s Darkest Hour

Grant Wonders makes the case for the imminent collapse of the euro currency. He calls for quantitative easing and the restructuring of Greek debt in order to save it.

From the window where I currently write, I can see the tip of the Reichstag dome that looms over the grey sky of Berlin. The sleek modern glass enclosure offers a skylight into the chamber of the Bundestag parliament below. This odd juxtaposition of sharply angled glass and severe neoclassical stone hangs over the chamber, much like a sword of Damocles, reminding us that the fate of Germany, the euro zone, and the entire world economy now dangles beneath this dome, in the hands of Angela Merkel and her government. Two years ago I wrote a book predicting the collapse of the European monetary union titled The Imminent Crisis1 – today, I fear, the crisis has become much more “imminent.” Without swift action by the ECB and bold policy compromises by euro zone governments to meet the exceedingly insurmountable scale of needed reforms, the euro currency could collapse within months.

The dissolution of the currency would precipitate massive defaults, dramatic currency fluctuations, widespread banking failures, and challenge the viability of the European Union itself. Amid the breakup of the world’s most integrated financial and trade zone, the global economy would be thrown headlong into a deep recession that would make even the halcyon days of September, 2008 preferable.

Even as the euro hurls towards a catastrophic collapse, the relative stability of global capital markets suggests continued faith that policymakers will (eventually) find a way to save the single currency. Nonetheless, the brinksmanship of Mrs. Merkel’s government has pushed Europe into a vicious spiral where demands for fiscal austerity and higher taxes are fueling an even deeper recession amongst already tenuous economies.

Such foot-dragging on the part of policymakers is aggravating consumer and business confidence and digging a deep grave from which recovery, by the day, is becoming increasingly arduous and unlikely. The decline in output that is projected for both the euro zone core and periphery this year, complemented by substantial transfer payments to the growing unemployed workforce, will serve to further increase ballooning budget deficits. With each day of inaction, the compounding overhang of government debt raises the cost of borrowing and increases political and popular opposition to the very reforms that might have a shot of saving the currency union.

Recent steps taken by the ECB have helped to alleviate the funding challenges faced by euro zone banks. In December, a €489 billion liquidity facility in three year loans to more than 500 banks, was deployed in an attempt to thaw the frozen bond markets. The longer duration of loans is intended to promote lending and stabilize banks by reducing their reliance on short-term funding. Still, as in the recent financial crisis, the bigger challenge is not liquidity but solvency. Banks are rightly terrified about potential assets losses in sovereign debt. If the value of an asset falls, or if haircuts demanded rise, banks expose themselves to the threat of spiraling collateral requirements. Each credit downgrade notch can trigger an incrementally greater demand for collateral by the ECB. The downgrade of Italian sovereign credit quality from A- is particularly troublesome given the ECB’s abrupt collateral standards. A mere 1.5% haircut is applied to A- sovereign debt, whereas the haircut spikes all the way to 6.5% with just a single notch downgrade. Similarly, the recent downgrade of France from AAA (although dismissed by President Sarkozy) will reverberate across the euro zone through rising interbank collateral demands.

Moreover, the timing of capital requirements imposed by the European Banking Authority, forcing banks to meet minimum Tier I capital ratios of 9% by a June deadline4, is likely to exert further pressure on lending. Rather than raising new equity to meet capital shortfalls, banks are shrinking balance sheets. Although sovereign debt sales cannot be used to meet the capital buffer, banks are permitted to use the sales of vaguely defined “selected assets” to meet deleveraging requirements. This dangerous, “first out the door” mentality places downward pressure on prices, threatening not only bank lending, but also seriously imperiling the value of other collateral (including sovereign debt) throughout the entire financial system.

Banks are naturally hesitant to issue new equity and dilute existing shareholders. Adverse selection causes only those banks with overvalued stock prices to voluntarily issue equity. Thus, the negative signal that an equity issuance conveys to the market reduces a firm’s flexibility to voluntarily dilute shareholders. This is especially true when the continuing debt crisis makes the value of balance sheets uncertain. In the face of these realities, European regulators should abandon a strict ratio and seek to beef-up bank capital by suspending dividends and prescribing equity issuance quotas for struggling banks.

The triggers for a full-blown euro collapse are becoming more prominent. A slow run on bank deposits has already commenced in periphery nations such as Greece. Foundering bond auctions, even in core nations such as Germany, are heightening stress in the banking sector, raising collateral requirements, and promoting the potent combination of asset sales and lending squeezes that threaten to destroy the entire financial system. This year alone, Italy is due to refinance €341 billion of in sovereign debt5, around 17% of its GDP. At the mercy of markets, a failed bond auction could easily push the nation’s titanic obligations into default. Similarly, the collapse of a major European bank, much like the demise of Lehman Brothers in 2008, could also have widespread systemic ramifications.

The most recent EU summit in Brussels has only further highlighted the failure of government leaders. Chancellor Merkel is quick to criticize the structure of the monetary union, yet continues to treat doomsday as a distant scenario. Instead of devising evacuation plans as the euro loses altitude, Mrs. Merkel clings to idealized notions of austerity while religiously opposing any form of Eurobonds. With the engines of growth failing and the airplane transporting the euro plummeting, it is far too late to be designing parachutes. The procrastination of the policy response cannot kick the can down the road any longer.

Under Mrs. Merkel’s leadership, Germany has ignored the power of growth by dwelling on structural reforms that rule out the joint-liability of Eurobonds and focus vehemently on austerity. German leaders justify this choice for protracted economic pain on the grounds that the moral hazard of Eurobonds might “doom” the currency union. Yet, given the lack of cohesive policy coordination amongst euro zone governments, the single currency is clearly already on the path to doom.

If Germany does not change its stance, and continues to impose the burden of sovereign debt on the troubled economies of deficit countries, the present recession will be particularly acute. The current slowdown promises to trigger further credit downgrades across the euro zone that will enflame deficits and only increase Mrs. Merkel’s wayward calls for austerity. Without political unity (which has eluded the currency union since its founding), the single currency experiment is destined, perhaps as it always has been, towards failure.

A scant ray of light shines through the grey sky. The euro zone can still be saved from the curtain of gridlock that has descended across Europe. Aggressive monetary easing via ECB bond buying (quantitative easing) should proceed in earnest. The possibility that the central bank might act as a lender of last resort for governments should not be ruled out. This temporary monetary support must be complemented by political compromises that restructure the unsustainable debt of Greece and rectify the trajectory of Italy and Spain through a shared euro zone burden. For now, global markets continue to have faith that euro zone governments will pursue a treatment that can cure the euro. The surgical reforms to the currency union that Mrs. Merkel champions should be adopted, but the patient needs to survive long enough to make it to the operating room first.

Grant Wonders is a senior economics concentrator in Kirkland House. Next year, he will be working in private equity at Blackstone.

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