The Euro is Dead, Long Live the Euro
One does not need to venture too far to hear or read about the demise of the Euro. From every analyst on Bloomberg to the investment bank research that fills my inbox, no one has had anything inspiring to say about the Euro. In fact, while doing research for this post, Google came back to me with this:
While not very promising, the grossly lopsided sentiment about the Euro tells a much larger tales than its woes. The Euro is not without its problems. Clearly some nations have taken on more debt than they can service which has created a host of problems. These problems include everything from inability to access debt markets for funding at “reasonable” rates (think Italy and Spain) to outright questioning of if a nation is a going concern (Greece). Within this article we will cover what the problems are and how this time is different, what we feel ultimately needs to happen and why we believe the Euro wont fail.
To any Bill Murray fan, what we have seen in the markets since 2010 surely makes us feel as though we are living out Ground Hog Day (insert IMBD link). Every year around March, the economic data out of Europe starts to get worse and the markets fall. After an extreme amount of volatility and policy response out of the EU, global capital markets shake off their rut and end the year largely unchanged. This year is no different, with the economic data out of Spain, Italy and even the much vaulted Germany missing expectations. So why are things different this time around? The major difference is the plumbing. The plumbing, or the funding markets for the greater EU banking system, have been made flush with liquidity. The exact name for this was called the Long Term Repurchase Operation or LTRO for short. The LTRO accomplished two very important goals. First, it ensured that banks were able to meet their short term funding requirements, regardless of the amount, backed by the European Central Bank. Thus there would be no Lehman Brothers type event as all institutions would have short term funding facilities available. Second, with the funding rate set artificially low, banks could then use these monies to purchase higher yielding Sovereign Debt. By being able to monetize the funding spread (the spread between the fixed income banks can buy vs their cost of funds) the banks would be able to repair their balance sheets to better equip them to handle negative economic shocks. This would also help drive down the borrowing costs for the EU banking system as confidence was restored.
So if the “Black Swan” banking event was taken off the table, why are people still concerned?
What got most of these nations in trouble was their inability to spend within their means, taking on far too much debt relative to their income. In order to combat this issue and prove to the funding markets they could get their financial house in balance, many governments have chosen the path of austerity to solve their problems. Austerity in and of itself is not wrong, though when every one of your major trading partners is undergoing the same financial malaise and is responding with austerity, there is no way to generate growth. The clear difference in US policy response can be seen in the chart below, where the US Government has chosen to fill the gap of private sector spending with public spending.
The issue is such, without the government of many troubled EU nations filling the consumption gap, it is nearly impossible for them to grow their way out of their debt burden. Thus, it is the austerity measures combined with the large debt balances which are hindering the abilities for these economies to heal their wounds.
So what happens?
While the path is uncertain, the end result is quite clear; the Euro will continue to operate as one of the world’s reserve currencies. Currently the Maastricht Treaty has no provisions for a nation to exit the Euro. For lack of a better term it’s a Suicide Pact. With no plan in place to map out how an exit from the EU would work, it’s unlikely (but not impossible) that a nation will be allowed to leave, given the years of legal issues which would arise. What is more likely is the formation of a Fiscal Union. This solution has its own problems, but in our opinion is much better than the alternative. Upon the creation of a Fiscal Union, debt (also known as Euro Bonds) could be raised that would be backed by all nation states. This would help create a system much like in the US with municipal vs governmental debt. By having this two tier system of debt, markets could more effectively value each nation’s balance sheet and subsequently their debt. By doing this, we would see an immediate revaluation of such nations as Italy and Spain, where debt haircuts (jargon for debt restructuring) could be arranged that would not put the whole system at risk. The system would have true risk free debt back stopped by all nation states and individual nation-state debt which would trade based on a spread to those Euro Bonds. This would avoid situations like we have now, where the Germans end up paying (begrudgingly, I might add) for Greece’s fiscal imprudence. It would also prevent nations from obtaining artificially cheap funding rates by joining the Euro and allow nations to go bankrupt without systematic implications. Setting up a Fiscal Union is no small feat, but those toilings are certainly preferable to the alternative of dissolving the Euro. It is also worth noting here, that the system is run by politicians. The politicians and their promises are what got many of these nations in trouble. While politicians are not the most financially savvy individuals, they do understand the financial benefit of continuing to receive their paychecks. Since they are the only ones able to change the rules and effect policy, it is highly, highly unlikely they will jeopardize their own personal income by letting the Euro fail. It is not clear at what level of turmoil they will take action, but one can be certain they will come to action and do whatever is necessary should a systematic risk present itself. The claims of the Euro’s death have been greatly exaggerated. As we have discussed, the outlook is not rosy and the road to recovery will have many ups and downs, but the Eurozone and the Euro will remain intact. We look forward to hearing any and all of your questions.