The Ultimate Demise of the Euro is a Matter of When, Not If

The coordinated intervention of central banks calmed the European situation in the runup to 9 December EU summit, but the fundamentals of the situation have not really changed.  To get a handle on how things might play out, it’s worthwhile to lay out the basic facts.

1. Some countries on the Euro will never be able to pay back what they owe.  Greece is clearly at the top of the list, but Portugal is likely in the same boat.
2. Other countries, notably Italy and Spain, are not clearly insolvent, but they are in a sufficiently parlous fiscal condition, and have enough short term debt that must be rolled over, to make them vulnerable to speculative attacks that make these rollovers impossible.  In the event, this would result in default.  Put differently, these countries are sufficiently dodgy fiscally that they are at serious risk of a shift from a rollover equilibrium to a run equilibrium.
3. The European Central Bank is not supposed to print.
4. The ECB is not supposed to serve as a lender of last resort (LOLR).
5. In terms of the insolvent countries, default would be very costly not just for the debtors, but the creditors.  Some highly leveraged European banks with huge balance sheets would likely become insolvent, likely requiring government bailouts.
6. Given the price stability mandate of the ECB, the debts of Greece, etc., can’t be inflated away.  Even if the ECB mandate was abandoned, inflating away the problems of the Greeks, etc., would have huge distributive effects in a single currency. The real value of all Euro-denominated sovereign debts would decline.  (As would the real value of Euro-denominated private debt.)   This would lead to huge transfers of wealth across the Eurozone and worldwide.  It could cause S&L-like problems with European banks, as the real value of their long term assets would decline more than the value of their shorter term liabilities, making them insolvent on a mark-to-market basis.  German fear of inflation is not just a Weimar neurosis.
7. There are various means of allocating losses as a way of avoiding default.  Some of the obligations of the insolvent countries could be assumed effectively by richer countries through Eurobonds, for example.  Some of the obligations could be written off “voluntarily” by holders of the debt of insolvent countries.
8. The liquidity problems of Italy could potentially be addressed by allowing the ECB to act as LOLR, but this exposes the ECB to substantial credit risk.  Realization of credit losses could result in inflation (with the implications discussed in 6) or the recapitalization of the ECB, with the cost paid by the taxpayers of the more fiscally solid countries.
9. Any mechanism (e.g., Eurobonds, closer fiscal union) to address the debt problems of insolvent or illiquid nations will likely create substantial moral hazards.
10. The bargaining problem is a multi-lateral one.  Moreover, the bargainers (heads of government) are agents for disparate interests that will be impacted very differently by alternative outcomes.
11. Multiple issues/alternatives are up for negotiation.
12. There are serious problems with enforcing any deal that is negotiated.  For instance, if Germany prevails in its insistence that any fiscal transfer mechanism be accompanied by fiscal reforms in the debtor countries, its ability to enforce this agreement is highly limited.
13. Germany and the other relatively fiscally sound states could afford to bail out Greece, and maybe Greece plus Portugal.  Those plus Italy, or Spain, or Spain and Italy–no.
14. A deal extended to any state (e.g., a substantial writedown of Greek debt) becomes a precedent (or focal point) in negotiations with any other state.

In other words: a fine mess.

The costs of default or inflating away debts are large for the creditor countries.  This gives the big debtors substantial leverage in negotiations: it is well know that it corporate bankruptcies, equity can often extract substantial amounts from creditors, and something analogous is true with spades here.

Also, these costs give rise to a huge bargaining range, which in turn encourages all sorts of opportunism and gamesmanship, and which can result in failures to come to agreement.  EU political mechanisms, and the large number of parties involved, increase the likelihood of such a bargaining failure.

It’s hard to see this ending well.  If I had to guess, I’d say it will go something like the following.  The costs of default, or of inflating away insolvent countries’ debts, are so large that the debtors will have substantial bargaining power. Germany et al will have to find some way of writing off or absorbing a big chunk of these debts, but will demand in return some mechanism to ensure that the debtors adhere to fiscal discipline, to which the debtors will grudgingly promise to implement.  Given such a deal, the ECB will find its way to serve as an LOLR, mitigating the liquidity problem for Italy.

But the debtors’ promises to get their fiscal houses in order will not be credible, and will not be enforceable.  So even if the Euros successfully escape their immediate predicament, it will return with a vengeance before too long.

And even this not-so-rosy-rosy-scenario (in which reckoning is merely postponed for a bit, rather than banished for all time) is not a sure thing.  The bargaining problems–huge bargaining range; the massive distributive effects of any deal, and the fact that different deals could have very different distributive effects; large numbers of participants in the negotiation, with the negotiators being subject to conflicting demands from their diverse domestic constituencies; the difficulty of enforcing any deal–are ugly individually, and arguably intractable collectively.  Failure is a very real option.

And in the event of failure, the various amputation options become much more likely.

I could perhaps see some kind of relatively stable, long-term deal coming out of this process if there was a robust enforcement mechanism, and if political commitments made today were credible and binding on future politicians.  But there isn’t, and they aren’t.  From which I conclude that the ultimate demise of the Euro is a matter of when, not if.

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