Friday, April 29, 2005

Scary Stuff

In a post which appeared earlier this week Tobias asks us whether, given some of the possible consequences of a French "non", it might not be reasonable to 'scare' voters a little by spelling out some of the potential fallout which might follow a French rejection of the Constitution Treaty.

Perhaps the phrasing is unfortunate, but undoubtedly voters in Eurozone countries need to think long and hard about one especially sensitive area of impact: the future of the euro itself.

Obviously it is precipitate to start speculating about what would happen 'if'.......... In the first place the final outcome is far from decided, and in the second next months vote will hardly be the end of the story. One thing is sure though: if the French were to vote no the future of the institutional structure of the EU would become much more uncertain. And if there is one area where such uncertainty can be painfully expensive it is that of financial markets. Hence the interest in the euro.

And this is where the 'scary movie' might just begin. I think it isn't spelt out often enough and clearly enough that the existence of the single currency is predicated on the long term evolution of an integrated political platform to make it solvent. This is why those states which have shown most reticence at the idea of European federalism have understandably (the UK is the most obvious case) been the most reluctant to adopt the common currency. This is also one of the reasons why a no vote in France would be much more important than a no vote in the UK. In the worst case scenario of an eventual British rejection it could be just possible to find some alternative structure to work round, but to have the eurozone's second largest economy institutionally 'out' would be really unthinkable.

The implications of just such a development are explored by Morgan Stanley economist Joaquim Fels in an article entitled "euro at risk". Now this is not the first occasion on which he has expressed views which might seem alarmist to some. Back in January 2004 he wrote a piece entitled Euro Wreckage? which evidently drew blood since it evinced an immediate response from Nobel economist Robert Mundell (intellectual 'parent' of the euro) in the EU Observer. Simply put Fels pointed out there that the technical and legal obstacles to leaving the euro were not as great as was often thought. Some evidence to back this point of view might be found in the fact that Greek expulsion from the common currency was one remedy proposed in some quarters after the 'deficit manipulation' scandal came to light.

This time Fels makes three central points:

As I see it, there are at least three developments with potentially lethal implications for European integration: (1) the surge of protectionism, especially in Germany, against perceived ?wage dumping? from Eastern member states; (2) the probability of a rejection of the EU constitution in France and the Netherlands; and (3) the prospect of much larger fiscal deficits in coming years now that the Stability and Growth Pact has been watered down beyond recognition.
Source: Morgan Stanley Global Economic Forum

Now adroitly side-stepping the first - protectionist - problem (which could reasonably involve a separate post), the second and third points do seem to me to be interconnected in a way which gives some force to Fels' argument in the sense that a combination of the two could lead to increasing speculation about the very viability of the euro itself.

Essentially the 'loosening' of the stability pact has meant that there is now much less control on the continuing accumulation of deficits. This in the medium term wouldn't necessarily present an insurmountable problem (ie one which was going to produce a 'crisis' situation) if the problem of the ongoing political unification didn't present itself. Put bluntly the latter is necessary to guarantee the solvency of the former. If the economically stronger states are not going to be bound (morally if not legally) to bail out the weaker ones, then one day the markets will wake up to this and pressure on the government debt of these states will begin to pile up. Italy and Greece are prime canditates here with relatively stagnant economies and government debt already above 100% of GDP.

The FT today offers one indication of what might become an ongoing trend: divergence on the relative interest rates paid by the various eurozone governments on their debt (the so-called 'sovereign spread') is increasing:

The French referendum on the European Union constitution is starting to unnerve debt markets, prompting investors to become more discriminating about eurozone bonds.

In particular, the price of German bonds has recently diverged from Greek or Italian instruments, because investors are favouring paper issued by stronger eurozone countries. This helped to push the 10-year yield on German government bonds down to just 3.389 per cent on Thursday the lowest rate for at least four decades.

(meantime).... the cost of protection against a default by Greece or Italy, using credit default swaps, has risen. Last month it cost about ?14,000 to insure ?10m of Greek or Italian debt; it now costs ?23,000 and ?17,500 respectively. The swap spread between Greek and German assets has also risen by 6 basis points in the past month from a normal spread of 10-15bp.
Source: Financial Times

In other words it now costs more for the Greek and Italian governments to raise money. As the FT points out these differences are currently relatively small (and indeed miniscule in comparison with the differences prior to monetary union). However as political union proceeded these spreads had been converging, now they are diverging. A major hiccup like a French no, coupled with a failure to seriously address the deficit problems would only see this process accelerating, and it would be this acceleration which could seriously place the unity of the eurozone in question. Ironically government finances in Greece and Italy are only sustainable due to the very low interest rates made possible by euro membership. Should debt costs start to escalate (remember we are talking here about servicing debt to the tune of 100% of GDP) then financing interest payments would almost inevitably lead (as we saw in the case of Argentina) to an ongoing spiral of expenditure cuts, economic stagnation and even higher interest rates. The end result would almost certainly be default, and normally default would require the significant devaluation of a currency and the application of an independent monetary policy, both of which imply the return to an independent national currency.

Of course, telling the French electorate that they need to vote yes so the will be able to shore up those eurozone economies with serious public debt problems may not be the best way to convince them (there *is* intended irony here NB), so perhaps those who suggest we shouldn't be in the business of scaring people (we can leave that in the capable hands of Wes Craven) may be right after all.