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Home > Blogs > Ian Fraser > There is a way out of the EU's debt slavery

There is a way out of the EU's debt slavery

European economy | There is a way out of the EU's debt slavery Ian Fraser

There are a number of reasons why the eurozone might disintegrate and many of them are historical. First, is the way the currency bloc was originally constructed – as a currency union that lacked either an economic or a fiscal union (by the way, I am not aware of any previous currency unions lasting very long without being reinforced by the other two, but correct me if I'm wrong).

Or it might be because of the incorrigible penchant of some peripheral nations to abuse the spirit of EMU by riding roughshod over the Maastricht criteria and living beyond their means, on Germany’s credit rating, for years. Or it might be the fault of the more fiscally disciplined members for turning a blind eye to such profligacy for years.

You might also like to blame international bond investors (speculators?) who for years lent vast sums of money at crazily low interest rates to near bust peripheral nations such as Greece, based on the implicit guarantee and assumption that a sugar daddy (i.e. Germany) would bail them out if crisis struck.

But however we got here, there is no getting away from the fact that the eurozone is today in a state of crisis. The peril is so great that one more false move from policymakers could cause the currency launched with such fanfare and hope in January 1999, to implode.

Rather than any further 'sticking plaster' solutions or any further kicking of the can down the road, what we desperately need now is a longer-term approach to bringing the euro back from the brink.

In a recent issue of John Maudlin’s “Outside the Box” newsletter, the London-based hedge fund manager Omar Sayed delineated some of the possible options:

  1. the Marshall Plan II;
  2. the Treaty of Versailles II;
  3. the printing press option;
  4. the Icelandic option.

Sayed said the Marshall Plan II is politically the hardest to pull off, but is also “potentially the most effective.” Under this option, the EU would enlarge the EFSF rescue fund (which I have already pointed out is too small to be fit for purpose) or else convert it into an asset-buying program for the purchase of sovereign debt, alongside the issuance of a new type of bond, the €-bond. Sayed continued:

"The EU can float its own euro-bonds for the periphery or make guarantees that periphery debt is EU debt. They can cut interest on loans to help states better balance budgets. The EU could also lighten up on austerity and take a more active role in fiscal programs and auditing. Then, focus on fixing the periphery's lack of export competitiveness.

The EU is sitting on billions of unspent redevelopment funds that could be channeled into projects… The idea is that rather than make periphery nations deflate, you help them grow and pay their way out of debt… For EU integrationalists, this could be a dream come true, a way to homogenize fiscal accounts and assume greater EU sovereignty over individual states."

The biggest challenges to Marshall Plan II would be in the execution. In particular, would member states be willing to cede fiscal power to Brussels? And would traditionally quite selfish northern European countries be willing to invest in making peripheral economies more competitive and to implement projects that would take years to bear fruit?

Sayed said European policymakers have already rejected option one. Instead, they are currently pursuing a Treaty of Versailles II option. This option includes punishing the profligate by forcing through internal devaluations, via a lowering of wages and public sector cuts, as a prelude to enabling them to rediscover export competitiveness.

The Achilles Heels of this approach are that the cost of capital does not fall (said Sayed), and that few democratically-elected governments can push through austerity on this scale and remain in office. I highlighted the dangers of this approach in my earlier blog post, ECB becomes Europe’s “feudal overlord".

Sayed’s third option is for the European Central Bank to continue buying sovereign bonds, giving the EU breathing space to establish ways in which over-stretched countries like Ireland, Greece and Portugal can balance their budgets - which would eliminate their requirement to issue further bonds.

"The ECB can keep monetizing the debt and hope the problem gradually goes away. The problem is that Spain and potentially Italy are deflating; therefore the problem will not go away. Also the euro would decline leading to scope for significant inflation. My commodity basket is pushing its highs. At some point debt monetization becomes suicidal."

Last but not least, says Sayed, is the Icelandic option. This basically involves heavily indebted nations restructuring their borrowings and forcing their bond-holders to share some of their pain – the famous “haircuts” so partial to German chancellor Angela Merkel.

"Already there are discussions taking place about a managed default where deposits and payment systems would be transported into a “good bank”. Bank loan books would be excised and the bank would be infused with new capital through “bail-in” procedures, where bond-holders receive equity. A mechanism would be necessary to manage cross-border banks."

The main risk of the Icelandic option is that it would spark sell-offs of Spanish, Italian and Belgian debt, causing bond spreads in these markets to dramatically widen, and potentially forcing debt restructurings there too (the so-called "contagion effect").

The losses from such restructurings could create a Lehman-like effect across the shadow banking system, warns Sayed. Even so, he believes an Icelandic solution is the “second best solution if a Marshall Plan option is unfeasible.”

Interestingly, such thinking is gaining traction in the chancelleries of Europe. According to the BBC, the EU is considering making future bailouts conditional on bondholders first taking a haircut (after the EFSF expires in 2013). The BBC report said:

"In future, Brussels may require a crisis-stricken eurozone government to force losses on its existing private lenders - including investors in government bonds - before it would provide a bail-out package."

However Sayed is disappointed that a Marshall Plan II is not on the cards, given the IMF’s (i.e. America’s) willingness to pump more money into salvaging Europe. He believes the main obstacle is the determination of Northern European nations to make the profligate south suffer. He said:

“I can understand the sentiment and it can be done to a limited extent, but they will force the people to rebel against austerity. At that point, the whole experiment unravels. If the EU wants its venture to succeed, they have to think growth and restructuring, not austerity."

Further reading on the European economy and Europe's financial crisis:

Tags: EU , European Central Bank , European Monetary Union , Greece , Ireland , sovereign debt
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