by Andrew Balls, PIMCO
This article was originally published in thetimes.co.uk on May 28, 2012.
Amid great uncertainty and huge challenges in Europe, it can be helpful to cut through all the detail and map out what we know and what we don’t know. This is at best depressing and, at worst, terrifying.
What are the known knowns?
First, Greece is spiralling out of control. No good outcomes appear possible for Greece or the eurozone. They face only bad outcomes that will be chosen or forced. Arguments over the economics of Greece’s programme and creditor country demand for adherence to what looks like an impossible task have run into political and social rejection in Greece. The country’s political system is fragmenting and social unrest is sure to persist. While there may be a way for Greece to remain in the eurozone, an exit looks far more likely.
Second, this is not merely a Greek or a eurozone challenge. Across the world, rich countries are trying to de-lever in a controlled way while maintaining growth and jobs. The eurozone’s institutional challenges make this difficult task far worse. Individual eurozone countries are like emerging markets, borrowing in foreign currency in their susceptibility to a run on the sovereign. During a crisis, investors will go to the safety of the strongest balance sheet, which in the eurozone’s case is Germany. Italy and Spain are not insolvent countries, but nor can they maintain stable debt dynamics with nominal yields well above their nominal growth rates owing to the absence of a predictable central bank lender of last resort.
Third, the eurozone’s monetary and fiscal interventions to date have not succeeded in stabilising its sovereign debt markets and crowding investors in, in part because they have been reactive and insufficient and also because of the public slanging matches between European leaders and with and between central bankers. Rather, these interventions have financed the exit of banks and other investors retreating back within their borders and the exit of foreign investors. Bank deposit withdrawals now threaten to accelerate the process.
Fourth, it is a known known that the eurozone’s most important challenges are political, rather than economic. Measured by debt and deficit levels, the eurozone is no worse off than the United States or Britain. The challenges are of co-ordination among countries and regional legitimacy, as governments try to overcome disagreements over how to mutualise the risks within the eurozone and on the proper role of the central bank.
Finally, it is clear that the eurozone status quo is not sustainable. A risk of a Greek exit and/or bank runs across the eurozone threatens to press fast forward on the crisis.
Turning to the known unknowns, it is unclear if the eurozone’s governments have the technical capacity to administer what will be a difficult process of managing the crisis in the short term and of integrating the eurozone over the medium term. It will require some combination of: policy and political coordination; measures to reduce the vulnerability of the banking system; the European Central Bank acting as a credible, committed lender of last resort for sovereigns to prevent self-fulfilling runs; closer fiscal union involving the mutualisation of debt in the form of guarantees or common eurobond issuance and a pooling of fiscal sovereignty; a more sustainable balance between the need for growth and the need for fiscal retrenchment; and, most likely, support to facilitate a managed Greek exit and limit the run on the eurozone as a whole. Indeed, the signal from a Greek exit that this is not an irrevocable currency union but a fixed but adjustable exchange rate could unleash a re-pricing of currency risk across the eurozone’s private markets, not only the government bond market, heightening the risk that the technical capacity to respond is overwhelmed.
This difficult prognosis is compounded by the huge known unknown over whether the eurozone’s leaders have the ability to overcome their co-ordination challenge and lay out an immediate plan to deal with a Greek exit, to defeat spiralling contagion risk in the short term and to build a more stable eurozone in the medium term.
Perhaps hardest of all, there is the known unknown of whether European populations will support or at least acquiesce in the face of miserable economic conditions, the pooling of sovereignty and greater transfers across borders.
Taking together the known knowns and the known unknowns, it seems likely that the eurozone’s big four — Germany, France, Italy and Spain — as well as other German satellite countries will find a way to hang together in a smaller currency union backed by stronger regional co-ordination and financing mechanisms.
But it will be difficult and costly and the tail risk of failure is very fat, indeed.
For investors, the balance of risks suggests preparing for the worst, even if, as citizens, we hope for the best. This would include limiting exposure to real confiscation risk in the eurozone and focusing instead on better global alternatives available in countries with stronger balance sheets, exposure to better growth prospects and less intractable governance challenges.
Copyright © PIMCO
