Euro breakup : Why Morgan Stanley is wrong

A few months back Morgan Stanley analyst Joachim Fels produced a set of warning signs that would indicate the Eurozone was at increased risk of breakup. He’s back today with a new research note

To be clear, we neither advocate a EUR break-up nor is this
our main scenario. However, the risk that it happens is far
from negligible and the consequences for financial markets
would be severe. Given recent developments, a break-up
scenario has clearly become more likely, for two reasons.
First, the lesson for other euro area members from the Greek
bail-out package is that no matter how badly you violate the
SGP guidelines, financial help will be forthcoming, if push
comes to shove. This introduces a serious moral hazard
problem into the European equation. Fiscal slippage in other
countries has now become more rather than less likely in our
view.

Introduces a serious moral hazard? Bollocks. Look at the timelines people! 5th of November the Greek government admit they (previous administration) had been lying, on the 20th of November the ECB threw them to the wolves (by tightening collateral obligations which meant there was a good chance Greek government debt would become unacceptable). Come December, the Greeks were desperately scrambling for the lifeboats, the Socialist Party implementing the first round of pay cuts and other austerity measures. Throughout most of the first half of this year, Greek screams of pain were met with varying degrees of indifference from the rest of Europe. It was only after significant additional austerity was promised, riots that left three dead and the bond market had completely sunk Greece that the European creditors reacted with a credible bail out plan. There is no moral hazard here. The Greeks were dealt a savage, bloody, beating by the European Central Bank and the European creditor nations. No Greek government will ever want to repeat this experience.

Joachim continues –

Second, the ECB’s climb-down on its collateral rules
regarding lower-rated bonds, which ensures that Greek
government bonds will still be eligible as collateral in ECB
tenders beyond 2010, adds to this moral hazard problem and
confirms that the ECB is not immune to political
considerations and pressures.

Which kind of misses the point. The ECB was already accepting those bonds, withdrawing that right is what made Greek vulnerable to attack in the first place. In fact the inverse is true here, had the ECB not reversed it’s decision Greece would have been forced to default – perhaps threatening the solvency of the entire Eurozone.

It’s easy to misinterpret incentives, we saw much the same thing around the proposals for the EU ratings agency. The assumption seemed to be that the agency would kindly rate the debt of deliquent EU rule breakers as AAA. Why would European creditor nations, like Germany, want that? More likely they’d want a ratings agency that does it’s job and alerts them to problems before they’ve blown out of all proportion. An agency which doesn’t have a track record of rating junk sub-prime loans as investment grade (grippling European banking systems). But no, the thought processes were, that the Germans want a ratings agency that will lie to them so they can lose money on Greek debt. Yeah, right.

Anyhow, Joachim has some arguements about a weakening Euro

The shift from the initial fiscal problem in the
periphery (Greece) has now become a fiscal problem for core
Europe; more importantly for the euro, it has also undermined
the credibility of the ECB. The ECB’s priority has not been to
focus on the euro as a store of value but has shifted to
helping stabilize the situation. Its role as lender of last resort
has been fully tested and arguably its independence
undermined now that it is buying government bonds to help
ease Europe’s debt problem. There is little doubt in our minds
now that through this crisis there is growing evidence that the
euro is no longer a hard currency like the deutschemark but
something softer. If this is true then those that hold euros
might be less willing to hold them and, as Exhibit 5 shows,
investors – especially central banks and equity investors –
have bought significant amounts of euros since its inception in
1999.

While this is all true, it ignores the fact that the Federal Reserve has been doing this and much, much more since the crisis began. It also ignores the fact that a store of value is a two-way street. The Euro must not become a debtors prison, debt-deflation which would increase the value of real debts must be avoided. If anything the ECB is behind the curve on this, having demonstrated toughness in dealing with fiscal indiscipline Jean-Claude Trichet should perhaps reread Ben Bernanke’s seminal ‘Deflation making sure it doesn’t happen here’ and initiate an EU-wide monetary stimulatus blitz, that would offset the deflationary measures being taken by the governments of the PIIGS. A weaker Euro is a good start, but if that doesn’t do the trick, perhaps he should note we don’t need a helicopter – just a debit card for every man, woman and child pre-loaded with €10,000 courtesy of the ECB. That will do nicely (and if we really need a new treaty for this – I confidently predict a landslide!).

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  • More likely they’d want a ratings agency that does it’s job and alerts them to problems before they’ve blown out of all proportion.

    That may be what they wanted (which is arguable), but that doesn’t mean that’s what they would get. State-controlled vehicles have a very poor track record in producing credible independent data. Remember how the UK Treasury forecasters conveniently changed their definition of the economic cycle so that Gordon Brown could keep spending without breaking his Golden Rule? (whatever happened to that, BTW?)

  • Mack

    That’s a vehicle under the control of the UK government responding to the needs of the UK government (this more complex, the EU consisting of many governments and having the general interest of stability at heart). The US rating agencies inflicted incredible damage on the Euro system when they rated sub-prime debt AAA, I imagine an EU ratings agency would be more cautious about giving investment grade status to similar foreign products in future.

    On Greece and Germany – it’s likely in the eye of the storm the thinking was that Greek debt wouldn’t have been rated junk and that the storm would have then subsided without shock and awe. I accept that was probably the overriding emotion at the time, and that in itself would be a strong incentive for creating an EU ratings agency. But such an agency wouldn’t exist simply for an instant, it would be constantly appraising debt.

    Given that it was the creditors calling for it, the incentives would stack up for the agency in ordinary times to be pretty strict (esp. given the damage caused to German banks by subprime, and now potentially via the risk of Greek default). My guess that an EU-ratings agency would be more vigilant about the delinquent fiscal policies leading to unsustainable debts in the EU. Given that such an agency would have real market power, and we’ve already seen that the ECB, France and Germany were prepared to allow Greece to be knocked about by the markets because of their fiscal deliquency. It could actually be a pretty powerful force for enforcing stability within the Eurozone. I think the assumption that such a ratings agency would play nice with deliquents, just because it was proposed in the eye-of-the-storm when maybe the US agencies were a little harsh – misses the longer term view of where the balance of incentives lie.

  • Cynic

    The problem is that it was viable to do this for Greece (just). Its probably not financially or politically viable to do it for the rest of the PIGS especially Italy. There is a domino effect risk inherent in the Euro where so many have been fudging the rules and enforcement has been so lax that these problems have accumulated.

    I don’t think the risk is of total failure of the Euro. I think the real risk is of some states being blown out of the Euro leaving a solid core of stable economies around Germany. This will be a blow to the great project of a united Europe but not a fatal one.

    The other option is to accelerate integration but I don’t see a mood for that especially in Germany which has just experienced the costs of Eastern integration over the last 20 years

  • You, of course, realise that all this media attention on the euro is to divert attention away from the dire state of the dollar and their ballooning deficit and national debt, which will never ever so long as pussy is a cat, be repaid and they just want to go on printing greenbacks which allows them to purchase what they want from the rest of the world, basically for free, for that is what printed currency allows you to do.

    If you have some spare time take a look and listen to the three-parter videos here, starting with this one, to understand what they don’t want you to know. ….. http://www.youtube.com/watch?v=cr7vG0pnZCc

    Its two ugly Goliaths [$ and €] slugging it out to save a corrupt top dog/fat cat system which right royally screws everyone except the very few at the top of the tree p******* on everyone else and playing God with your sad, sorry lives and slave existences.

  • ForkHandles

    cheers mars. that vid was very interesting and quite scary ! its a 5 parter you know.. made me think about how all civilisations have fallen throughout history. we think now we have reached a level were we are too advanced to fall, but something as simple as the system of money grinding to a halt could make life as we know it cease and we’d be back in the stone age.

  • Kevin Barry

    The US rating agencies quite rightly get a bollocking, but so should the EU banks. At the end of the day, they too are supposed to do due diligence on their investments, however, they outsourced this to ratings agencies/never bothered looking at securities that, who they also bullied into giving AAA ratings for their funds, securities, debentures and hybrids.

    They got sloppy and we’re all paying for it.

    I would much rather prefer the democratisation of the whole ratings business instead of the ratings business as opposed to the ratings agencies becoming quangos

    Some food for thought; I recommend their views on Rating Agencies for a start

    http://www.makemarketsbemarkets.org/

  • “cheers mars. that vid was very interesting and quite scary !” … You’re very welcome, ForkHandles. And thanks for the 5 parter info.

    “we think now we have reached a level were we are too advanced to fall, but something as simple as the system of money grinding to a halt could make life as we know it cease and we’d be back in the stone age.” …… 🙂 Others would be thinking that man is still a primitive and not nearly advanced enough to make any lasting impression on life, and would be resolved to engage with significant others to change that pathetic situation, sublimely, and would judge that with the simplistic control of the money system in better hands …. under new much more intelligent Virtual Machine Management …… is it most easily seamlessly achieved.

    To go back to the stone age whenever just pieces of printed promissory paper can deliver as much wealth as is needed to deliver whatever future you can imagine and build/present, or as is more the case, pay others to build and present for you, is never going to be the Future and ITs Reality, which is, even as we consider these words, being built Virtually with Loded Text HyperRadioProActively Transmitted for CyberIntelAIgent Use/Global Command and Control.

    And should you think that to be just too far fetched to believe, does your disbelief unbelievable aid its rapid progress completely unopposed in an Immaculate Stealth Program. It is though of concern to others, who may not know exactly what it is they are concerned about but recognise that something irregular and unconventional is afoot and running rampant/riot in Global Operating Devices and SCADA Systems ……. “The U.S. is nearing total reliance on the integrity of cyberspace. This trend is irreversible. A small number of people, states, and organizations can manipulate cyberspace with devastating effect. The expense of cyber intrusion prevention systems is very high and can never be completely effective because the identity of the threat cannot be determined with a high degree of certainty.

    For the immediate future, unless there is a technological breakthrough, society must adapt to the new reality—that cyber threats are inevitable and pervasive. The new phenomenon is that nefarious actors can cloak their identities in virtual worlds and operate freely with relative impunity.” …. http://nationalstrategy.com/Portals/0/documents/Winter%202009%20NSFR/Chapter%207.pdf

    And to not positively engage, results in a overwhelming power surge to smarter engaging alternative entities/more intelligently competitive, rather than intelligently challenged, contemporaries, whom I suppose, in some challenged channeling minds, would be considered and treated as adversaries rather than embraced as a much more advanced leading partner.