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
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
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!).