With regard to Europe, it’s interesting how the semantics of the phrase “everything necessary” has been used to obscure the differences between Euro-area countries when it comes to monetizing bad debt. The distinction can be seen in a comment last week by German government spokesman Georg Streiter: “The ECB president said that the ECB will do everything necessary to preserve the euro and the government will do everything politically necessary to preserve the euro.” As long as the phrase is shortened to “everything necessary,” everyone is in agreement. The differences are in the subset of actions that constitute “everything.” For the German government, it is everything politically necessary. For Finland, it is everything necessary provided that collateral is pledged for every loan. For the German courts, it is everything legally necessary. While everyone can be unanimous about their commitment to doing “everything necessary,” it’s important to recognize that “everything” means something different to each party.
Even Mario Draghi had to resort to oxymorons to explain why the ECB did not initiate bond purchases last week despite what investors had taken as a pledge to do so, saying that the endorsement of bond purchases among ECB council members was “unanimous with one reservation” (he then left to enjoy some jumbo shrimp in a plastic glass, but they were found missing, leaving Draghi and his broken fix for an enduring Euro alone together in the deafening silence).
My impression regarding the Euro remains unchanged – liquidity will not durably counter insolvency, and the solvency problem among peripheral European countries is too great to be addressed without debt restructuring. ECB purchases of distressed sovereign debt would most likely have to be permanent purchases, and would therefore represent a fiscal transfer at the expense of stronger countries that would prefer to use the proceeds of money creation for the benefit of their own citizens. Doing those purchases indirectly – the ECB buying the debt of an ESM with a banking license, and the ESM buying distressed debt – does not change the arithmetic. Very reasonably, Germany is only willing to mutualize the debts of its neighbors if it can exert centralized authority over their fiscal policies – in Angela Merkel’s words “liability and control belong together.” But while Europe is geographically united, it is culturally and politically diverse, and a surrender of national sovereignty to the required extent is unlikely.
As a result, the Euro is likely to be pulled apart, and the tensions will probably be greatest across geographic and socioeconomic fault lines. From a geographic perspective, Finland (which insists on good collateral even for EFSF actions) and Italy (where popular sentiment against the Euro is strongest) have the greatest divide. From a socioeconomic standpoint, Germany (which is strongly anti-inflation and more oriented toward free enterprise) and the southern European states of Greece, Italy, Spain and Portugal (which have high debt ratios, heavily socialized economies, and very fragile banks) seem to be the furthest apart. The real question is who will get the Euro if the wish-bone snaps – the stronger more solvent states, or the weaker more inflation-prone states. Until the answer is clear, it will be difficult to anticipate the future direction of the Euro’s value. I would expect the least amount of systemic disruption in the event of an exit from the Euro by the stronger European countries, but that would also be associated with the maximum amount of Euro depreciation as the remaining members are left to inflate as they (and the ECB) please. All of this will be extraordinarily interesting, but it will not be easy.