- Tue, Nov 29, 2011
Macro Focus: Europe’s Rock, and its Hard Place
Given the incessant focus thrust upon Europe, and with an inflection point seemingly imminent, I thought it worthwhile to take a moment to explore the blocs two options: break-up or backstop.
This fall, economists at UBS Investment Research made an attempt to quantify the costs of a euro break-up. If a feeble and unstable country like Greece were to leave the monetary union, it would almost certainly have to default on its sovereign debt, and indolently watch its domestic banking system fold as depositors rush to withdraw euros before they are replaced with new and noticeably less-valuable drachmas. Unrest at a level not yet seen would certainly ensue. UBS projected that a “weak” country like Greece or Ireland leaving the euro would take a whack to their GDP of up to 50 percent in year one, with an additional 15 percent per annum over the next few years. That is an unimaginable and crushing shock, which would likely take a generation to recover from.
The other side of the break-up coin looks like this: a financial stalwart like Germany decides to leave the euro in order to preserve both its regional economic prowess and political compass. Sounds like a no-brainer fix for a country that is resolutely opposed to bailouts and the moral hazards they carry.
It’s not.
True, Germany would not default on its sovereign debt — quite the contrary, its new currency would undoubtedly be more valuable vis-à-vis the old euro — but the problem is its banks would suddenly be awash in assets denominated in the old, relatively-devalued euro. Bank balance sheets would become a mess, and Germany would have to inject a colossal amount of money into cleaning up its financial sector [see: bailout]. Too, the country’s exports would likely be profoundly dented as the new high-value Deutsche Mark renders German goods less price competitive on the global stage. This is deeply important because Germany’s economic engine is heavily influenced by its export market; an export market that is the second largest in the world, per WTO statistics. According to UBS estimates, all told the aggregate cost of breakaway to a country like Germany would probably reach 20-25 percent of their GDP, and persist at about half that for a couple years thereafter.
Taking it a step further, the team at UBS suggests that it would be much cheaper [by a long shot] for Germany to simply bail out the PIGs [ex-Italy]. According to their math this route would cost approximately 1,000 euros for every German man, woman and child. If, however, Germany were to exit the euro zone the cost would be 8,000 euros per German in year one, and 4,500 euros in the subsequent few years.
Myself, along with other members of the Albion research team have performed a similar mathematical exercise to which we derived very similar conclusions. Both are proprietary estimates in effort to explain and demonstrate the same thesis – the cost of disbanding the currency is greater than the cost of the bailouts. As abovementioned, bailouts are strongly ostracized in Germany, and for reasons we can all understand, but they do appear to be the cheaper path. Of course, critics could point out that the analysis doesn’t include Italy, the current 800-pound gorilla in the room.
Enter Bernard Connolly.
The renowned analyst and ex-EU monetary economist estimates that it would cost Germany 7 percent of its GDP for several years to bail out all troubled euro zone countries. Indeed, the Connolly analysis includes Italy; he even threw in France for good measure. Armed with this understanding, bailouts again look to be a less-painful and messy option at this point. This is why our position has been – and will continue to be until data to the contrary surfaces – that it would be foolish for Germany to allow the euro to fracture. Put plainly, it just isn’t in their best economic interest.
The clear path, though admittedly difficult, is euro zone locomotion toward selected levels of fiscal integration in concert with an enhanced monetary backstop – be it from the ECB, EFSF, IMF, ESM, the Fed, or a joint arrangement of this alphabet soup – as the best course of action. This is likely the highest probability outcome.
Unfortunately, as is so often the case with many of life’s challenges, the most reasonable solution is not often clear to those in the trenches until great losses have befallen. Here’s to hoping policymakers appreciate this before these great losses occur.
Jason Ware
Market Strategist, Analyst
(801) 487-3700; (877) 487-6200
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