A Vulnerable Equilibrium

Jens Nordvig: The Fall of The Euro

National Review Online, April 29, 2014

He ate poisoned cakes and he drank poisoned wine, and he was shot and bludgeoned just to make sure, but still Rasputin lived on. And that gives me just enough of an excuse to use the mad, almost indestructible monk to begin an article about a mad, possibly indestructible currency. The euro has crushed economies, wrecked lives, toppled governments, broken its own rule book, made a mockery of democracy, defied market economics, and yet it endures, kept alive by the political will of the EU’s elite, fear of the alternative, and the magic of a few words from Mario Draghi, the president of the European Central Bank (ECB) back in July 2012.

Speaking to an investment conference, Draghi said that, “within our mandate” (a salute to watchful Germans), the ECB was “ready to do whatever it takes to preserve the euro.” “Believe me,” he added, “it will be enough.” Those few words, and their implication of dramatic market intervention, did the trick. Financial markets calmed down, and there are now even faint hints of economic recovery in the worst corners of the euro zone’s ER. And all this has happened without the ECB’s actually doing anything. Simply sending a signal sufficed.

The crisis has been declared over by the same Brussels clown posse that always declares the crisis over. They may be right, they may be wrong, but a calm of sorts has descended on the euro zone — not peace exactly, but quiet, punctuated occasionally by tremors that may be aftershocks, but could be omens of fresh chaos ahead.

That makes this a good time to take a look at The Fall of the Euro, a guide to the EU’s vampire currency by Jens Nordvig, global head of currency strategy for the Japanese investment bank Nomura Securities. If you are looking for a quick, clear, accessible account, free from financial mumbo-jumbo, that explains how the euro came to be, why trouble was always headed its way, what was done when the storm broke, and what might happen next, this book (which was published last autumn) is an excellent place to start.

It is written from the point of view of a market practitioner. Nordvig is not too fussed about the deeper European debate. He mainly wants to know what works. Here and there he will nod politely to democratic niceties, but this is a book where worries over lost sovereignty are dismissed as “sentimental.” Overall, Nordvig is a supporter of closer European integration (“a noble ideal,” he maintains — it isn’t, but that’s another story), but one with considerably less time for illusions than most in his camp.

And the euro, he argues, was built — and run — on illusions, the illusion that Germany was Italy, Italy was Portugal, and Portugal was Finland, the illusion that one size would fit all. Its creation was a “reckless gamble.” Politics prevailed over economics. No one made any preparations for the rainy day that could never come. The foundations for catastrophe were laid, and then built on by regulators, policymakers, and financial-market players only too happy to believe that the impossible was possible. Imbalance was piled on imbalance, and a shared currency masked the nightmare developing underneath. Employed by Goldman Sachs at the time, Nordvig saw how markets viewed the euro zone as an indivisible whole. But Greece was still Greece. And Germany was still Germany.

“Policy makers,” writes Nordvig, “can attempt to circumvent the basic laws of economics, but over time, the core economic truths take their revenge.” Unsustainable boom was followed by what has seemed, until recently, like permanent bust.

Nordvig does a fine job of explaining how the euro zone has been kept intact since the storm first broke, but he focuses more on the how than on the implications. Thus he relates how some of what has been done appears to “circumvent” a clear legal prohibition on European Central Bank financing of public-sector deficits, but seems to see that as more of a curiosity than cause for concern. But concern is called for: The EU’s combination of lawlessness at the top (remember how the Lisbon Treaty was used to “circumvent” those French and Dutch referenda) and tight control over everyone else has been a hallmark of tyranny through the ages.

Then again, financial types generally focus, understandably enough, on the financial rather than the political. But when the two look to be at risk of colliding, market attention shifts. Nordvig suspects that the euro zone may be getting closer to one of those moments.

He sees the euro zone as having emerged from its travails into what is now a state of “vulnerable equilibrium.” But to work properly, it needs substantially deeper fiscal and budgetary integration — something resembling the set-up that underpins monetary union in the U.S. He’s right about that, and that he is goes a long way toward explaining why euroskeptics are so opposed to the single currency. A realist, Nordvig concedes that the political support for such a step is simply not there, and he’s right about that too. New Yorkers might grumble about the way that, courtesy of the federal government, they effectively send cash to Mississippi, but they accept that their two states are in the same American boat. Germans look across at the Greeks (and other mendicants) and realize that they have been conned into bailing out a bunch of foreigners. That’s why, when Germany accepted the need for some sort of fiscal union to keep the euro zone in one piece, it insisted (as Nordvig explains) on an arrangement that falls far short of how such a union is usually understood. The Fiscal Compact that ensued is intended to minimize deficit spending in euro-zone member states rather than give Brussels additional spending power, spending power that could have been used to help out the battered periphery. It is no “transfer union.”

All that is left for the euro zone’s weaker performers is yet more austerity (sensibly enough, Nordvig sees the current currency regime as akin to a gold standard, and not in a good way), adding further bite to the deflationary crunch which these countries face. And it’s a crunch made worse by the perception, both fair and unfair, that it is being imposed on them from “abroad.” Greece is not Germany. And nor is France.

With bailouts resented in the euro zone’s more prosperous north, and austerity loathed elsewhere, it’s surprising how passive voters have been. There are plenty of explanations for this, but Nordvig is right to stress fear of the turbulence that abandoning the euro might unleash (a fear reinforced by establishment propaganda and the failure of many of the euro’s critics to articulate a credible alternative). A residual attachment to that “noble idea” of closer European union has also played a part as has, Nordvig notes, the determination of the dominant parties of center right and center left to hang onto the single currency. That’s something that has left anti-euro, but otherwise mainstream, voters struggling to find an outlet for their discontent.

That said, the prolonged economic grind is increasingly forcing voters in the direction of less respectable parties (such as France’s Front National) that believe that the euro zone and EU need much more than a mild course correction (the FN would pull France out of the euro). If these parties gain significant ground in May’s elections to the EU parliament (the betting is that they will), the danger (or opportunity) is not that they will overthrow the prevailing consensus in the EU parliament (they have neither the numbers nor the cohesion to do that), but that their success will shove their mainstream opponents in a more euroskeptic direction back home. Credibly enough, Nordvig identifies the possibility of a revolt within the political center (which could take very different forms: The Finns, say, may decline to support another bailout, while the Greeks might eventually turn away from austerity) as another potential block on the road to the closer integration that the single currency needs.

Even if the euro zone’s leadership does manage to fumble its way to agreeing on how closer integration could be secured — a deal that would inevitably involve massive transfers of sovereignty to Brussels — it will not be easy to push such a package through without the approval of a referendum or two. On past form, and in the electorate’s present mood, that will not be easy.

But, warns Nordvig, “if further integration is not feasible, some form of breakup is inevitable.” Nordvig may be sympathetic to the European project, but he is too much of a realist to pay too much attention to the Brussels myth that there is no alternative to preserving the euro “as is.” Specifically, he rejects the argument that, just because a “full-blown” breakup would be cataclysmic (as Nordvig convincingly shows, it could well be), all forms of breakup must be too. That’s a claim he heretically and correctly regards as little more than “a convenient tool to bind the euro zone together” and one, moreover, that has been used to stifle any proper analysis of what the costs and benefits of, say, a particular country’s quitting the euro might be. Such a departure, he believes, could be engineered “without intolerable pain.”

In understanding what Nordvig means by this, pay attention to his observation that “the cost of exit may be more concentrated around the transition phase, while the cost of sticking with the euro accumulates gradually over time.” Jumping out of a burning building is never easy, but it often beats the alternative.

Nordvig deftly summarizes what the costs and benefits of that jump might be, concluding that quitting the euro would be very tough for Ireland, Greece, Portugal, and Spain, easier than perhaps expected for France and Italy, and easiest (although far from problem-free) for Germany (I’d agree). That’s a position that logically takes him not too far (although he doesn’t quite arrive there) from support for a division of the single currency into northern and southern euros, something that has, in my view, long been the way to go. According to Nordvig, however, the most likely quitter is a country reduced to a state of such excruciating agony (not only in that burning building, but on fire) that exiting the euro finally comes onto the agenda. That is highly unlikely to be Germany, the nation most able to cope, inside the euro and out.

So what happens next? Suitably cautious in the face of such an uncertain environment, Nordvig lays out a number of different scenarios. While accepting, as he should, that political turmoil could upend everything, Nordvig appears, on balance, to conclude that the German austerity model will prevail, that a transfer union will be avoided, and that the euro zone’s laggards will trudge their way to an excruciatingly slow recovery. My own suspicion is that this assumes too much patience on the part of the periphery. Pushed both by common sense and fear of an increasingly unruly electorate, its governments will start a slow-motion revolt against what remains of the hard-money ECB that the Germans were once promised. Still in thrall to the cult of “ever closer union,” and terrified of the alternatives, Germany’s leadership will acquiesce. In fact there are clear signs that this process may be well underway.

This will lead to another of the scenarios sketched out by Nordvig. Loose money will try to fill some of the gap left by the transfer union that never was, and will do so just well enough to enable the euro to survive, but as a currency that is more lira than deutsche mark. That will be yet another betrayal of taxpayers in Europe’s north, while leaving the continent’s south still trapped in a system that does not fit.

And for what?