Here We Go Again

The Weekly Standard, April 30, 2012

Penas Blancas , Spain, 1972 © Andrew Stuttaford

A phony peace is unlikely to end much better than a phony war. When the European Central Bank (ECB) poured a total of $1.3 trillion in cheap three-year funding into the continent’s financial institutions, that’s what it got.

Sure, it beat the alternative. Lehman part deux was staved off yet again. All those billions (and the suggestion of future ECB support that they represented) were enough to restore confidence that Europe’s sickly banking system would not crumble too far or too fast—for now. Between the announcement of the first of the bank’s long-term refinancing operations (LTRO) in December and the arrangement of the second at the end of February, many of Europe’s stock markets soared, and yields on much of its sovereign debt fell. But that was then and this is now. Dodging a bullet is not the same as victory. That trillion-and-a-bit bought time as well as confidence, but it bought less breathing space than was first hoped, and what little it did buy was squandered. The markets noticed. The crisis is back. And Spain is taking its turn on the rack. But if it hadn’t been Spain, the fear would simply have settled somewhere else. On Portugal, perhaps, or on Italy, or maybe even France, take your pick.

Given the scale of the problem, the rescue party has been grudging. There was the ill-tempered finalization of the second ($170 billion) Greek rescue in March. There was also the gritted-teeth agreement in the same month to use the eurozone’s new $650 billion permanent bailout fund (the European Stability Mechanism) to complement, rather than replace, the existing “temporary” European Financial Stability Facility. But band-aids costing hundreds of billions are still band-aids, and the eurozone’s key political problem remains unresolved.

Those running the richer, mainly northern member-states continue to be unwilling to risk the wrath of domestic electorates already riled up by bailout after bailout and resistant to further moves towards the closer fiscal union that is the best hope of preserving the single currency in its current form. Many northern voters have grasped that this process would culminate in the creation of a grotesquely expensive bailout regime (“transfer union” is the polite term). Given the vast economic divergence that is found within the eurozone, this would endure through the ages. Over a century and a half after Italian unification, Naples is still not Milan. How long would it take to transform Athens into Berlin?

So for now the “fiscal pact,” the Merkel-driven attempt to enforce a shared budgetary discipline that was drawn up in Brussels in December before being finally agreed to in early March (it has yet to be fully ratified), is all that is going in the way of structural change, and to the extent that it’s going anywhere, it’s going in the wrong direction. The imposition of austerity on the eurozone’s stragglers may be good politics (in Germany, the Netherlands, and Finland anyway), but it is primitive, apothecary economics. Draining the blood out of enfeebled, tottering economies and then—fingers crossed—hoping that they bounce back into rude health is a dead end, not a discipline.

Consider the sorry spectacle of hopelessly dysfunctional, hopelessly uncompetitive, hopelessly indebted Greece. Its GDP will have fallen by almost a fifth between 2009 and the end of this year. The country is trapped in a spiral in which austerity (however overdue) is dragging its laggard economy ever lower, shrinking the tax base and thereby increasing the fiscal woe that better budgeting is meant to resolve. Greece holds a general election on May 6. With the political establishment under pressure, and radicals polling strongly, a dramatic rejection of the apothecary regime cannot be ruled out. And the markets know this all too well. They also recognize that Portugal, now doing its best to adapt to the single currency for which it was never going to be suited, but struggling badly, is headed towards a second bailout.

Then there’s the other Iberian nation, Spain, the twelfth largest economy in the world and, therefore, potentially much more of a problem than, say, puny Greece, a country that took an infinitely more self-indulgent route to hell. Prior to the crash, Spain’s government finances were decently managed. Debt stands at around 70 percent of GDP, even now a ratio that is far from the worst in the eurozone, but it has been rising rapidly (the budget deficit was 8.5 percent of GDP in 2011). Overspending by this highly decentralized country’s regional authorities is emerging as a major problem, but the most dangerous poison may be brewing in the banks.

Like just about everywhere else, Spain saw a massive construction and real estate boom in the 2000s. This was fueled by low interest rates that reflected conditions in the eurozone’s Franco-German core rather than Spanish reality, as well as the belief, cheer-led by Brussels, that the economies of the currency union’s members were converging when, particularly as compared with Germany, they were doing anything but.

The bust that followed that boom took down a large chunk of the Spanish economy (unemployment stands at 23 percent, over 50 percent among the under-25s, a disaster exacerbated both by Spain’s sclerotic labor market and the malign impact of apothecary economics). There will be more misery to come. The IMF is forecasting that Spanish GDP will shrink by 1.8 percent in 2012. If Ireland is any precedent, and if the apothecaries have their way (the proposed deficit reduction amounts to a daunting 5.5 percent of GDP over this year and next), Spanish real estate prices could fall by another third. Should that happen, the country’s battered banks are (according to Open Europe, a mildly Euroskeptic think tank) likely to take a hit too large for cash-strapped Spain to cover by itself.

And the knife has further to twist. When the first LTRO was announced, French president Nicolas Sarkozy had a bright idea. Each state could sell its bonds to its newly flush banks. At first glance, such a trade would not only be patriotic, but profitable. The yield on debt issued by the eurozone’s struggling sovereign borrowers would comfortably exceed the bargain rate that the banks were paying to borrow from the ECB. And that’s the “carry trade” that Spain’s banks made. Indeed, in the view of Open Europe, Spanish banks have been the principal (“essentially the only”) buyers of Spanish government debt since December. But these banks are fragile and frighteningly reliant on ECB support (their borrowing from the central bank almost doubled between February and March). What would happen if their vulnerability to Spain’s mounting economic distress, not to speak of their specific exposure to Spain’s real estate nightmare, meant that those banks could no longer keep buying? How would Spain’s bills then be paid? After all, membership in a currency union means that Spain (unlike, say, the U.K.) can no longer print its own way out of a liquidity crunch. As the University of Leuven’s Paul De Grauwe pointed out last year, a “liquidity crisis, if strong enough, [could] force the Spanish government into default.” Indeed it could. Spain has already (and wisely) issued about half the debt it will need for 2012, but the rest?

Wait, there’s more. Spain’s borrowing costs are rising (yields on its 10-year bonds have been testing, and sometimes breaking, the toxic 6 percent barrier), to a level that may not be sustainable. That’s bad enough, but those higher yields also mean that the value of Spanish bonds bought by Spanish banks playing that Sarkozy carry trade will have been falling, with unpleasant implications for their beleaguered balance sheets at exactly the wrong time. If you are looking for a fine example of a vicious circle, this will do nicely.

Optimists will counter that the European Central Bank can again help out. And they are right. As an institution subject to relatively low levels of direct democratic control, it is better placed to ignore the concerns of northern voters than many eurozone institutions. Meanwhile the IMF’s managing director is in full telethon mode. Maybe the IMF/G20 meetings (underway in Washington, D.C., as I write) will see agreements to fund a firewall large enough to reassure. Maybe, maybe, maybe .  .  .

Outside Spain, Portugal, and the carcass that was Greece, the theoretically praiseworthy reforms launched by the eurozone’s proconsul in Italy, the technocrat prime minister Mario Monti, are beginning to run into serious opposition. The country’s planned move to a balanced budget in 2013 has also been postponed by two years (for now). New spending cuts will add to the economy’s pain. Italy has revised its forecasts for 2012’s decline in GDP from 0.4 percent to 1.2 percent, but that’s a sunny projection when contrasted with the fall of 1.9 percent forecast by the IMF.

Then there’s France, facing a presidential election in which the increasingly clear favorite (as I write), Socialist François Hollande, is clearly no great fan of the fiscal pact. And finally there’s the awful, undeniable fact that lies at the core of this tragedy: One size does not fit all. Laurel cannot wear the same suit as Hardy. Portugal is not Finland. Greece is not Germany. A shared currency designed to bring nations together is tearing them apart. Confining them in a monetary union that, as constituted today, cannot realistically cope with the profound differences that define their economies is an insult to common sense, an affront to democracy, and a rejection of elementary decency. Those countries it does not loot, it will sentence to stagnation and worse.

No matter: Whether due to the (not unreasonable) fear of what a breakup could mean, or to fanaticism, careerism, or simple, dumb inertia, the eurozone’s political class is sticking with its funny money. As it does so, other Europeans are quietly passing their own judgment. Stories of capital flight from Greece are not new, but a recent analysis of eurozone central bank data by Bloomberg News appears to show that euros are flowing out of Italy and Spain and into Germany, the Netherlands, and Luxembourg at an accelerating and unprecedented pace.

Just a few weeks ago, Mario Monti declared that the eurozone crisis was “almost over.”

Not yet, I reckon.

A Bridge, but Leading Where?

The Weekly Standard, February 4, 2012

Purity has no place in a crisis. The 2008 TARP bailout was a clumsy, ugly, and rather shameful creation, but by signaling that Uncle Sam was in the room (with his printing press not far behind), it headed off the final descent into a panic that would have brought the banks, and, with them, the economy, and, with that, who knows what else, tumbling down. Three years later, another four-lettered program has been launched, this time in Europe, but once again designed to calm fears that were threatening to metastasize into catastrophe.

It was no coincidence that the European Central Bank (ECB) launched its first LTRO (long-term refinancing operation) on December 8, the first day of a two-day Brussels summit in which the EU’s leaders planned to show that they were really, really in control of a currency union on the edge of chaos. The central bank’s billions were intended to sugar the bitter pills that the Brussels summiteers were bound to prescribe—and did. The eventual, uh, “Treaty on Stability, Coordination and Governance in the Economic and Monetary Union” that was hacked out of those talks (and a second summit last week) combines the big-heartedness of Scrooge with the vision of Magoo and the credibility of Madoff. Its significance lies more in what it won’t do than what it will. Few were impressed.

The LTRO, by contrast, got off to a tremendous start. In the months prior to the new program’s debut the central bank had been criticized (not always fairly) for not doing enough to support the eurozone’s stumblebum banks. Its rescues were too ad hoc, too brief, and too grudging. Not any more: Just in time for Christmas, the ECB repackaged itself as Santa, offering out longer-term (three year) funding at highly attractive rates and, as an added bonus, not being too fussy about how it was collateralized.

The combination of one generous lender and many anxious takers produced a spectacular result. From across the eurozone, 523 banks borrowed a total of 489 billion euros ($641 billion), a far larger haul than financial markets had anticipated. This was a measure both of the easy terms being offered and the difficult straits in which so many European banks had found themselves. Lehman’s unquiet ghost was on the move. Trust in the banks was eroding, as was trust between them. Interbank lending was slowing, crimping the banks’ ability and willingness to lend money out into the “real” economy.

By December, credit to the eurozone’s businesses and consumer clients was falling at a rate that conjured up memories of the nightmare of 2008. With the currency union’s extended ordeal driving Europe into recession, the last thing anybody needed was credit crunch part deux to make matters even worse. Yet that is what the continent was getting. And the deeper the recession, the harder it would be for the PIIGS (Portugal, Italy, Ireland, Greece, Spain) to escape their budgetary hell, and, crucially, for their lenders’ faith in them to return. And so the vicious circle turns.

Initially, the market was unsure how to respond to the LTRO. Was the program’s size a reason for celebration or concern? But then sentiment changed for the better. Italy completed a number of successful bond auctions. Yields on French and Spanish government debt fell—while those of Germany’s safe haven bunds rose. The Rodney Dangerfield euro even made up some lost ground against the dollar. And this was despite the flow of dreary news that just would not go away. The impasse over the “voluntary” restructuring of Greek debt continued, Portugal slid closer, again, into bailout territory, there was a further round of ratings agencies downgrades (this time from Fitch), and hideous fresh reminders of the plight of the eurozone’s periphery continued to slouch into view. In late January statistics were released showing that Spain’s unemployment rate had hit 22.8 percent in the last quarter of 2011. For the under-25s the rate is nearly 50 percent.

But for now the glass was half full. The old TARP trick had worked again. The European Central Bank had not only supplied the banks with nearly 500 billion euros ($650 billion) in badly needed liquidity, but it had also signaled that it was there on the ramparts alongside them. The cash was important, the boost to confidence no less so, and the message will be rammed home with an LTRO 2.0 scheduled to take place later this month. Another gusher? Maybe. The standard guess is that this second round will amount to 350 billion euros or so, but some have speculated that the total could swell to as much as 1 trillion euros.

According to the logic of a seminal paper published last year by Belgian economist Paul De Grauwe, the very structure of the eurozone (monetary union without fiscal union) was an invitation to financial panic. Fears that money would drain out of the zone’s weaker countries would be self-fulfilling. One consequence is that the possibility of bank runs cascading through the system has been among the most dangerous of the many threats swirling around the eurozone. By supplying that extra liquidity, by promising a second helping, and by implicitly suggesting that in a pinch there could be even more, the ECB is trying to deliver the message that there will always be cash in the banks’ tills. No need to panic, or even think about panicking, after all.

Theoretically (and for now in practice) that should make it easier—and cheaper—for those eurozone countries not yet in intensive care to borrow on the international markets. There’s something else that may be helping too. One of the devices used to reassure skeptical Germans that the new European Central Bank would be more Bundesbank than Weimar was a broad ban on direct purchases by the ECB of government bonds from the eurozone’s members. There’s no equivalent rule, however, that stops commercial banks from using the LTRO loot they have just received from the ECB to purchase the bonds that the central bank cannot. Indeed the banks appear to have been incentivized to do just that. Using cheap ECB funds to buy high-yielding eurozone government bonds looks, at first glance (if not necessarily the second), like a nicely profitable carry trade.

Pause for a moment, though, to think through this money-laundering: Banks that have been weakened by their exposure to dodgy European sovereign debt were being encouraged to use loans (secured by similar debt, and worse) from an already highly leveraged central bank (underwritten by increasingly restive taxpayers) that was itself heavily exposed to identical crumbling borrowers, to buy even more of the same poison. Ponzi himself would have blanched. Nicolas Sarkozy, however, thought it was a great idea. “Each state,” he said, “can turn to its banks” to buy its bonds. Because thanks to the LTRO, the banks “will have liquidity at their disposal.”

It remains uncertain how many banks followed the French president’s advice. Quite a few, in all probability: Nevertheless a good portion of the LTRO proceeds have been placed right back on deposit with the ECB. The banks are still building fortifications in preparation for the day of reckoning they obviously fear may be on the way. That they are has something to be said for it (healthy cash reserves represent a handy preemptive strike against panic), but it is also a sign of a system that no longer believes in itself. The wider slowdown in lending that comes with it carries, as Europe has seen, its own terrible cost.

The next few months will show how effective the LTROs are at calming these fears. Somewhat, I’d guess, but sorting out the eurozone’s predicament will take more than the European Central Bank’s billions. The fundamental flaw of the euro was, and is, that this one-size currency does not fit all. All the liquidity in the world will not change that. Europe’s monetary union was assembled on the basis of political fiat rather than economic reality, and the economics and politics have both turned sour. And not just sour: They have combined into a murderous cocktail. Understandably enough, the looted taxpayers of the north want to see budgetary discipline imposed on the dysfunctional south. German chancellor Angela Merkel has been leading the posse pushing for just that. But too much austerity too soon is draining the ability of the PIIGS to generate the growth that is the only way out of their burning sty. More dangerously still, it is reaching the limits of the politically possible. Shuttered businesses, soaring unemployment, and the prospect of years of stagnation to come are not the stuff of social stability. If insults like the recent draft German proposals that would have ground into dust the last shards of Greece’s economic sovereignty (and much of what remains of its self-respect) are then added to the mix, an explosion is unlikely to be far behind.

The next moves will not be straightforward, but, if they want the eurozone to survive in its current form, those who control its destiny will have to reshape it into a cut that will eventually (if they are very lucky) have a chance of fitting all. They will have to make a drastic change of course. They will have to acknowledge that austerity alone is failing and move instead to fiscal union (and a permanent transfer payment regime) buttressed with, to quote IMF managing director Christine Lagarde, a “clear, simple firewall.” This, I’d guess, would have to be a jointly underwritten financing mechanism of a size (2 trillion euros?) that recognizes how prolonged and tricky this process will be.

Whether the voters will go along with all this is an entirely different and very pointed question, but if the eurozone continues to be run as it is now, the LTROs will turn out to be brilliant, necessary bridge financings that lead, ultimately, to nowhere.

Grade School

National Review, February 6, 2012

Niagara Falls, October 1989  © Andrew Stuttaford

When watching a disaster movie it’s occasionally worth pausing to take stock of where the main drama, obscured by subplots, rubble, and confusion, really stands.

Standard & Poor’s announcement, on, suitably, Friday the 13th, that it had downgraded nine euro-zone countries in various disapproving ways was a chance for just such a moment. S&P’s stripping France and Austria of their highly prized triple-A ratings grabbed the headlines. The downgrades of less-than‒Black Card nations such as Cyprus, Italy, and Spain (each down two notches, to BB+, BBB+, and A, respectively) added the clickety-click of tumbling dominoes to the story. But most striking of all was the rating agency’s release of answers to questions it anticipated it would be asked about the downgrades, answers that portrayed the euro-zone crisis in ways that Angela Merkel, in particular, will not have wanted to hear.

This mess is not, explained S&P, just about the debt. While their governments’ “lack of fiscal prudence” had undeniably played a part in some countries’ arrival in the PIIGS sty, not least in the case of a certain Hellenic Republic, this was not always the case. “Spain and Ireland . . . ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, [between] 1999 [and] 2007,” a period in which, the agency added, a touch cattily, Germany had run a deficit averaging 2.3 percent.

So what had gone wrong? S&P makes coy references to “boom-time developments” and “the rapid expansion of European banks’ balance sheets,” but appears unwilling to spell out too bluntly how the mirage -- promoted in Brussels, Frankfurt, and elsewhere -- of economic convergence (and whispered hints of mutual support) within the euro zone did so much to set in motion the spree of mispriced lending (Irish real estate is just one of many hideous examples) that has now unraveled to such destructive effect.

That’s a shame, because publicizing the truth about those years might have helped counteract the notion, heavily pushed by the EU’s elite, that the euro zone’s troubles are the result of market failure, when in fact they are the product of just the opposite. The devastation of recent years is in no small part the consequence of economic reality’s finally returning to a space from which it had been barred by the introduction of a “one size fits all” currency that was, of course, nothing of the sort. Perhaps S&P was concerned that dwelling too much on the misdeeds of the past might further infuriate a euro-zone leadership that has fallen menacingly out of love with the rating agencies that were once its accomplices (less than two years ago S&P was, remarkably, still treating Greek debt as “investment grade”) but are now, belatedly, stumbling along the road to long-overdue repentance.

Instead, the agency looks forward. As mirages tend to do, convergence is receding: “The key underlying issue for the eurozone as a whole is one of a growing [emphasis added] divergence in competitiveness between the core and the so-called ‘periphery.’” Indeed it is, and, with monetary union meaning that the zone’s weaker members are unable to devalue themselves back into contention, any reversal of this process will be extraordinarily difficult, if not close to impossible. And, as things now stand, they may no longer even be given the opportunity to try.

Up until now the PIIGS (as S&P does not call them) have been able to manage their “underperformance . . . (manifest in sizeable external deficits) because of funding by the banking systems of the more competitive northern Eurozone economies.” That party is now over.

So what to do? S&P argues that “a greater pooling of fiscal resources and obligations as well as enhanced mutual budgetary oversight” could buoy confidence and cut the cost of borrowing for the euro zone’s weaker brethren. What these arrangements would look like is not spelled out. What they would not look like is the misshapen agreement that slunk out of Brussels in early December, a pact that S&P clearly views as too little, too vague, and too stingy.

Thus, the rating agency is understandably skeptical about whether plans to advance the start date of the €500 billion European Stability Mechanism (the permanent bailout fund designed to replace the existing €440 billion European Financial Stability Facility) by twelve months, to July 2012, will make much of a difference. Tactfully enough, S&P does not speculate whether its own downgrading of some of the countries that stand behind the ESM will make that almost certainly inadequate entity’s job even more trying. In case you wondered, it will. And in case there was any doubt about that, on January 16, S&P downgraded the EFSF.

Although it never comes out and directly says so, S&P seems to want today’s currency union to evolve into something far closer to the Brussels dream (and democratic nightmare), a fiscal union that would be the logical complement to a monetary union encompassing 17 different countries. Left unstated, but surely implicit, is that this process would be preceded by the firing of the long-awaited, effectively German-underwritten “bazooka,” the resort (however artfully described) to the monetary printing press on a scale thought (fingers crossed) to be sufficient to extinguish the euro’s growing fever. The fever is one thing, but curing the underlying disease -- the competitiveness chasm -- would be the work of generations (how long do you think it would take to build a Portugal that could keep pace with the Netherlands?), and would be an immense challenge to the social and political order in countries struggling to adapt to the theoretically admirable disciplines of a currency for which they are in fact very poorly suited.

Meanwhile, even if they can get past historic memories of what Weimar’s printing presses eventually led to, the prospect of paying for what will be, by any reasonable reckoning, a prolonged, expensive longshot is something that horrifies the taxpayers in Germany (and elsewhere in the euro zone’s north) who would be stumping up the cash. That’s why Angela Merkel, a trial-and-error politician at the best of times, will give every alternative approach a go before marching her country down a route that would enrage the electorate that is supposed to be reelecting her in 2013.

But no other alternative is likely to provide much relief for long. S&P warns that “a reform process based on a pillar of fiscal austerity alone” may well prove self-defeating. However overdue they are, and however necessary they may be to sell the bailout parade to northern voters, austerity programs on the scale now being implemented in the PIIGS suck money, confidence, and demand out of their already battered economies. They shrink the tax base to such an extent that higher rates cannot compensate for falling revenues. Policies designed to cut deficits may actually end up increasing them. The PIIGS will have been chasing their own tails.

The markets understand this well. That’s why those PIIGS that can still tap the international markets have been finding it so expensive to do so. And that’s why there is such limited trust in a European banking system (already enfeebled by the 2008–09 financial debacle) that is, directly or indirectly, dangerously exposed to the woes of the euro zone’s laggards. And when there is limited trust in the banks, credit begins to freeze up. And when credit freezes, economies slow. And when economies slow, tax revenues decline. And when they do, bad deficits get worse. And, and, and . . .

If there’s one scrap of comfort to be found in S&P’s ruminations, it is in its observation that the European Central Bank has staved off “a collapse in market confidence” by a series of measures designed to prop up the EU’s banking system. Basically, the ECB has supplied Europe’s banks with large amounts of low-priced, comparatively lightly collateralized funding that, in December, grew to include €500 billion in three-year money -- and there will be more such bonanzas to come this year. That this may have left the ECB’s balance sheet looking like the books of an unusually generous pawnbroker is a problem, but it is a problem for another day.

All that money has bought some confidence, but not, unfortunately, a lot. Contrary probably to the hopes of the ECB, the banks have not been lured into using these cheap funds to “invest” in high-yielding government bonds issued by the likes of Italy. Instead the cash just piles up -- much of it, ironically, back at the ECB -- as nervous bankers wait for the crisis in which Angela Merkel is forced to choose between deploying the bazooka that saves the euro zone but destroys her career and (much, much less likely) abandoning the euro zone and taking a leap into the unknown.

That crisis will arrive. It could be triggered by Greece, which is teetering, as I write, on the edge of disorderly default, or maybe a spreading bank run will do the trick. There are plenty of possibilities to choose from. And that’s before the black swans come into view.

Clickety-click.

Euro Melee

National Review, December 1, 2011 (December 19, 2011 issue) 

Brussels, July 1985 © Andrew Stuttaford

The euro may not have brought Europe together, except in shared misery, but it has divided it in previously unimaginable ways. Votes can now be won in Finland by bashing faraway Greece, a place hitherto thought of in Helsinki (if at all) as a helpful supplier of beaches. Europe being Europe, the troubles of the single currency have also given a boost to more traditional antagonisms and, Europe being Europe, revived plans for a nasty new tax.

That tax, the financial-transaction tax, is now being pushed by Germany (with France scampering behind). Britain, already in the doghouse for allegedly not doing enough to help out the single currency it had rejected, is talking veto, while Germany, being Germany, is threatening to proceed regardless. Fleet Street being Fleet Street, there are warnings of a “Fourth Reich.” Many Greeks are saying (and shouting) the same thing, much to the fury of those German taxpayers bailing out a nation they see as idle, dishonest, ungrateful, and — old prejudices bubble up — a little too swarthy to be trusted.

It’s time to calm down. The financial-transaction tax is a thoroughly bad idea, with a dose of old-fashioned national nastiness thrown in (Britain would pick up a huge percentage of the tab), but Merkel’s demands for better budgetary discipline within the eurozone are, in theory, rather more easy to justify. If Germany is, one way or another, to underwrite the common currency, insisting that its money is not frittered away is good housekeeping, not empire-building. Not an empire in any traditional sense.

But Merkel is pfennig-wise but mark foolish (or she would be if such splendidly sound money still existed). She is set on defending Germany’s interests, but only within the parameters of the EU’s transnationalist, post-democratic agenda, to which, it seems, she subscribes. The appealing idea that Germany should, for its own good, quit the eurozone, either alone or in the company, say, of the frugal Dutch, remains off limits, and there is absolutely no prospect that Germany’s voters will be given any direct say on that topic. They never wanted the euro, but they got it. Now they are stuck with it.

And that’s how the EU, born out of a distrust of nation-states and their voters, was always meant to work. The difficulty for Brussels is that this system is now being tested as never before: The eurozone has become the site of a dangerous, chaotic, and half-hidden power struggle between its political and bureaucratic leaderships (which are themselves deeply divided on how far to take deeper integration, but that’s mainly a tale for another day), nervous financial markets, and increasingly riled-up voters.

This wasn’t on the program. To the extent that Brussels had any strategy at the time of the single currency’s launch beyond finger-crossing and prayer, it was that the eurozone’s inherently flawed nature (very different economies joined in monetary, but not fiscal, union) would eventually lead to an over-by-Christmas “beneficial crisis.” Financial markets would force through the closer fiscal union that politics could not deliver. Once that had been achieved, the zone’s individual nation-states would count for very little, and their voters for even less.

That’s not how it has worked out. The mechanics of currency union (more on that later) have combined with irresponsible sovereign borrowing and the economic horrors of recent years to foment a financial storm that may be too devastating to be harnessed in quite so “beneficial” a way. The crisis could yet work out (in that cynical Eurocratic sense), but the terrible damage it has already caused has driven home the real costs — political, economic, and financial — of the monetary union to electorates that have long been denied an effective say in its future. Now that they know what they now know, it will be more difficult to keep them on the sidelines.

But over in the PIIGS they are still huddled there for now. In the last few weeks, Prime Ministers Berlusconi and Papandreou have been forced out with shocking ease, replaced by technocrats bearing the Brussels stamp. Italy was issued a former EU commissioner, and Greece a former vice president of the European Central Bank. Neither man had previously been elected to anything. Who cares? The message to Italian and Greek voters was clear — beggars cannot expect to be, so to speak, choosers — and so far surprisingly few of the beggars have objected. So long as it is seen to be better to be in the zone than out, hairshirts and all, this argument will fly. Underlining this, Spain, Portugal, and Ireland have all held elections, and, in each case, the electorate supported austerity. But if virtue’s reward is too long delayed, that consensus could easily shift, and if that change in sentiment is not addressed by those in charge, there could well be serious disorder.

A kinder, gentler eurozone, fueled by the printing presses of a looser, laxer European Central Bank and, once fiscal union has been safely set up, significantly higher transfers from the frugal “north” to the PIIGS, might be one way of smoothing the path to some sort of recovery. But the rise of the populist True Finns, the collapse of the Slovak government, and the continuing success of Holland’s Euroskeptical Geert Wilders all suggest that growing numbers of northern voters are in not such a generous mood. The only fiscal union they would be likely to support would be more Scrooge than Santa. These voters are signing checks, not receiving them. Their concerns ought to count for far more than those of the pauperized periphery. And they just might.

Even in Germany, there is some evidence that portions of the overwhelmingly Eurofederalist political class are becoming unnerved not only by popular discontent (as a proxy for that, nearly 80 percent of German voters are opposed to the issuance of Eurobonds guaranteed by all the eurozone’s members) but also by clear signals of unease from the country’s powerful constitutional court over the liabilities Germany may be taking on. Merkel’s grudging responses to the bailout requests of the last two years may have been an attempt to maintain financial discipline, but they are also a recognition that her domestic voters once again count for something. And maintaining that tough stance is playing well at home. According to a new ZDF poll, the percentage of German voters who approve of Merkel’s handling of the crisis has risen sharply (from 45 to 63 percent) over the last month.

To the extent that Merkel is a fan too of a Scrooge-style fiscal union, this may actually strengthen her hand as the eurozone’s bad cop. That’s something that alarms another key participant in this drama: the financial markets. Market players are fond of a quick fix. They are not very interested in the plight of the eurozone voter. Most are pushing for closer integration (preferably Santa-style) as the only way to make the single currency work. Merkel has not appreciated this pressure, or the turbulence that has come with it, and she is not alone. The currency union echoes with the rage of a European political/bureaucratic class that prefers to blame the crisis on wicked “Anglo-Saxon” speculators rather than on overspending and the shortcomings of a gimcrack currency union that should never have seen the light of day.

And it’s in the operation of the latter that the immediate danger lies. As Paul de Grauwe of Belgium’s University of Leuven has noted, if markets panic about one of the eurozone’s members, euros will pour out of that country (let’s call it Greece), and unless that flow is somehow reversed, that country (unable to print its own money) will simply run out of cash, and it will go bust. As I said, let’s call it Greece.

That gives markets the whip hand, and that does not play well on a continent that has never really shaken off its command-and-control traditions. So long as financial markets bought into the euro dream, their exuberance was welcome and, indeed, encouraged in Brussels, Frankfurt, and elsewhere. There were few complaints about ratings agencies, banks, or speculators back then. Now the bubble has burst. The markets have woken up, and, as we all know, the results have not been pretty to see — and they are visible to all.

This has not pleased the eurozone’s leaders one bit. They have responded with an onslaught of measures — from bans on certain kinds of short sales, to the financial-transaction tax, and, even, an aborted plan to censor the ratings agencies — all designed to throw sand in the gears of the free market, cut financiers (whose pay, even higher than that of the Brussels elite, has long been a source of irritation) down to size, and, in particular, give those semi-detached Brits, arrogant Yanks, the greedy City, and even greedier Wall Street a very good kicking.

To be continued . . .

Tango Lesson

The Weekly Standard, December 12, 2011

Casa Rosada, Buenos Aires, August 2011 © Andrew Stuttaford

There are good days and bad days, but even on the good days the abyss is never too far away. The eurozone’s dangerously original mix of innovation, incoherence, and unaccountability makes it difficult to identify a single event that could finally push it over the edge. But, with confidence already shot, there is one obvious contender, a series of old-fashioned bank runs given a brutal new twist by the logic of currency union as cash pours out of the stricken banks and the country (or countries) that hosts them. Unless the European Central Bank could show that it has what it really takes, fear would feed on itself, credit markets would seize up, and that, quite possibly, would be that.

The extra liquidity offered by the Fed and other central banks on November 30 was a sensible precautionary move, but its extent and its timing were clear signs of anxiety that, while the eurozone’s leadership moves from grand plan to grand plan, the building blocks of disaster are falling into place. U.S. institutions are wary about extending short-term funding to many European banks. European banks are wary about lending to each other.

Of all the sickly banks surviving on the Rube Goldberg life support systems now being deployed in the eurozone’s grisly ER, Greece’s are probably (and the implications of that “probably” are appalling) the most vulnerable to the panic that could set everything off. Their country is the closest to default. If Greece goes under, its banks will, without fresh capital, go under too. So what are their depositors doing?

They are not yet running. But they are walking away at an ever quicker pace (deposits have fallen by over 20 percent since January 2010) that can only have accelerated since the moment in early November when Angela Merkel and Nicolas Sarkozy first conceded that a country’s eurozone membership might not be irrevocable after all.

To understand just how bad things could get, the best place to look is Argentina in early 2001. In 1991, just 10 years before, Latin America’s most gorgeously faded republic had decided to turn over its latest new leaf. It linked its peso to the dollar at a 1:1 exchange rate. This peg was backed by reserves held by a currency board. Despite its distinctly permissive, distinctly Argentine, characteristics, it was designed to use external market pressure to force the country into the tough financial discipline that it had found impossible to impose upon itself. Those Greeks who regarded the EU’s single currency as something more than a free lunch supported signing up for the euro for pretty much the same reason.

At first, the Argentine experiment worked well. The economy grew briskly, and foreign lenders were pleased to feed its growth in a manner well beyond the capability of Argentina’s relatively small banking sector. After all, they told themselves, the country had changed its ways, and, thanks to the peg, exchange risk had been hugely reduced. What could go wrong? If you think that sounds a lot like the talk that accompanied the prolonged surge in international lending to Hungary, Latvia, Greece, Ireland, and all the other future catastrophes crowded into the euro’s waiting room (and, subsequently in some cases, the eurozone itself) just a few years later, you’d be quite right.

What could go wrong, did: Deep-seated structural flaws within the local economy, a series of external shocks (starting with the Mexican crisis of 1994), weaker commodity prices, and stresses flowing from the fact that the dollar and the peso were an ill-matched pair all combined to push the country into difficulties made cataclysmic by ultimately unsustainable levels of foreign debt. Private lenders shied away. Private capital fled. Taxpayers hid. Ratings agencies screamed. The cost of borrowing soared. The resemblance to Greece in 2011 is unmistakable. Interestingly, the Argentine storm was gathering strength at the same time as Greece was being accepted, not without controversy, into the eurozone, raising the question what in Hades the EU’s leadership was playing at. The implicit warning for Greece contained in the Argentine disaster was as clear as Cassandra, and just as ignored.

In any event, as the 20th century lurched into the 21st, Buenos Aires previewed Athens. There were differences, of course, not least the fact that Argentina had hung on to its own national currency, but that meant less than it might have done. By the end of the 1990s, 90 percent of Argentina’s public debt was denominated in a foreign currency, marginally better than Greece’s 100 percent (for these purposes the euro is a “foreign” currency everywhere), but not by enough to give any comfort. And it wasn’t just the debt: Wide swaths of the economy had been dollarized.

And so had the banks: According to the IMF, close to 60 percent of the Argentine banking system’s assets and liabilities were denominated in dollars throughout the second half of the 1990s, leaving the banks horribly exposed in the event that the peg broke. Indeed, the potentially enormous cost of breaking the peg was a good part of why it was maintained, a logic similar to that now keeping the embattled PIIGS (Portugal, Italy, Ireland, Greece, and Spain) on the euro’s leash. This should come as no surprise: The stability that such mechanisms can bring largely rests on the absence of any obvious exits. Countries that sign up for them need to be sure that they have what it takes to stay the course. Slinking in on fudged numbers and, ludicrously, expected to maintain some sort of pace with Germany’s Porsche economy, the Greek jalopy stood even less of a chance than had far-better-intentioned Argentina.

Argentine headlines in 2000-01 must have read much like those in Greece today. The country accepted billions in international assistance (from the IMF) in exchange for the imposition of austerity measures that pummeled an already faltering economy. There was a voluntary debt swap (on terms as absurdly expensive as those proposed for Greece earlier this year) that bought time, but no confidence.

Massively widening spreads between peso and dollar debt signaled the market’s fear that the peg was doomed. But, to quote the IMF’s invaluable Lessons from the Crisis in Argentina (approved by one Timothy Geithner), it was “the resumption [in July 2001] of large scale withdrawals from Argentine banks [that was] perhaps the clearest sign of the system’s impending collapse.” Indeed it was.

The banks—and, of course, the country itself—were quite literally running out of the dollars that made up a monetary base already depleted by previous capital flight, and a growing current account deficit. The rules of a currency board (even in its looser Argentine variant) meant that it was not possible simply to print money to fill the gap. This is a problem familiar to those of today’s PIIGS who have to watch the money drain out of their economies, yet are blocked from direct access to the printing press by the European Central Bank. Argentina’s more sinuous treasuries (provincial and then national) tried to meet this challenge by issuing a series of evocatively named quasi-monies (IOUs, basically), but these patacones, porteños, quebrachos, and lecops were harbingers of doom, not a solution.

And when the dominoes of finance finally fall, they fall quickly. To return to the IMF’s grim textbook: “The crisis broke with a run [on] private sector deposits, which fell by more than $3.6 billion (6 percent of the deposit base) during November 28-30.” At that point the game was up. The authorities’ response (notably the introduction of the corralito) should alarm depositors throughout the PIIGS as they mull how their governments might stop precious euros escaping to safe havens abroad in the wake of bank runs at home.

The corralito limited cash withdrawals from individual bank accounts to the equivalent of $250 a week (the dollar value would soon fall sharply). And the response to it should worry those now running the PIIGS. Argentinians took to the streets and reduced the country’s political order to chaos. Depending on how you define the term, Argentina had five presidents in less than a month, but none could change the inevitable. The country defaulted on its debt, the peg was scrapped, the peso tanked, and the corralito was replaced by the corralón, the centerpiece of an even tougher regime. Depositors were allowed to withdraw a little more money than before, but only in heavily depreciated pesos. Term deposits were frozen, and transfers of money out of the country heavily restricted. Not so long after, dollar deposits were switched into pesos, and the ruin of Argentine savers, many of whom lost their jobs as the economy crashed, was complete.

History does not always repeat itself. Maybe those remaining Greek depositors are confident that, however battered their nation’s finances, its guarantee of bank deposits up to some $135,000 will hold up through the toughest times. Maybe they have faith that Greece will stick with the euro. And maybe they trust that, should the walk from Greek banks turn into a run, the European Central Bank will do what it takes to put things right. But if they do have any doubts, they can, for now, easily move their euros to a part of the eurozone—Germany, say—where there is no currency risk and bank deposits are blessed with a guarantor that is, you know, solvent. Thinking like that is how a run on the banks can begin. Paranoid? Well, if you were a depositor with a Greek bank, what would you do?

And, if you were a depositor in an Italian bank, watching all this and aware that money is ebbing away from Italy too, what would you do?

I know what the Argentine advice would be. Run.

And if the Greeks run, and the Italians run, who will be next?

The Euro Endgame

The  Weekly Standard, August 1, 2011

Billion by billion by billion, showdown by argument by ultimatum, Greece’s latest bailout is being put together by those who run the eurozone. The country’s finances are so bad, and its prospects so poor, that even the new $159 billion rescue package announced on Thursday will (assuming it comes into effect) probably only prove to be a reprieve.

Never mind. Buying time is the name of the game. If Greece can be kept going, and Portugal and Ireland too, financial markets might, fingers crossed, calm down, and the threat that panic might engulf Spain and Italy—two economies too big to bail out—and the banks that have lent to them might recede. Then, come July 2013, the $1.1 trillion European Stability Mechanism will spring to life. It will be backed by the 17 members of the eurozone, be policed by Brussels, and it will inherit the proto-IMF powers now being proposed for the European Financial Stability Facility that it will succeed. Well, that is the plan (at the time of writing), complete with a hint of Ponzi, a dash of Micawber, and dire warnings of what the alternative might be.

There’s a lot that needs not to go wrong, but of all the elements that could, the most dangerous may come from a source that Brussels has long tried to write out of the plot: the ballot box. There’s an irony to that. If there was anything (other than misplaced Carolingian nostalgia) at the heart of the project for a European union it was the idea that, after the wars of the first half of the twentieth century, the peoples of the old world could no longer be trusted with their own sovereignty. It’s never been much of an argument, but it’s worked well enough for the EU’s emerging technocratic elite.

The establishment of the euro is thus best understood as just another stage in the progressive disenfranchisement of Europe’s voters. The replacement of domestic currencies with what was, in effect, foreign money meant that, as a practical matter, the countries (and particularly the weaker countries) of the eurozone lost much of what was left of their fiscal and economic autonomy. Previously a nation with subpar finances and/or an uncompetitive cost base could allow the depreciation of its lira, its drachma, or its escudo to restore some balance. Its standard of living might fall relative to its international competitors’, but it could usually muddle along in the fashion that its people had, one way or another, chosen.

Now that option was closed. Forget the voters; once a country could no longer print its own money it had to run itself in ways that ensured it could keep international creditors—which is to say all creditors—happy. More generally, it had to manage itself in a manner that allowed it to keep reasonably close to the pacesetters of the monetary union in which it now dwelt—and if that country was Greece and the pacesetter was Germany, that was only going to be possible (if at all) with wrenching political and cultural change. That change might have been desirable, but to think that external discipline alone would be enough to set it in motion was a fatal conceit.

After 10 years in the currency union, Greece needs to devalue its currency by perhaps 50 percent. With no drachma to debauch, the only alternative is drastic austerity, and that is where politics may spoil the unlovely technocratic party that is now being thrown for the Hellenic Republic. In early July, Jean-Claude Juncker, the Luxembourger who presides over the organizing committee of the eurozone’s finance ministers, announced that Greece’s “economic sovereignty” would be “massively limited.” But what if the Greeks say no?

So far, their parliament has voted through what it has to, but the opposition is not on board, and the economy is being pulled down ever further by debts that cannot be repaid and a currency that Greece cannot afford. With unemployment at an official 16 percent (or 43 percent of those under 24) and further street disturbances a certainty, how long will it be before Greece decides that it has less to lose than its creditors from the “selective” default it is now to be permitted? The crisis has already brought down the Irish and Portuguese governments and contributed to the humiliation of Spain’s ruling Socialists in recent local elections. For all the Brussels chatter of additional “structural funds” to be deployed in the “relaunch” of the Greek economy, how much do Greece’s politicians really have to lose by calling Juncker’s bluff?

Faced with a future that offers, at best, a bleak and humiliating road ahead, their counterparts in other PIIGS (Portugal, Ireland, Italy, Greece, and Spain) may come to feel the same. Thus the Irish are reexamining the wisdom of guaranteeing the liabilities of their broken banking system to the extent that they have—a promise that, at this stage, may be worth more to foreign creditors than anyone at home.

Those who have found themselves feeding PIIGS are unhappy too, nowhere more so than in Germany, the country that is effectively underwriting the euro, a currency that—true to Brussels form—its electorate was never truly asked to endorse. As for the risks, they were barely discussed with voters, and when they were discussed, they were denied. German taxpayers would not be on the hook for anyone else, oh no. But that’s not how it has turned out for them, and they are not well pleased.

This has put German chancellor Angela Merkel in a spot. Without German support for the eurozone’s crumbling periphery, decidedly unselective defaults will trigger the financial contagion that policymakers are trying to avoid. For all her disapproval of PIIGS sty failings, the pragmatic Merkel understands this perfectly well, but her power to force through another round of assistance is not what it was. She still commands a comfortable majority in the Bundestag, but, in part thanks to the controversy over German participation in earlier bailouts, she has lost her grip over her country’s upper house. There may be worse to come. Polls taken before the announcement of the latest rescue plan showed that over 60 percent of Germans opposed extending further money to Greece, and this discontent is penetrating her governing coalition.

And opposition to bailouts has been mounting amongst voters elsewhere in the eurozone’s richer north for quite some time. That’s ominous. The new Greek package, and the changes to the European Financial Stability Facility that accompany it, require the approval of every member of the coalition of the unwillingthat is meant to be providing the funds. Earlier bailouts have already riled voters in Austria, divided the ruling Dutch coalition, and helped propel the True Finns, a once-small populist party, to third place in April’s Finnish general election with 19 percent of the vote. Under the circumstances the notion that the Greek rescue plan will sail smoothly through all the national parliaments involved looks like fantasy.

The politics will be rough, and they will get rougher. Neither this bailout, nor the expanded European Financial Stability Facility, nor its successor, will be enough to unwind the imbalances now ravaging the eurozone’s periphery. The best chance of achieving that will be to move on to a quasi-federal budgetary, fiscal, and “transfer” union. That will be a hard sell to electorates in those countries that will be footing the bill (probably in excess of an annual $150 billion), and after the fiascos of the last year or so it will be politically too dangerous to try, once again, to bypass them.

Voters may well start to count after all.

Greater Europe, Lesser Europe

National Review, June 2, 2011 (June 20, 2011 Issue) 

By the time you read this, Greece may have defaulted on its debt. Or it may be preparing to default, but without the D-word. Most likely it will be negotiating another rescue package, but it may still be fighting to secure the latest payment under its existing bailout. Only one thing looks certain as I write. The eurozone crisis will not be over.

It’s been a long, hard journey since the first Greek bailout just over a year ago, a €110 billion loan package from the European Union (€80 billion) and International Monetary Fund (€30 billion) secured by pledges of drastic austerity. A €750 billion European Financial Stability Facility was announced a little later. The prospect of its billions’ being available to any eurozone country that ran into difficulties was intended to “shock and awe” (yes, that term again) the financial markets into calm.

It did not work out. Both Ireland and Portugal have since had to be bailed out. The destructive contradictions of the one-size-fits-all currency remain unresolved. The damage they caused is unrepaired. Then there’s the fact that the very nature of the eurozone leaves its weaker members vulnerable to fears of default. Most of their debt is in euros, and, for all practical purposes, the euro is a foreign currency. Once investors move out of, say, Irish bonds to safer euro debt elsewhere, all that Ireland can do to lure them back is increase interest rates and tighten its belt yet again. If that doesn’t work, the cash will run out.

Belgian economist Paul de Grauwe argues that a liquidity crunch of this type could force an otherwise solvent country into default. Maybe; but in Greece’s case that’s beside the point. The country has, financially speaking, ceased to be a going concern. Neither the 2010 bailout nor the (partial) introduction of austerity measures that are already at the limit of the politically possible have been enough to do the trick. Indeed, by depressing domestic demand, the latter have — at least in the short term — made the budgetary situation even worse. Tax revenues have been hit by the slump in an economy that shrank by over 4 percent last year, and will likely dwindle by another 3.5 percent this year. The conventional response — a massive devaluation designed to restore international competitiveness — is unavailable so long as Greece remains yoked to the euro.

And it’s not easy to break free. Capital controls would be introduced overnight. The Lazarus drachma would collapse in the morning. Inflation would surge the day after. The country would, de facto or de jure, default on its debt (as would a sizeable slice of its private sector). Greek industry would face a painful funding squeeze. Payrolls would plunge, a brutal blow with the official Greek unemployment rate already at 16 percent or so — and rising.

Beyond Greece’s borders, there would be panic selling of debt issued by some or all of the other PIIGS. With a number of EU banks heavily exposed to the PIIGS, an uncontrolled Greek default, and, more dangerous still, its consequences, could conjure up sweaty memories of the financial crisis. And those affected might include the European Central Bank itself. The ECB has been an active buyer of PIIGS debt. Writing down those holdings could be awkward, especially since the eurozone’s embattled taxpayers would be left holding the tab.

But if Greece’s departure from the euro is too risky to consider, that does not change the fact that the May 2010 financing has not worked. And default would be default whether inside the eurozone or out. It’s all very well criticizing the dodgy process by which Greece was admitted into the currency union, and there are few words ugly enough to describe the squalid state of Greek public finances. Nevertheless, for creditors to insist that the country can cut, privatize, and tax enough quickly enough to stave off disaster is to allow indignation to prevail over financial and political reality. Greece lacks the social cohesion (and shared memory of recent hardship) required to weather the kind of drastic “internal devaluation” that (fingers crossed) took the Baltic countries through their recent debt crises.

According to the EU Commission, Greece’s debt/GDP ratio will rise to 166 percent next year. The annual budget deficit will stand at just under 10 percent of GDP. Under the terms of the May 2010 bailout, that number is supposed to fall to 3 percent by 2014. Dream on. On May 30, Greece’s two-year bonds were yielding over 26 percent. The market’s message was clear. Without substantial additional external financing, default was on the way.

Adding to the concern have been worries that Greece might not satisfy the conditions necessary to allow the IMF (more rule-bound, it is speculated, in the wake of Dominique Strauss-Kahn’s departure) or EU lenders to release their next portions of the original bailout funds. You may know if they have agreed to do so by now, but the best guess must be that these monies will somehow reach Athens, even if it takes a new bailout agreement to get them there. If they don’t, that could, within weeks, trigger the “hard” default that no one wants.

Arranging a fresh bailout will be an unpleasant process, thanks not least to politics. After years of restraint at home, financing the feckless abroad has proved highly unpopular in Germany, the EU’s principal paymaster. The single currency has been a boon for the country’s exporters, but its voters don’t seem to care. They never wanted the euro, and the events of the last twelve months have only reinforced their suspicion that their beloved Deutsche mark was replaced with an extremely expensive dud. Forcing through the earlier support for the PIIGS was a nightmare for Chancellor Merkel. To ask this most cautious of politicians to demand yet more from restless German taxpayers is to ask a great deal. And lender discontent, a useful reminder of how little grassroots appeal EU “solidarity” really enjoys, is not confined to Germany. The Austrians are unhappy, the Dutch government is floundering, and anger in Finland over its participation in eurozone rescue parties has helped propel the populist-nationalist True Finns to the top of the polls. A new bailout will only add fuel to these fires. Merkel, it seems, may be preparing to walk through them. On May 31 markets surged on reports that Germany had dropped its insistence that any new bailout should be conditional on bondholders’ sharing in the taxpayers’ pain.

But despite, doubtless, additional austerity measures and fierce mechanisms to enforce them, new rescue packages will do little to solve the underlying structural problem in Greece and, for that matter, elsewhere. They may buy time but, in the end, there is simply too much debt for some PIIGS to repay. If an honest, old-fashioned default is too terrible to contemplate, that leaves three routes to a theoretically more permanent solution.

The first is, basically, what Merkel wants, “restructuring,” a default in sheep’s clothing, albeit one timed later than she would like. This would be designed in a way that allows banks to dodge the write-downs that could bring them low. The ECB is fiercely opposed to this approach, arguing that it will inevitably set off a fresh wave of financial contagion, even a new Lehman. Nouriel Roubini, Doctor Doom himself, disagrees. It is impossible to say who is right. Both sides are, in the end, making guesses about the mood of a perpetually manic marketplace. That said, the ECB’s stance implies the PIIGS will eventually be able to repay all their debt: an idea as implausible as the notion that they might fly.

More probably, the ECB is relying on Brussels to push forward with the closer fiscal and economic union without which no large monetary union can succeed. This has always been on the European Commission’s agenda, but until this thoroughly predictable and most convenient crisis, it had been politically impossible. That’s changing. Fiscal and economic integration has gone farther and faster over the last 18 months than would have been imaginable just a few years ago. The Eurocracy may, despite current traumas, even see this all as a vindication of the great gamble that was taken when the euro was launched half-done. The problem for Brussels is that the events of the last year have left voters in the eurozone core free from any illusion as to how costly such deeper integration — which would essentially establish a permanent funds-transfer regime from north to south — would be. Will they go along? Will they even be asked?

The third, and, I’d argue, best alternative for now — the split of the euro into two, a strong “core” euro and a weaker euro for the PIIGS — is not without its difficulties, but it ought to work. It would give the PIIGS both the devaluation they need and a chance of avoiding default, and, in addition, it should trim some of the “excess” German surplus. This may be the best alternative, but it’s also the least likely. To Brussels such a velvet divorce would represent an unacceptable step back, and that would never do.

Estonia’s anti-euro campaigners compare the single currency to the Titanic. It’s easy to see why.

PIIGS to the Slaughter

National Review, December 2, 2010 (December 20, 2010 issue) 

Checking into a roach motel often seems like a straightforward decision.

Signing up for the euro, the shiny new currency supposedly saturated in German fiscal rectitude, not only pleased Ireland’s paymasters in Brussels (the country has benefited hugely from lavish dollops of EU “structural” assistance) but offered Dublin the prospect of riches far closer to hand than the end of the traditional rainbow. The combination of EU aid (amounting in some years to as much as 3 percent of GDP), domestic frugality, shrewd supply-side reforms, and (those were the days) a timely currency devaluation had already given birth to a Celtic Tiger nourished on export-led success. But that beast was now set to burn very bright indeed.

And so it did. Money poured in, bringing the traditional speculative excess in its wake. So far, so normal: Usually such festivities are brought to a more or less timely close by both external and internal pressure. Inflation heats up, the currency buckles, interest rates rise, fiscal policy is tightened, bank lending is reined in, and everyone is soon back on their best behavior — until the next time.

Joining the euro meant that much of this script was jettisoned. Market signals were muffled by membership in a unified monetary system in which one size truly did not fit all. In particular, Irish interest rates, determined primarily by the needs of the eurozone’s sluggish Franco-German core, were kept far too low (on average, they were negative in real terms between 1998 and 2007) for a roaring economy growing at an annual average rate of 6 percent between 1988 and 2007. Throw in a poorly regulated banking system, endemic cronyism, vast infusions of foreign cash (euro membership had dramatically reduced currency risk), a lending war led by the remarkably reckless Anglo Irish Bank, the genuine housing needs of a large new immigrant population (a striking phenomenon in this land once known for its emigrants), and briskly increasing wage rates, and the stage was set for a gigantic property boom. What could go wrong?

Just about everything; and it went so badly that (finally) doing the right thing may have made matters even worse. When the global financial crisis erupted and the Irish economy slumped (GDP fell by 7.1 percent in 2009 after a 2 percent decline the previous year), real-estate prices fell (they are now some 35 percent below their peak, and weaker still in Dublin), and the banks came down with them. The government’s response bore some resemblance to the approach taken so successfully by Sweden during a not-entirely-dissimilar banking crisis in the early 1990s. This included guaranteeing most of the liabilities of the country’s troubled banks (and troubled they were — by 2007, property-related lending accounted for some 60 percent of their loan books) and transferring toxic assets to NAMA, the National Asset Management Agency, a state-run “bad bank.”

But Ireland’s banking sector was far larger relative to its GDP than Sweden’s had been, and so was its real-estate bubble. The Irish government has also had to contend with a far less favorable economic climate, a difference made even more damaging by the fact that the Irish tax system is unusually sensitive to changes in economic activity. Tax revenues fell by almost 14 percent in 2008 and by 19 percent in 2009, bringing yet more misery to the republic’s previously respectable but swiftly deteriorating public finances.

Recovery from a mess like this is never plain sailing, but one way to lessen the pain is to arrange a currency devaluation (Sweden let the krona fall by 20 percent in late 1992) to give exporters a break. Unfortunately, membership in the eurozone had closed off that option. Ireland was thus stuck with an overpriced currency, an overpriced workforce, and a rapidly growing hard-money debt burden that could not be inflated away. All that was left was “internal devaluation.” That’s an ugly name for an ugly cure generally revolving around extraordinarily brutal public-sector austerity. The aim is to restore both the state’s finances and the nation’s international competitiveness, and it’s just what Ireland had been attempting since 2008 with a series of increasingly bleak budgets intended to reduce the deficit by over $19 billion.

Internal devaluation is a bitter pill to swallow even when it works, but when it doesn’t . . .

And in Ireland it may well not. As it has lurched its way through 2010, the government has fed ever more money into the country’s devastated banks (most notably the now-reviled Anglo Irish Bank), effectively canceling out the savings being generated by the austerity program and pushing the estimated 2010 public-sector deficit to some 32 percent of GDP (it would otherwise have been around 12 percent). This renewed the market’s worries about Ireland and, ominously, other fiscally fragile eurozone members. Exacerbating the rising tension, the European Central Bank appeared to be continuing with its effort to scale back the short-term support it had been extending to the eurozone’s financial institutions — support that was widely assumed to be vital to many banks in most or all of the notorious PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Perceptions of sovereign and banking risk were converging, not unreasonably so given the way that governments were standing (either explicitly or implicitly) behind their countries’ banks. To take one example, when Fitch cut Ireland’s rating from AA- to A+ this fall, it specifically cited the mounting cost of the bank clean-up.

All this made October a terrible month for German chancellor Angela Merkel to demand that the European Stability Mechanism, which is scheduled to replace the current European Financial Stability Facility in 2013, include a provision requiring private holders of government debt to share in the pain of future sovereign bailouts. The provision is common sense. To call for it at a time of jagged nerves over European sovereign risk was not. Merkel’s comments related only to arrangements that might be put in place in the future, but given her frequent tirades against “speculators” and Germany’s key role in funding any bailouts to come, many in the financial markets worried that they might herald an attempt to change the ground rules well before 2013 — and not in a way that would be in the interests of bondholders. Yields on PIIGS bonds rose, while money continued to drift away from Ireland’s banks, and investors from its debt. Theoretically, the country still had enough money to meet its financing needs until mid-2011, but, if panic was to be headed off (at least temporarily), its government had to be persuaded to accept the bailout that it was desperately claiming not to need.

The risk posed by spreading financial contagion was simply too high, and not just for Ireland. The European Financial Stability Facility, which was created for the eurozone with such fanfare (there was talk of shock and awe) at the time of the Greek bailout, is not large enough to rescue Ireland and Portugal and Spain, the next two countries most likely to be hit should confidence fall any farther. Dublin caved. An outline rescue package was announced on November 21. The full details were released a week later. The total package will amount to $110 billion, including an immediate $13 billion injection of fresh capital into the banking system. In an unanticipated development, Ireland will chip in $23 billion from its pension reserve fund and various other pots of money. The balance is set to come from the International Monetary Fund, from the European Financial Stability Facility, and from three non-eurozone countries, the U.K., Sweden, and Denmark. The whole thing is conditional on the passing of yet another Irish austerity budget, one that contains an additional $20 billion in tax increases and spending cuts. These cuts, when added to the earlier bouts of slash-and-burn, amount to roughly 20 percent of GDP.

At the same time, more details were given of the planned new European Stability Mechanism, but — not insignificantly — with (some) dilution of Angela Merkel’s proposal for sharing the burden of future bailouts. It was also agreed that Greece should be given an extra four-and-a-half years to repay its emergency financing from earlier this year. Ireland, however, will no longer be obliged to contribute to Greece’s bailout. On a brighter note, and over the objections of some in the rescue party, Ireland was allowed to retain the 12.5 percent corporate tax rate that has served it so well.

The republic’s governing coalition, a dying partnership between the centrist Fianna Fail and the Greens, has to pass the new austerity budget within a few days with a parliamentary majority of only two and without much popular support. In a clear warning sign for the general election now set for January, Fianna Fail received a November 25 by-election shellacking from Sinn Fein, a party frequently described as the political wing of the IRA. The EU’s mandarins like to claim that their “ever closer” union is burying Europe’s old nationalisms. That’s not how it looked in Donegal South West that weekend.

Despite this, Ireland’s mainstream parties recognize that the deficit needs to be reduced soon — even if they disagree on the specifics of the rescue package. At the time of writing, things are very fluid, but the best guess is that the budget will probably squeak through, albeit with a great deal of shouting. If it doesn’t, there’s a clear risk that financial chaos will soon engulf some or all of the PIIGS, and, no less dangerously, the banks that have lent so much to them. Even if it does go through, don’t expect too much. The distinctly downbeat market reaction to both the initial announcement of an Irish bailout (yields on the PIIGS’ government debt rose; the euro fell) and its later confirmation reveals a widespread belief that this rescue is not the end of the story.

It’s not. More bailouts undoubtedly lie ahead, and, in the case of Greece and Ireland, so does a debt restructuring (that’s the polite word for default) at some moment when it is judged that the financial markets can cope with the news. So long as these countries are yoked to the euro, there is no feasible alternative. Their domestic demand will be crippled by the processes of internal devaluation. Their export sectors will be hobbled by a hard currency. Under the circumstances, they will struggle to grow their economies at a pace fast enough to reduce their debt burdens to manageable levels. There are good reasons the yield on their debt continues to rise.

Meanwhile, Brussels, apparently unshaken in its belief that one size can be made to fit all, will try to impose unified fiscal and budgetary rules across the eurozone. If this succeeds, it may reassure restless German voters that there are credible limits on the amount they will be asked to pay to support European monetary union. That the implementation of such zonal discipline will, if carried through, also deepen European integration is even more to the Eurocrats’ point. That it would doom a large swath of the continent to years of subpar growth is just too bad. The European project must move forward!

Splitting the single currency into a “northern” euro for Germany and those of its neighbors that want to come along and a “southern” euro for the rest is one more congenial, if risky, alternative route to take. It would retain important elements of the status quo while paving the way for the devaluations that the PIIGS so badly need. But to take this path would be an admission of defeat too humiliating for the EU’s leadership to accept, at least for now. And if that’s off the agenda, so, even more so, is a return by the nations of the eurozone to their old currencies.

The final alternative, for an Ireland or a Greece to exit the euro on its own, would involve national bankruptcy, the collapse of much of the domestic private sector, and Lehman Part Deux. 

It’s not always easy to check out of a roach motel.

Scapegoating les Anglo-Saxons

The Weekly Standard, June 21, 2010

Sutton Hoo

When America’s flimsier corporate colossi threaten to collapse, they tend to follow a wearyingly familiar script. Quarterly reports “disappoint,” the media begin to stir, and questionable financial dealings come to light. The CEO then emerges from his bunker to announce that all would be well but for the (vicious/ill-informed) press, (greedy/destructive) short-sellers, or both. Then all hell breaks loose. That’s how it was with Enron. That’s how it was with Lehman Brothers. And that, more or less, is how it’s going with the euro. A dangerous gamble with other people’s money, irresponsibly operated, and dishonestly sold, the European single currency has been showing signs of severe stress, and leading EU officials have been doing just what the Ken Lays of this world do: dodge.

There have been the “all is wells” from the likes of José Manuel Barroso, president of the EU commission—the man who boasted in February that the euro was “a protective shield” against the crisis. There have been the attacks on the press—often with an interesting twist. Spain’s transport minister, José Blanco, for instance: “None of what is happening including editorials in some foreign media with their apocalyptic commentaries, is happening by chance, or innocently. It is the result of certain special interests.”

Just who were those unnamed “special interests”? (Clue: Europeans traditionally believed that they wore Stetsons or bowler hats.) The Spanish prime minister reportedly ordered his country’s National Intelligence Center—the Inquisition no longer being available—to investigate. An alternative theory was conjured up at around the same time by Jürgen Stark, the European Central Bank’s chief economist. Asked by Der Spiegel whether he suspected that the “Anglo-American” media were “behind the attacks” on the euro, Stark replied that “much of what they are printing reads as if they were trying to deflect attention away from the problems in their own backyards.” That’s a nice try, but it’s also an answer of staggering disingenuousness. Can Stark really have been unaware of the long-running media furor in Britain and the United States over their domestic deficit disasters?

To be fair, the head of the ECB, Jean-Claude Trichet, did warn in May that “one should be wary” of talk of Anglo-Saxon conspiracies, but by then plenty of far-fetched plots had been dreamt up. Were those “apocalyptic commentaries,” for example, an ideological assault by diehard euroskeptics or were they, perhaps, part of a dastardly scheme to preserve the U.S. dollar’s position as the ultimate reserve currency? As conspiracy theories go, neither was bad, but such theories play even better when seasoned with a “speculator” or two. Maybe, the Anglo-Saxon media were in cahoots with Anglo-Saxon plutocrats looking to make a sleazy buck out of a sickly euro. By talking up the crisis, were these hacks simultaneously peddling a sexy story and filling the coffers of Wall Street and the City of London? Quelle horreur.

That there might actually be a crisis to talk about was only grudgingly conceded, and its true cause remained the stuff of denial. Far easier to blame the sons and daughters of Gordon Gekko. It was in this vein that Ireland’s minister of state for finance, Martin Mansergh, claimed last month to have gotten to the bottom of the market’s distaste for the euro: “If you had lots of separate currencies that would be more profits for the financial sector.” Let no one say that blarney is dead.

Wiser blamesayers have avoided conspiracy theories and stuck to abuse. Anders Borg, finance minister in Sweden’s (vaguely) right-of-center, (not so vaguely) Europhile government, grabbed headlines in May comparing market players to a “wolf pack.” The jibe might have had more weight had it not come from someone who had, just a few months before, sternly intoned that there was “no legal basis” for an EU bailout of Greece, exactly the sort of ill-starred comment that is now food for the wolf pack.

As zoological insults go, however, Borg’s lupine sneer was one of the best since the moment in 2005 when Franz Müntefering, then chairman of Germany’s Social Democratic party, compared foreign hedge funds and private equity groups to “locusts.” Yes, those investors had been buyers rather than sellers back then, but they had been the wrong sorts of buyers (short-term, asset-strippers, foreign).

To his credit, Müntefering spoke out when the times were good. Many of those now criticizing “speculators” held their peace when those wicked markets were betting on the “convergence plays” that kept interest rates down (and pushed asset prices up) in the countries now known as the PIIGS (Portugal, Ireland, Italy, Greece, and Spain).

But it was never more than an uneasy peace. The scapegoating of Wall Street and the City may be a diversionary tactic but there is nothing fake about the animus that lies behind it. The great majority of the EU’s political class disdains the Anglo-Saxon market capitalism that is, in its disorderliness, brutal competitiveness, and unembarrassed pursuit of profit, the product of an economic and political tradition that is the antithesis of its own. Americans expect that sort of thinking on Europe’s left, but it’s present on the continent’s right too. Outside the U.K., the dominant strain of thinking amongst the EU’s establishment right is in the Christian Democratic tradition. Its origins lie in Roman Catholicism—a creed never entirely comfortable with the free market. The mixed “Rhineland” model of capitalism is its model and “solidarity” its lodestar. For a very French example of this thinking, check out Nicolas Sarkozy’s Testimony (2006), where the future president attacked “stock market capitalism” and “speculators and predators.” (Note the date: Sarkozy was not one of those who kept quiet when times seemed to be good.)

Thus the rejection of the Wall Street way by European elites is philosophical and aesthetic as much as it is party political. Its roots are deep and its expression, sometimes, ugly. In November 1942, a French official wrote a piece for a pro-Vichy magazine (interestingly, the same issue features an article by one of the future architects of the euro, François Mitterrand) bemoaning those who would live “free” (his scare quotes) in the “soft, comfortable mud of Anglo-Saxon materialism.”

The “Anglo-Saxon” other (the Vichy crowd liked to throw in the Jews, as well) is a convenient target for European leaders looking for someone, anyone—other than themselves—to blame for the current shambles. But this is a scapegoat that the EU’s mandarins are also riding in pursuit of two long-standing objectives: crippling the City of London and, so far as possible, keeping Wall Street out of Brussels’s domain. Less than two weeks after the implosion of Lehman, Sarkozy announced that laissez-faire was “finished.” Wholesale reform of the global financial system was, he pronounced, essential.

Few would deny that some reform is needed. It’s even possible to assemble a respectable defense of the “anti-speculative” measures (such as certain restrictions on short-selling), if not their confidence-killing timing, recently put into place by German chancellor Angela Merkel. But look more closely at the underpinnings of Merkel’s actions and the picture darkens. The new measures can then be seen not as well-intentioned reform, but as the next step in Merkel’s populist crusade against the “perfidy” of international “speculators,” a crusade designed to mask the extent to which the current crisis (and the bill to German taxpayers) was brought on by the speculative scrip—the euro—that Germany’s politicians had forced upon their voters.

The fact that “speculators” have had little to do with the convulsions now shaking the eurozone means nothing to Merkel. It’s far easier to talk to the electorate about a “battle of the politicians against the markets”—a not unfamiliar tune to U.S. voters—than admit that the real battle that she has been fighting is against what remains of the political, democratic, and financial integrity of the European nation-state.

And we can be sure that the EU elite will continue to stand alongside Merkel in combating the bogeyman bankers, a wag-the-dog war that dovetails nicely both with short-term expediency and long-term belief, and is designed to cut the financial sector—specifically the Anglo-American financial sector—down to size. That doesn’t mean the death of the local big banks that have for so long been a part of the European financial landscape, but it does mean that their business will be reined in. They will see a return to the far tighter political control of the past with all the potential for abuse that can bring. Significantly higher taxes lie in their future, although increasing worries over the fragile state of many EU banks (not least because of their exposure to the PIIGS’ debt) may stymie such plans for now. The bonus culture will come under additional pressure (not all Americans will mourn that), and efforts will be made to ensure that the markets are just that bit friendlier to entrenched interests—such as those of governments that borrow too much. The news last week that France is falling in with Merkel’s recent initiatives and that both countries would like to see them extended across the EU, is an early indication of what is to come.

Much of this is bound to affect the business carried out by Anglo-American finance in Europe, but it is not directly protectionist. The same cannot be said of Brussels’s Alternative Investment Fund Managers Directive, a rough beast now slouching towards some kind of birth. The primary focus of the directive is much tougher regulation of “alternative” investments, such as hedge funds, private equity funds, and the rest of Müntefering’s locust class (funds, incidentally that have received no bailouts—but who cares about that in Brussels). That’s not good news for the players in this market—mostly in the U.K.—and it could also represent a major obstacle to U.S. funds operating within the EU. In neither case is this a coincidence.

Hogtied by recent changes in the EU’s rulemaking procedure, the U.K. cannot do much to stand in the way (should David Cameron’s new, not very City-friendly government even feel so inclined). That leaves Washington as the last line of defense. There are clear and reassuring signs that Treasury Secretary Timothy Geithner now recognizes the nature of the danger that American finance now faces.

That’s something. But will the Obama administration really be prepared to go to the mat for an industry that it too finds convenient to demonize? And even if it is, just how much will Brussels be prepared to listen?

As Rahm Emanuel once said .  .  .

The ‘Beneficial Crisis’

The Weekly Standard, May 31, 2010

It would have taken a heart of stone not to laugh. Wheeled out earlier this month for celebrations to mark his 80th birthday, a rickety Helmut Kohl announced that the fate of the EU’s floundering single currency was a matter of life and death: “European unification is a question of war and peace .  .  . and the euro is part of our guarantee of peace.”

The former chancellor’s dire warning might have been a touch more persuasive had it not been repeated quite so many times before. To take just one example, in the course of Sweden’s 2003 referendum on whether to sign up for the euro, a “weeping” Kohl told the Swedish premier that he did not want his sons to die in a third world war. A reasonable ambition, but hardly the strongest of arguments for junking the krona. Sensible folk that they are, the Swedes voted nej and are all the better for it today.

Panzers will not roll in the event of a euro collapse, but that doesn’t mean there isn’t a decent case to be made for the $1 trillion (actually $937 billion at the time of writing, but who’s counting?) support package for the EU’s single currency union announced on May 10. The growing financial panic triggered by Greece’s economic woes was metastasizing into a crisis of confidence in the eurozone’s southern and western rim—the now notorious PIIGS (Portugal, Italy, Ireland, Greece, Spain)—a development that threatened ruin for much of the EU’s fragile banking sector and the shattering of any hopes of European economic recovery. After a dangerous delay caused by German hostility to the idea of bankrolling the Greeks, a 110 billion euro ($137 billion) EU/IMF bailout of the Augean state had been agreed. But it came too late to head off the financial markets’ mounting unease.

Financial panics are best dissipated by a swift, decisive, and dramatic response that signals that a believable lender of last resort has arrived on the scene. This is why, for all its faults, TARP worked. Uncle Sam had rolled into town. There would be no need after all to storm the ATMs.

Jittery Europeans have had to make do with considerably less reassurance. The eurozone lacks the characteristics and resources of a unified nation. It is a hodgepodge of pacts—some observed, some not—whispered understandings, cultivated ambiguities, and clashing interests that does little to inspire confidence. The nearest it comes to a plausible lender of last resort is Germany, historically the EU’s most generous paymaster—a real nation, with real wealth but, awkwardly, real voters too.

Those voters have been up in arms at the thought of helping out Greece. This was the real reason that German chancellor Angela Merkel dithered so long before coming to Athens’s aid. She was right to be worried. Within a day or so of the Greek bailout, her governing coalition was thrashed in regional elections in North Rhine-Westphalia, Germany’s most populous state.

Something spectacular had to be done. And if $1 trillion isn’t spectacular I don’t know what is. The support package that finally emerged on May 10 falls into three main parts. The largest is the creation of a “temporary” (three-year) special purpose financing vehicle. This is authorized to borrow up to 440 billion euros ($550 billion) to fund or guarantee loans to member states who find themselves being frozen out of the capital markets. On top of this, there will be a 60 billion euro  ($75 billion) “rapid reaction” facility operated by the EU Commission and designed to help any eurozone country facing an immediate cash crunch. Oh yes, the IMF agreed to throw another 250 billion euros ($312 billion) into the kitty.

But, wait, there’s more. To make sure that struggling European financial institutions are not starved of dollars, a number of the world’s major central banks, including the European Central Bank (ECB) and the Fed, revived the emergency currency swap agreements put in place in late 2007. The ECB then topped up the punch bowl by commencing to purchase government debt from the PIIGS, a move explained by the need to move fast (it will be a while before the full support package can be put in place), but which opened the ECB to the charge that it had been reduced to printing money (“quantitative easing” is the preferred euphemism). The ECB denies this, saying the bond purchases are being “sterilized” by other maneuvers draining the excess liquidity the purchases create.

International investors feted the support package for all of one day. Then they recognized that, as Merkel conceded, it had “done nothing more than buy time.” The rot within the eurozone continues to fester. As for claims that this was all the fault of the wicked speculators of Wall Street and the City of London (a tiresome cry from the EU’s leadership in recent months that reached a new crescendo last week), well, that’s like blaming the canary for the gas in the coal mine.

The Greeks, Portuguese, and Spanish have all announced new austerity measures, but, even if we make the optimistic assumption that the recent riots in Greece will be the exception rather than the rule, these steps are unlikely to be enough to bring this story to happy ever after. Piled on top of existing budget cuts, the fresh rounds of slashing and taxing run the risk of crushing what’s left of domestic demand and with it an essential element in these countries’ ability to generate the additional tax revenues their treasuries so badly need. The usual remedy for such a predicament is devaluation and an export-led recovery, but with the PIIGS yoked to the euro that option is not available. The euro may be weakening against currencies outside the zone, but against their competitors within, the PIIGS are as uncompetitive as always.

It’s not easy to unscramble an egg. For one of the PIIGS to quit the euro would almost certainly mean both default on its public debt and the bankruptcy of wide swaths of its private sector. The domino effect across the rest of the continent, and beyond, would be appalling. Another, more promising, alternative, albeit one freighted with severe technical and practical risks of its own, would be for a German-led group to depart the euro and form a separate “hard currency” union of its own, leaving the PIIGS with the deeply depreciated (down perhaps 30-40 percent) euros they so obviously need. This would be tough on the PIIGS’ unfortunate creditors, but there would be a chance that default, and all its attendant dangers, could be sidestepped.

Yet no such alternative is on the menu. In confronting the hole into which joining the euro has dropped them, the eurozone’s leaders seem determined to dig ever deeper. We can debate their rationale, in all probability a mix of cowardice, conviction, careerism, and delusion, but not the likelihood of the conclusion to which they will come. Speaking in Aachen—the burial place of Charlemagne, an early Eurocrat—on May 13, Merkel made clear that she was still drinking the Kohl-Aid: “If the euro fails,” she warned, “Europe fails too, [and so does] the idea of European unification. We have a common currency, but no common political and economic union. And this is exactly what we must change. To achieve this, therein lies the opportunity of this crisis.”

Long before Rahm Emanuel’s infamous dictum, the idea of a “beneficial crisis” (to borrow the terminology of Jacques Delors, a former president of the EU Commission) was common in Brussels. Indeed, there is evidence to suggest that some smarter Eurocrats saw the flaws in the way that the euro had been set up as a feature, not a bug. The crisis to come would create the conditions in which the nations of the EU could be persuaded to submit to further federation.

On May 12, the current president of the EU Commission, José Manuel Barroso, argued that “member states should have the courage to say if they want an economic union or not. Because without it, monetary union is not possible.” The commission’s proposals include greater macroeconomic supervision, increased emphasis on deficit reduction, and the establishment of a permanent emergency financing mechanism. The most controversial idea is the suggestion EU governments submit their national budgets for review by their counterparts within the union before presenting them to their own parliaments. Whether this review would be merely advisory or carries a veto power has been left conveniently vague.

Barroso also wants a more punitive regime imposed on governments that persist in breaking the budgetary rules that supposedly underpin the euro. There are limits, however. The commission did not back Merkel’s call for provision to be made to allow the eurozone’s more persistent reprobates to be expelled from the currency union. Permitting such a procedure, even in theory, would imply that the grand European project could sometimes go into reverse, and that would never do.

Most of these measures will edge forward at best. Not all member states are enthusiastic about the push for what Herman Van Rompuy, the president of the EU’s council, has referred to as a European “gouvernement économique,” an elastic term capable of, in Van Rompuy’s sinuous prose, “asymmetric translation” in different languages, from the comparatively nebulous English “governance” to something altogether more concrete.

But, if some governments are not enthusiastic, it’s difficult to see what else they can do—unless they are prepared to quit the eurozone. And they are even less enthusiastic about that.

The next stage of this drama ought to have been something of an anticlimax as nerves were soothed by that calming trillion. Instead, Merkel sent markets sliding by imposing, amongst other measures, a “temporary” ban in Germany on “naked” short selling (selling securities that you do not own and have not made arrangements to borrow) of eurozone government bonds and the stocks of some of her country’s leading financial institutions. This was accompanied by promises of further regulation and yet more railing against speculators, “out-of-control” markets, and banks.

The message sent by the new rules was grim. And it was received. By playing the populist card, Merkel had highlighted the extent of the political problems she faces back home. That’s not what investors wanted to hear. Some also fretted that the new restrictions were a hint that the finances of Germany’s banking sector were even worse than feared.

So, what’s next? Predicting short-term currency movements at a time like this is a mug’s game. I’ll just stick with the word “choppy” and the belief that a trillion dollars ought to buy the euro some time. It won’t be a huge surprise if some of that time—and some of that money—is eventually used to smooth the increasingly inevitable “restructuring” of Greek, and possibly Portuguese, sovereign debt. Nevertheless that will not be the end of the matter. A trillion dollar band-aid is still a band-aid. This spring’s crisis has demonstrated that the existing system cannot survive as it stands.

To succeed, a monetary union the size of the eurozone needs a high degree of central control, consistent and enforceable budgetary discipline, and spending (and thus taxing) powers sufficient to ensure that the cyclical imbalances in its constituent parts can be evened out. That reality has now essentially been accepted by the German and the French governments. Although negotiating the details of common economic governance will drag on for years, in the end the French and the Germans will, despite some truly fundamental differences, get there—and they won’t be alone. Faced with the prospect of being excluded from the EU’s tightening core, more countries than might now be imagined will choose to jump in notwithstanding its tougher disciplinary regime. While today’s “two-speed” union will continue to exist, the division will deepen, and on one side of it there will be something that looks suspiciously like a European superstate.

The financial markets could still disrupt this transition, which is one reason that the EU’s leadership is so keen to rein them in. Trouble may also come from a group often ignored in the saga of “ever closer” union—the electorates of Europe.

One of the more telling characteristics of the EU’s progress is the way it has been forced through regardless of the wishes of ordinary voters. The “reuniting” of Europe has been a project of the elites, the fruit of mandarin cabal and backroom deal. Voters have rarely been given much of an opportunity to demur. And when they have been asked their opinion and called for a halt to further integration, the results have been ignored or subjected to do-over until the “right” result came through.

That’s not to claim that Europe’s mainland is seething with euroskepticism. It’s not. There is, however, widespread apathy and a profound alienation. As the voters of North Rhine-Westphalia have just reminded us, there’s not a lot of fellow-feeling in that imaginary European family.

This might have mattered less in economically more comfortable times, or in the times when Brussels was not stretching so far, blithe times when voters (foolishly) and Eurocrats (realistically) could, for the most part, pretend that the other did not exist. That’s over now. Building an economic union is messy and intrusive. It’ll be hard to slip it through on the quiet. The PIIGS are being ordered to take a long hard road. The peoples of Northern Europe will be told to pay for its paving.

What if either says no?