Eurozone / Killzone

Unless something truly astonishing happens, it's all over for the Eurozone, and probably for Europe too. One way or another, we will live with the aftermath, with political, financial and economic structures which, right now, we simply don't understand and probably can't imagine. 

So let's start trying, whilst keeping things as docile and non-lurid as possible. This will obviously not be accomplished in a single piece. But in one respect, there is good news: we are finally reaching a point where at least the correct questions are being asked - for example, how to dismantle the Eurozone with minimum chaos. That's a start. Indeed, once you start asking the right questions, we may find that the answers are not quite so daunting, nor the future quite so lurid necessarily, as they currently seem.  

The key point this week is that yields on Italian bonds have reached an impossible 7%+ not because of any recent fiscal or financial profligacy on Italy's part, but because whilst it's locked into the Euro, the nation can't grow nearly fast enough to stabilize and repay its debt, and the imposition of short, medium and long-term austerity will only compound the problem. After all, during the last decade Italy's averaged 2.9% growth pa, nominal! What's being priced isn't the failure of the current or recent past, but the expected future failure provoked by Italy having a mispriced currency and a counterproductive fiscal policy. It's a whistle being blown on the whole Euro-delusion.

For now, for an idle hour or month, as Italy's financial failure heaves itself over the horizon, we are invited to believe that the Eurozone's financial frailties can be rescued by some form of leveraging of the European Financial Stability Facility. One hardly knows whether to laugh or cry. In one iteration, the EFSF is expected to act as a sort of credit insurance issuer – that's right, an attempt to re-invent the CDS markets which have just been killed by the fiction  that Greece can forget more than 50% of its obligations without triggering CDS payouts. In another iteration, we are invited to believe China will stump up fund the thing . . . . even though CIC chairman Jin Liqun has responded by specifically decrying the moral effects of the European 'social model' that it can no longer afford.

(Incidentally, if Europe can't get a good hearing from Jin Liqun, it can't get a good hearing from anyone in China. Mr Jin is probably the most Europe-friendly senior Chinese official currently in office. This is a  man who first taught himself English during the Cultural Revolution in order to read Shakespeare and the classics of Victorian literature. After that he taught himself French so he could read Victor Hugo. His favourite book is 'Wuthering Heights': when he first read it in Maoist China, he found it very easy to understand the theme of an intense love gone horribly and destructively wrong.)

But by now, we know that last month's solution will be discredited in a matter of weeks. The key point, after all, is the EFSF's structure: the body's financial credibility is backed by guarantees from 14 of the 17 Eurozone members – Greece, Ireland and Portugal are excluded, of course. But there are really only four shareholders which matter: Germany (29.07%); France (21.83%); Italy (19.18%) and Spain (12.75%). So, unless something truly astonishing happens, we will probably have to count out both Italy and Spain as viable sovereign guarantors. The EFSF's financial standing will then effectively be guaranteed only by Germany and France.

They're both triple A, of course, and France is passing successive emergency budgets of ever-tightening austerity to try to maintain that rating. The markets, however, are pricing in unprecedented spreads between French and German 10yr bonds, however, so the austerity alone doesn't seem to be working yet.

And why should it? BNP Paribas and Credit Agricole between them hold US$416.4 bn worth of Italian debt. With major recaps probably necessary in France, do we really expect France also to be able to underwrite the financial restructuring of most of the rest of the Eurozone as well? Without compromising its AAA status? C'est magnifique, mais ce n'est pas la finance.

As Sherlock Holmes may have put it, had he been a great economist rather than a bumbling detective, when you exclude the impossible, the options that remain become if not inevitable, then at least clearly identifiable.

So, in my next posting I'll explain how one can dissolve the current Eurozone without destroying the European Union, or even Europe's banks, and without outraging German notions about central banking.

And in the one after that, I'll look at how the Eurozone's current crop of financial institutions, including the ECB, can and should continue to play a central coordinating role in the evolution of a post-delusional system of European currencies. That, happily, will include nailing a truly revealing misunderstanding about how banking systems actually work currently being perpetrated both by a high-profile German economist, and . . . . no surprise here, I suppose . . . by the sages of the FT.