The costs of uncertainty

One of the benefits of European monetary integration was going to be the elimination of the uncertainty of the movements in currency rates so as to increase cross-border transactions and create the largest ‘domestic’ market in the world.

In order to remove that uncertainty the architects of the euro have unfortunately created much deeper anxieties and uncertainties. The reality in southern Europe right now is that savers are spending their time trying to protect their wealth from the spectre of bank failures, devaluations, and capital controls. Investors are demanding a high premium to invest in Italian and Spanish bonds, and entrepreneurs have to compete in an open global market with German (and French for the time being) competitors paying a fraction of their cost of capital. These economic distortions pale in comparison with the old threat of a lira or peseta devaluation of yesteryear.

The main point to consider is that these economies, including those like Spain and Italy which are on the path to fiscal consolidation, will never be able to meet their deficit targets with the real economy slowing down and going backwards due to the combined effects of increased taxation, lower disposable incomes, high relative interest rates, and anxiety about the future. The longer it takes to find a real solution, the more painful it will be to solve the issues at hand, without discounting popular discontent which at some point may force a reversion to populist measures.

Mario Monti and the limits of Technocratic governments

Back in November, Monti’s popularity was such that he could have imposed to parliament and to the country measures that would have been impossible to even discuss for the previous governments. His power was not due to the usual honeymoon effect, as here there was no election and no love, only fear of national bankruptcy and the general consensus that if there is someone that can save Italy, it is Super Mario.

Eight months later, the day after parliament finally passed the most complicated bill introduced by Monti (which had to be pushed with repeated confidence votes), the Labour bill, things are quite different. It is possible, even if not likely, that Monti will have tried to pressure his European colleagues at the summit currently underway that unless he comes back home with a tangible result from his list of requests, he will resign. It wouldn’t be an empty threat. Monti knows that his power base, the Italian people, has eroded as Italians have seen the famous ‘spread’ return back near the levels last seen during the last days of Berlusconi’s administration. Simply put, Italians agreed to tighten their belts without too much complaint but were expecting in return to be able to return borrowing at European and not South American rates, to see Italy diverge from not only Greece, but also Spain, Portugal, Cyprus.

Unfortunately, this hasn’t happened and there are two main reasons for this, the first endogenous and the other one exogenous, as Monti himself would have said in his Macroeconomics classes. The exogenous variable is the continuation of the European crisis which sees markets continuing to go after the next perceived weak link. When Spain’s banks got bailed out, Italy’s started appearing in the crosshairs.  Monti is quite appropriately trying to address this by persuading Ms.Merkel that the markets need some short term mechanism that automatically speed-limit the borrowing costs of Italy, Spain and the like to deviate too much from Germany’s.  We will know soon if he succeeds. The internal issue is that Monti’s government ended up watering down its initial promises and has had to acquiesce to the political games in an even greater way as ‘normal’ governments, as he has no constituency in parliament of his own. The main example is the Labour bill: nobody likes it because it didn’t really achieve anything. Ms.Fornero had a historical chance of rewriting the book on Italy’s terrible labour laws but only achieved to change a few footnotes.

A Hot June

June is going to be even warmer than usual, not only in the Med, but across Europe. If the ‘anti-Europe’ parties win the re-vote in Greece, the EU and the ECB in particular will have to unsheathe whatever secret weapons they have prepared in order to prevent the great recession turning into the great depression of the twenty-first century.

There are three main outcomes following a ‘bad’ outcome in Greece. The most likely, but just, is still that the ECB and the EU will step up to the plate and do whatever it takes to keep Greece in the Euro despite the vote. This will have to include agreeing to much softer bailout terms, debt forgiveness, quantitative easing, and other novel weapons.

The second possible outcome is that Greece is allowed to leave the Euro in an ‘orderly’ fashion, i.e. with the cover of many of the same actions described above save of course for the softer bailout. The objective will not be to help Greece but to attempt to stop the rout by the Balkans and prevent a Southern European contagion. This will probably be a short term solution.

The third possibility is that in the context of a disorderly Greek exit, the ‘hard’ countries, led by Germany leave the Euro and adopt some new version of the DMark. This will have the effect of mitigating the depreciation of the ‘leftover Euro’ and of curing the problem of the two speed euro once and for all. Strong countries will adopt the new DM and be under German orbit, while the Med and others will have a ‘weaker’ common currency.

Clearly, all solutions save for one where the Euro remains in its current form with its current members will generate short term disruption in a scale that hasn’t been seen in most people’s living memory.

ECB, time is running out

With the first and second LTRO programs the ECB was able to buy precious time to allow the slower workings of politics to solve the problem structurally. Unfortunately, this placebo only worked until a Greek exit from the Euro became a likely outcome rather than a discussion theme for economists.


The excessively pro-cyclical policies imposed by the Germans and the EU on the weaker countries goes against all textbook economics, not only Keynesian. The results, deepening of recessions, deterioration of bank balance sheets, and the beginnings of social unrest, may end up provoking the opposite effects. If Greece leaves the Eurozone, it will be a signal to the markets that they should price in a Portuguese, Spanish, Italian, and who knows, maybe even French exit. That would of course mean the end of the euro.


As with all problems, the later you tackle them, the more aggressive you will need to be to hope to achieve success. Clearly the only body able to fight for the Eurozone survival is the ECB. Its next steps will have to include a strong signal, a double notch rate reduction, and a pragmatic relaxation of collateral rules. Lack of decisive action soon with these tools will only leave it the option of real QE, sometime in the summer months.

The Greek Drama

It wasn’t difficult to imagine that the Greeks would have voted with anger in their hearts. A fiscal readjustment without currency devaluation is not a pleasant experience. When people’s pensions are cut by 15-20% in nominal terms, the cohesiveness of society is at risk. The inconclusive results of that election and the standoff between a Balkanic and a European Greece are going to keep markets unsettled for another couple of months at least.

The election of the new French president that ran on the platform of ‘we can’t live on rigour alone’ is another, more core-European reaction to the same malaise. Given that Europe without France is an oxymoron, the challenge is now on Mrs Merkel to find the way to square the circle. Absent the ghosts of Weimar, a little inflation would be good for Europe, as a collective mechanism for adjusting their economies in a less painful fashion.

It is too early to tell if Mr.Hollande will be able to use his new mandate to help achieve what Mr.Monti has been arguing for some time, namely that the economies that had spent beyond their means in the good years needed to put their fiscal houses in order, but that this cannot be the only solution at a time where we are still mired in the ‘great recession’ which was initially precipitated by the 2008 banking crisis. Monti is having his own problems in Italy, where the level of taxation is near or beyond the point of diminishing returns. The next three months will be telling for the future of Europe beyond the question of whether Greece is in or out.

The French Elections

Next week we will know who will be responsible for running France for the next five years. If we are to believe the polls, Angela Merkel will have a new partner in the German-French axis, with which she will need to start doing business. At the next French-German-Italian summit, there will be two leaders out of three that are leaning towards a growth strategy, even if nuanced. If until now Monti has politely reminded Sarkozy and especially Merkel, that the problems that Europe is facing cannot be resolved by cuts alone, now he will be joined by an Hollande who has practically ignored the needs for fiscal prudence in his campaign, and has basically insisted on the need to keep and actually reinforce the French welfare state that costs about half of GDP.

Of course Merkel has been there and seen this already, and as the Economist reminds us, all chancellors end up ‘convincing’ French presidents over time. The problem is this time there isn’t much time, and the markets tend to like to test new paradigms or leaders sooner rather than later.

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