"The world of men is dreaming, it has gone mad in its sleep, and a snake is strangling it, but it can't wake up." - David Herbert Lawrence, English writer.
Courtesy of our good friends from
Rcube Global Macro Research, please find enclosed their recent note on the Euro and its "Third Snake in The Tunnel".
"During the past few weeks, the global markets’ spotlight has moved from Europe
back to its usual US focus, concentrating on US companies’ results and on the effects
of the coming “fiscal cliff”. In Europe, as cans were kicked and bazookas were
loaded, the “muddle‐through” scenario that we referred to in our previous Eurozone
papers1 is now back on track. That said, like most observers, we believe that the
Euro crisis is far from over.
Let’s first look at the Euro from a historical perspective and reminisce about the
system that led to its creation: the “snake in the tunnel”.
The “snake in the tunnel” was the mechanism that European Economic Community
(EEC) members used in an attempt to limit currency volatility after the collapse of
the Bretton Woods system in 1971. The “tunnel” consisted of bands of 2.25% up and
down, inside which currencies were allowed to trade (in other words, currencies
were allowed to lose 4.5% against the Deutsche Mark, the strongest currency). The
system started in April 1972 with 9 members (the six EEC founders and three soon
to be members). The UK left the tunnel in June of the same year, Italy in January
1973 and France in 1974 (it later rejoined and left again in 1976). By 1977, only
Benelux and Denmark were left in the tunnel with Germany. Even for those who
remained, tunnel limits had to be adjusted a few times because of the strength of
the DEM.
In 1979, the system was resurrected with a more appealing name: the “European Monetary System” (EMS).
Tunnel limits were readjusted regularly during the early eighties. By the mid‐eighties, disinflationary policies
throughout Europe finally brought semblance of stability to European currencies (see graph below):
However, by the early 1990s, the system had failed again: in 1992, after only two years of membership, the
UK left (soon after “Black Wednesday”), and Italy followed in 1993. Although Germany’s insistence at keeping
interest rates high following its reunification was blamed for the failure of the EMS (it was already Germany’s
fault!), any other large asymmetric shock would have resulted in the same outcome.
After two failed attempts in their battle against volatility, as “third time’s a charm”, European politicians
decided to up the ante. In the Maastricht Treaty, they decided to eliminate currency volatility once and for all
by simply eliminating individual currencies themselves. The Euro would be an irreversible solution, because no
provision would be made to facilitate the return of national currencies. For the general public, the single
currency would simplify their lives when travelling within Europe (and save them money in exchange fees).
As we know in retrospect, the first ten years of the common currency (and common rates curve) led to huge
bubbles and malinvestment in PIIGS countries – on government debt, private debt, wage inflation, and so on.
Had the PIIGS countries kept control of their currencies, they would have been able to monetize part of their
debt in the face of the crisis that ensued (like most central banks currently do not refrain from doing).
Additionally, letting their currencies slide would have helped them regain competitiveness.
Instead, market adjustments had to be made in other ways, and volatility, the politicians’ nemesis, reared its
ugly head and found a new habitat: government debt yields.
With the Euro, we therefore now have a third “snake in the tunnel”. Instead of central banks trying to defend
their currencies, various entities (ECB / IMF / ESM / EFSF and so on) intervene whenever a Eurozone
member’s sovereign spread breaches an unofficial threshold of around 600 bps against Germany.
In exchange for being bailed out, PIIGS countries have to apply harsh austerity measures internally, under the
authority of the “Troika”. In a way, they have been demoted to developing countries original sinners,
indebted in a currency that is not theirs to print.
For both political and economic reasons, this system of conditional bailouts is not a viable solution in the long
term. This is evidenced by the fact that countries that benefited from a bailout are still trading above the
600bp tunnel limit.
For the Euro to survive in the long term, we believe that large explicit transfers of wealth between creditor
and debtor nations will be necessary at some point. Regardless of the term used, the European Union will
have to morph into a de‐facto “federation”.
The feasibility of a federal Europe
In his September 2012 State of the Union address, José Manuel Barroso, the European Commission President,
proposed to transform the EU into a “federation of nation states”, with preliminary discussions starting
before the 2014 European elections.
In early October, EU’s President, Herman Van Rompuy made the case for a Eurozone central treasury, which
would have its own budget and be able to raise funds.
Although these proposals havenft sparked enthusiasm, we believe that moves towards a federal Europe will
be the only way to avoid the next leg of Euro crisis to be fatal.
In fact, some of the most ardent supporters of a federal Europe have always considered the Euro as a way to
force deeper integration. The current debt crisis is the perfect setup to promote integration, because it forces
countries to create a gcommon beasth to feed.
In economic terms, the countries with the most to lose in a federal solution are the creditor countries, which
are generally also the ones with the highest GDP per inhabitant (Ireland being the exception). What follows is
a back-of-the-envelope calculation of what a federal Europe would imply in terms of permanent wealth
transfer for these countries.
Right now, the European gfederal budgeth represents a tiny percent of EU's GDP, with around half of that
devoted to the Common Agricultural Policy.
In the US, Federal outlays represent around 22% of US GDP.
As a thought experiment, we can imagine a Eurozone federal budget that represents 20% of the Eurozone's
GDP in the long term (the federal budget would probably only concern Eurozone members, because applying
it throughout the EU would require a preliminary "Brixit"). Like in the US, the federal budget for the Eurozone
would cover military expenses, a large part of social expenses, infrastructure, and so on. Some of the funds
would be spread according to each countryfs population (e.g. military expenses), while others would be more
heavily skewed towards poorer countries (e.g. social expenses).
Conservatively, we can estimate that richer EZ countries would have to give up around 30% of the difference
between their own GDP per inhabitant and EZfs average.
The current ranking of EZ countries by GNP per head of population is shown below:
Roughly speaking, countries in the richest group would have to reduce their living standards by between 5
and 7% if the EU was to transform into a European federation (we ignored Luxembourg, which is a clear
outlier at 244% of the average GDP per head).
At first glance, this does not look like a huge sacrifice to save Europe, especially if these adjustments are
spread over the next 10-20 years.
However, when we look at growing divides within countries such as Italy, Spain or Belgium, national solidarity
(let alone European solidarity) does not seem to be the course of history.
At the risk of sounding like parrots, we maintain that the Euro is a purely political construct, and therefore
depends on politiciansf (and ultimately voters') views of their best interest. If growth rates remain anemic in
Europe, it will be politically very difficult to add a new gbeasth to feed.
Right now, PIIGS' sovereign spreads still indicate large implied breakup probabilities over the next 10 years.
With a 10 year yield spread of around 350bp for Italy and assuming a potential 50% devaluation, the implied
exit probability for Italy is around 50% over the next 10 years (for more on this subject, see Rcube Macro
Analytics 18 01 2012 - The likelihood of a Euro Breakup).
In our view, spreads should continue to tighten in the coming months, as politicians still show strong
willingness to accept any compromise to maintain the system - even in the case of Greece, which should soon
receive an extra . 30 Billion despite its lack of progress in putting its own house in order.
At the same time, as long as Europe does not clear steps towards becoming a Mundellian "Optimum Currency
Area", we do not consider that Italy's or Spain's bonds are suitable carry investments, especially for the longer
part of their curve. To paraphrase JP Morgan when asked what the stock market would do, we believe that
Eurozone spreads will continue to fluctuate."
We could not agree more with our friends from Rcube.
"And for love’s sake, each mistake, ah, you forgave
And soon both of us learned to trust
Not run away, it was no time to play
We build it up and build it up and build it up
And now it’s solid
Solid as a rock " - Solid, Ashford and Simpson lyrics
Stay tuned!
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