The Euro - The Impossible & The Improbable

How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth? - Sherlock Holmes

Things that are impossible:

• Greece can austerity-its-way-out of a debt to GDP ratio of 160%

  At the beginning of the crisis, Greece had a debt to GDP of 110% (10% lower than Italy today, albeit with a high fiscal deficit).    After 4 years of austerity and a massive debt write-off, the debt is up to 160%.

  When a sovereign has high debt to GDP, the answer is to inflate, not deflate.   Because, using simple math, when you start having both the numerator (debt) and the denominator (GDP) go in unhelpful directions, it is almost impossible to get out from under a large debt load.

  So far, the history of the various agreements between EU and Greece on austerity is that the EU/IMF pretend the economics models will work and the Greeks pretend they will implement them.    And everyone kicks the can down the road.

• The Eurozone in its current form can eject Greece and prevent "contagion"

  Large parts of the Eurozone are suffering from this delusion.   Once a member leaves the Euro, it becomes clear that the Euro is not a currency union, but a hopelessly rigid series of currency pegs.    Currency pegs, famously, break all the time.    You will have immediate and massive pressure on the next country - in financial markets, from fleeing depositors, from businesses pulling investment.    And you wipe out the benefits of a currency union permanently, particularly around reducing cross-border currency/redenomination risk.   The EU has already done massive damage to itself in this regard.   If they let Greece go, it will get much worse.

  Just like nobody enjoyed getting paid back their Euros in drachmas, nobody rational is going to wait around to see if they will get back lira, pesetas or escudos in exchange for their Euros.    This triggers a self-fulfilling bank, investment and credit run.

Once you accept the following, then one of these three scenarios become the outcome, however improbable they might seem:

1. Renegotiation:  Europe will in fact renegotiate the Greek memorandum, if Greece ever puts together a government, and continue to 'extend and pretend'.
2. Collapse:  Greece will leave the Euro.    In a few weeks or months, another member will go - Portugal or Spain most likely.    Once Italy starts to go, the Germans lose their nerve, realize they can't rescue the whole Eurozone and let it fall apart
3. Integration:  The Eurozone, in some manner or another, decides to mutualize debts.   Given that the largest debtor in the EU is Italy and it, at this stage, is almost over the edge, this means the burden will fall very heavily on Germany.   This is going to take a level of domestic diplomacy in excess of what we have seen from Merkel to date.   We will discuss this more in further posts.

   There is a sub-plot here which is whether or not integration happens with or without Greece.    Germany seems to have given up on Greece and seems to be counting on managing a Greek exit, followed by further integration.    This strikes me as extremely risky living.    Given the huge coordination costs in Europe, I think this pathway has a 50:50 chance of ending in collapse as events get ahead of EU policymakers' ability to move quickly enough

These three outcomes are the only outcomes to Euro crisis:  Either Greece is going to get a renegotiated package, or the Germans will pony up to pay for the whole Med region or the whole Eurozone will fall apart.