To describe as sobering last night’s UBS report into the consequences of a European breakup hardly does it justice. It is about time someone began to assess the consequences of a breakup with a hard, cold eye and kudos to UBS for doing so. Hopefully it will help dispel some of the elementary drivel floating around that Australia will be immune to any breakup. Probably not.
But there’s one thing, unfortunately, that I felt was wrong in the report: it’s optimism.
That may sound a bit strange in assessing the most apocalyptic report I’ve ever read from an investment bank. But, despite writing an exemplary report, the bank has shied away from the conclusion its own analysis suggests we draw:
Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries can not be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such a move.
Let me say at this point that I have been a long-time supporter of the euro, not to mention the greater EU project, so my own pessimism is not the result of a long-term bias. Quite the contrary. I have supported the EU project because I’ve had some faith in the dialectical progress of man.
I was born in 1967. My father fought the Japanese on Bougainville. I recall the damage it did to him. I was not alone in this witnessing of the scars of the catastrophe of WWII. It imbued my generation, and the baby-boomers, with some sense that it should never happen again. That war was an intrinsic evil. There was no better illustration of this than ANZAC Day. In my youth, the national day was an ironic affair, when people gathered to curse the incompetence of the English.
But that has changed. We are now four generations beyond WWII. The great liberal empire of the United States is happy to embark upon “elective wars”. And they receive popular support from people who do not want to think of themselves as cringers or wish to be patriots. Dozens of Australians die in Afghanistan and we don’t blink. ANZAC Day has become a cause for the celebration of fallen heroes, not a reminder of the horror of war.
I guess Europe more than elsewhere is still driven by dark memory. It still fights to avoid wars of choice. But the fading of memory across generations appears to me to be universal.
Coming back to the UBS report, there are five facts about the European impasse that it is impossible to ignore. From Kantoos Economics recently:
- Scene 1: establishment of a currency union, celebrated as a milestone on the path to cooperation and mutual understanding in Europe (NOW: Helmut Kohl’s euro. THEN: the restoration of the gold standard in the mid-1920s in the context of the Briand-/ Stresemann rapprochement policy).
- Scene 2: the accumulation of macroeconomic imbalances in the wake of the currency union (NOW: capital flows into the GIPS economies 2000-08 that unleashed a debt-financed consumption and real estate boom. THEN: the debt-financed, capital import driven consumption boom of the Weimar Republic during the “golden twenties“). Capital flows go almost exclusively to the non-tradable sector -real estate, public administration, financial services – push wage levels upward and undermine the economy’s external competitiveness.
- Scene 3: a sudden stop of capital flows during a global financial crisis. The stop leaves behind economies that are as overindebted as they are uncompetitive and have large external financing needs (NOW: the GIPS-economies from 2009 / THEN: Weimar-Germany from 1929).
- Scene 4: attempts to reign in the crisis with austerity measures and multilateral financing packages cobbled together during painful negotiations. Everything is subjugated to the objective of avoiding sovereign defaults and preserving the currency union. The packages treat structural overindebtedenss as a problem of illiquidity, not insolvency (NOW: support packages for the GIPS-countries / THEN: Young plan, Young loan and Hoover moratorium); competitiveness has to be restored through falling wages rather than currency devaluation (THEN: Brüning’s deflationary policies) – both entirely inadequate to eliminate macroeconomic imbalances.
- Scene 5: continued loss of confidence, intensification of the crisis, upheaval in the debtor countries, whose populations are no longer willing to carry the crushing burden of adjustment, and tired frustration on the side of the creditors (THEN particularly destructive U.S. Congress that refused to follow the lead of a well-meaning but weak President – Herbert Hoover).
In short, Europe has somehow stumbled into the same macroeconomic settings that the Eurozone project was established to avoid (yes, there are differences, ECB etc.) These are the facts on the ground. If the leadership of the Eurozone has been unable to avoid the very fate they feared, why is UBS rating the risk of a break-up at zero? In effect, in perusing the fallout of a breaking Eurozone project, the UBS document is arguing that the costs will prevent it happening, even though it admits “no popular discussion of the break-up option considerably underestimates the consequences of such a move”.
But, as the above macroeconomic settings show, the alternative scenario is an ongoing grinding down of everyone other than Germany and possibly France, even in the event of fiscal integration. Ask yourself, what choice will politicians offer their people, or the people demand of the politicians? Will they accept a relatively swift grinding away of their standards of living or will they want to risk departure from the Eurozone in the hope of greater opportunity.
Indeed, the UBS document itself seems somewhat political to me. After all, one wonders what would happen to UBS in the event of a breakup.
I don’t know what the odds of a European break-up are but they are substantially higher than zero.
