Confidence or else

In the final scene of Le Corniaud, a classic of French movie comedies, as they ride to the police station, a gangster (played by de Funès), is explaining to the naïf who helped in his capture (played by Bourvil) how to multiply his prize money.  The naïf is doubtful and de Funès can’t help but blurt out: “Don’t you trust me? But really, don’t you trust me?”

The US, Europe and China face their own economic problems, but the common obstacle towards their recovery is the lack of trust in which their citizens hold politicians.  And of course, the greater the needed sacrifices, the more people will insist that politicians be both competent and fair-minded.

Take the Greeks.  Here they were, spending their merry and voilà, they got into the EU, no questions asked.  And not only could they keep overspending, but now they could borrow all the money they wanted almost as cheaply as Germany. Was it their fault if they took free money, or was it the fault of the markets that threw the money their way?

The problem is that markets now want Greeks to become German-like overnight.  Other European countries would give Greece more time, if they trusted it.  And the Greeks themselves would likely bite the bullet, if they trusted that the pain would be shared among all parties, rich and poor, foreign creditors and fellow European nations.   

But whom to trust to lead them?  The Panhellenic Socialist Movement (PASOK) was in power when Greece joined the euro-zone; the New Democracy succeeded it and it was on its watch that serious deficiencies in public finance accounting were recorded; finally, PASOK came back in 2009 but its current leader, George Papandreou, has seen popular support evaporate.

With responsibilities for mistakes so evenly shared, it is understandable that no party is viewed as a savior and that the Greek population seems to prefer a coalition government.  Still, even if this is what happens, the task of the new government will be extremely difficult.  More austerity looks unlikely as not politically feasible.  Increasing the “haircut” on foreign creditors wouldn’t reduce public debt that much, and if it reached 75%, the whole exercise would look more like repudiation than restructuring.  A meaningful debt reduction would necessitate the ECB, the IMF and several governments accepting to take a loss on their loans, which is possible but, in some instances, would be a first.

Even if some combination of the above were achieved, Greece would still need to grow and become more competitive.  It is regrettable than privatizations, which could both help reduce the debt and form the basis of a more competitive economy, have been deemphasized lately.  This leaves only three possibilities: cutting salaries further, introducing permanent transfer payments within the EU or devaluing the currency. 

As I noted earlier, I think that further cuts in salaries are not in the cards.  Setting up permanent transfer payments is a possibility.  After all, exports account for 1/3 of Germany’s GDP, and of these, 63% go to the EU (35% or so go to the euro zone countries).  It is clear that countries like Germany (and the Netherlands) need a healthy Europe to which they can export in euro terms; their exports outside the euro zone benefit from being denominated in euro, rather than in a stronger deutsche mark.  For the richer members, it makes sense to permanently share some of these benefits with the poorer members of the euro zone.  But again, it is unlikely to occur in the near term.  Finally, there is devaluation, i.e. exiting the euro; this would offer immediate and sizeable financial benefits provided that such a move was accompanied by very tight management of public spending and inflationary expectations.

I think that the odds are 50/50 that Greece stays within the euro zone.  Staying, in my view, would necessitate the following: (1) the ECB, the IMF and European governments taking a “haircut” on their loans; if my memory is correct, some supranational institutions took a loss on their Argentine loans a decade ago; (2) the privatization program being expanded to up to $100 billion and implemented as soon as possible, with some features akin to the Chilean capitalismo popular in order to give the Greek population a share in its upside potential; (3) the coalition government implementing the adjustment program  more effectively than its predecessors, and (4) some sort of medium to long term transfer system at the euro zone level (there again, confidence will be key, confidence by the euro zone members that Greece will deliver on its promises, confidence by the Greeks that richer euro zone members will deliver on theirs).

Unless all sides can show results, confidence will collapse and we will be left with the exit scenario.  External financial assistance will be cut; this won’t be so difficult if European banks are recapitalized and Italy mends its ways.  The Greek population will refuse to sacrifice further, will reject traditional political parties and leaders; unrest and violence will grow; parties outside the mainstream will gain influence and by the end of 2012 the possibility of a military coup will have greatly risen.  Contrary to popular opinion, military coups usually occur because a sizeable portion (at least 1/3) of the population wants it, not because some general feels like grabbing power.  This would isolate Greece politically and economically and precipitate its exit from the euro zone.

Greece may still choose to exit the euro zone in a democratic fashion if it decides that it cannot bridge the productivity gap with the core of the euro zone, or if it decides that the costs of such an effort outstrip its benefits.

What is clear is that Europe must be rethought as it is becoming fragmented.  At present, we have the 10 non-euro countries, some of which have sizeable and vibrant economies (Poland, Sweden and the UK), we have a strong core euro zone (with the likes of Germany, France, the Netherlands, Finland), we have a weak euro periphery (Portugal, Greece, Cyprus) and finally some countries which could move into any of the above categories (Italy, Spain and Ireland).

If a euro zone with 27 members is not feasible, at least for a long time, what should Europe stand for?  If its purpose is to strengthen the economies of its members, wouldn’t a free trade zone achieve that, without the need for a common currency?  If the purpose is enhanced security, what is the need for a common fiscal policy?  What is the sense of a common central bank if this bank is not the lender of last resort?  Harmonizing fiscal and monetary policies is much more demanding than it sounds when one realizes that this necessitates harmonizing social, labor and defense policies too.   

For a thousand years, France, England and Germany’s predecessors have followed a policy of triangulation to advance their interests and keep rivals in check.  In a sense, the European Union was a way to keep tabs on each other, to get not so close as to surrender sovereignty yet close enough to discourage confrontation.  It might have worked if the Union had been limited to its founding members.  It wasn’t.  The status quo will not work.  Each nation, the wiser for the experience, must now decide what it wants and what price it is willing to pay. 

I think that the current financial crisis can be contained in a relatively short period of time if confidence can be restored.  It will take years to solve it and longer still for a new Europe to emerge.