Le radeau de la Méduse

This painting by Gericault, one of the most famous of the French Romantic School, depicts survivors of the shipwreck of the frigate La Méduse as they are to be rescued by the brick Argus.  The disaster was caused by incompetent leadership and resulted in over 150 deaths.  The survivors picked from the raft resorted to cannibalism to survive.

It is too soon to compare the current travails of the eurozone with those of the sailors of La Méduse, but surely it isn’t to say that a euro shipwreck looks increasingly possible.

The latest report by the IMF on Greece is sobering.  The Greek economy is weaker than anticipated, the pace of structural reforms is slower (partly as a result of bureaucratic resistance, partly as a result of poor implementation); bank deposits keep on shrinking, credit to enterprises is falling, competitiveness is marginally improving, mostly as a result of dismissals.

While large institutional bank creditors had “voluntarily” agreed to a “haircut” of 50% on their Greek public bonds, rumor has it that the government wants to apply it only to the nominal value of the debt; by offering very low interest rates and extending maturities it would increase the effective “haircut” to 75%.

Greece is in a bind as the IMF, ECB and other euro governmental credits are exempted from the “haircuts” so that private creditors bear the brunt of the restructuring.  As I wrote in a previous note, there is little difference between a 75% haircut and reneging on one’s debts.  Argentina is a good example of that, and it has been a decade since it hasn’t been able to tap international bond markets.

Furthermore, can Greece fail to pay 75% of its public debts and still belong to the eurozone?  Can Greece restructure its public debts, exchanging them for new bonds worth 25% of the originals, and still characterize the process as voluntary? The answer is no and no.

Initially, I thought that the insistence by several European heads of state that the exchange be voluntary was nothing more than pride.  Now, I wonder.  What if big European banks had been sellers of CDS (credit default swaps)[1]?  Why not?  After all, the underlying credit risk was supposed to be zero; what a better business than selling for thousands of euros protection (CDS) against a risk that was non-existent (sovereign default)? 

European banks may have sold relatively few Greek CDS, but they may have sold tons of French, Italian and Spanish CDS, and a formal default in Greece would, at the very least, force these banks to provision against the other countries’ CDS because the myth of zero-risk eurozone would disappear.  Provisioning is a euphemism for taking a (big) loss.  I did look into the exposure of BNP and other banks to European sovereign debt but these banks only disclosure their exposure in their banking books, not in their trading books, which is very unfortunate under the circumstances.

The only way for Greece not to, in effect, renege on its obligations is for the IMF, the ECB and other euro governmental creditors to share in the losses of restructuring.  If not, Greece is out of the eurozone, with all the implications it carries for the rest of the area.  Even then, it is difficult to see how Greece will improve its competitiveness and enable its economy to grow fast enough, particularly given the European austerity and deleveraging policies.  At the end of the day, I can’t see how Greece stays in the eurozone.

The other eurozone members face different but equally daunting problems.  One is the fragility of their banking system.  In the US, banks account for 1/3 of total credit and capital markets for 2/3.  In Europe, the proportions are reversed yet banks have less capital and less stable funding (their ratio of loans/deposits being well over 1.0).  In recent weeks, big European banks have announced extensive divestiture programs to strengthen their balance sheets.  This may be good at the micro level, but it is bad at the macro, leading straight to recession.  And then there is the CDS question raised above.

European governments could have forced their hands with their equivalent of a TARP program (by far the most successful US effort to stem the 2007-2008 financial crisis).  Yet they shied away, afraid of jeopardizing their credit ratings.  This was a terrible mistake.  The financial situation will not improve until banks get stronger, and sovereign ratings will drop unless forceful governmental action is taken.

The other problem is existential.  Member countries share a goal but not the means to reach it.  They want to be a powerful economic bloc but they do not want to pay the price for it but harmonizing their fiscal and social policies, and in the process relinquishing some degree of sovereignty.  They desire a common currency but refuse to let the ECB back member states private banks not to mention member state public debts.  Finally, member state populations, when asked, reject the idea of a Brussels command, yet they now have to accept one from Berlin and, yes, Brussels.

As the situation worsens and tensions rise, the survivors are warily eyeing each other; numerous meetings have shown that they are unable to reach big decisions (such as recapitalizing their banks, getting the ECB to step up to the plate) or to display real solidarity.  The sniping has started (witness the French/UK[2] war of words on credit ratings) and will get worse. 

For all of the demonstrations of coordination and harmony, it is clear that Germany is the leader of the eurozone and France is the more equal of the rest.  When de Gaulle envisioned l’Europe des Nations, he meant not to relinquish sovereignty to Brussels; today, it has been relinquished in part to Berlin.  President Sarkozy will no doubt continue to play the game until the elections; doing otherwise would mean acknowledging a reality which the French dislike. 

Afterwards, changes are inevitable.  Pulling up to Germany’s level would require huge changes in labor laws and a shrinking of the public sector which seem beyond Mssrs. Sarkozy or Hollande powers.  France can’t revert to the age-old French/English/Prussian triangulation because the UK are outside the eurozone.  Italy, under strong leadership, could offer France some of the balance it wants.  Still, Italy would not offer a real triangulation, and as a result, I think that France will wish for less European integration rather than more, for a gaullian Europe of Nations so to speak.  Ironically, in so doing it would get closer to the UK position.

Perhaps a slowly healing US and resilient BRICs will give Europe six months to a year to avoid disaster.  But the pressure will not abate, the price to pay will not drop.  In the end, a Europe of Nations is more representative of the continent’s two millennia of history than a contrived eurozone.

Germany could mitigate the strength of its new currency by preserving a mini eurozone with Austria and the Netherlands.

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[1]  This is a question that hedge fund manager David Einhorn has also been asking.

[2]   I know, the UK is not part of the eurozone.