When England lose on penalties in the World Cup quarter-finals this month (we all know this is inevitable) the shootout will be governed by a new rule. Penalty takers will no longer be permitted to delay the kick at the last second with a feint to fool the goalkeeper. This tactic, much beloved of the splendidly moustachioed John Aldridge of Liverpool Football Club in the 1980s, has been banned by the International Football Association Board. Transgressors will receive a yellow card and be told to take the kick again.
Subtle feints are not the sort of thing that the European Union and European Central Bank engage in. They prefer a simpler path to success: pick up the goalposts and move them to a position that is more convenient. When sterling was forced out of the Exchange Rate Mechanism in September 1992, the rules were changed so that bilateral rates could fluctuate by up to 12% rather than 2.25%. The markets then turned their attention to the French franc in 1993 and this margin was duly increased to 15%. Remarkably, just six years later, the single currency was born.
The eurozone authorities have indulged their habit of game changing in spades of late. The inauspicious moment of Greek debt being downgraded to junk status prompted the ECB to open its window, despite insisting it would stay firmly closed only days before. Then, over a hectic weekend that recalled the good old bad old days of the financial crisis, the eurocrats tore up the rulebook by announcing a €750 billion stabilization fund and quantitative easing.
Shock and awe?
The newspapers called these tactics “shock and awe”. “Par for the course” would have been closer to the truth. There is form here. After the briefest of relief rallies, markets have once more been sent sliding. There are any number of reasons to be fearful rather than cheerful: policy tightening in China; the bizarre unilateral actions of the German regulator; deflation; inflation; or sabre-rattling in the Korean peninsula. But it is the fate of the euro that is front and centre for investors.
This column has set out before why the euro is dysfunctional. But Schadenfreude would be cheap (and dull). Suffice to say that this crisis was inevitable. However, my US friends who dismiss the euro as an ill-thought-out “project” are also wide of the mark. Many of Europe’s political elites are more committed to the single currency than they are to their marriages. For them, its preservation is a sine qua non.
Sterilization paradox
A political construct undergirded by poor economics was always going to be flawed, however. The devil is in the details. For example, the ECB has said it will “sterilize” the bond purchases it makes when it starts quantitative easing. It cannot do this and at the same time offer limitless liquidity to the financial system via its Long-Term Refinancing Operation. The most effective way to sterilize QE would be to set up an ECT (European Central Treasury) that could also issue bonds and offset that excess liquidity.
That could have and should have been done in 1999. Politics got in the way. It means that the ECB does not control its monetary base. Currently that probably does not matter. Outright deflation is the bigger threat. However, it is just another illustration of why some form of euro crisis was entirely predictable. Dealt a different set of economic cards the ECB could now be dealing with soaring inflation expectations and (again) would have no means to cope.
If politics is the cause of many of the euro’s problems, it is also politics that has saved Greece, for now. The one treaty that does seem to have mattered to markets in the past 18 months is the G20 agreement inked in London last April. In the six months following its signing equities enjoyed the biggest rally since the 1930s. It says: “We are committed to… ensure the soundness of systemically important institutions…” If the G20 signs up to protect banks, it must surely also stand behind countries. This has given Greece, perhaps at the behest of the US, a stay of execution.
German chancellor Angela Merkel’s subsequent discussion of a mechanism to let euro members secede as well as accede is also telling. It may be that she was playing politics to ensure the Bundestag voted for the stabilization fund. But it is also a yellow card for Greece and the rest of the southern comfort zone and hints at what was going on behind the scenes over that weekend in May. German politicians know that their population has had enough. Having rescued eastern Germany there is no appetite to serially bail out southern Europe.
The red card option
The choice for Portugal, Greece and those like them is now an era of austerity coupled with chronic deflation or leaving the eurozone. They might get a red card or choose to leave the field. If Greece forces investors to take a 50% haircut on its debt, Europe’s banks pick up a $135 billion bill. The €750 billion stabilization fund means this can happen in an orderly way. The exit of Greece would cause a period of extreme turbulence in markets but it would neither be a systemically important failure nor an existential threat to the euro. Reform is desperately needed and the instincts of the self-preservation society will prevail.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own
