Timing, Generals, and the Euro

At the beginning of the new year, thoughts return to time. We think of what has passed over the last year and look to the year ahead.

But what is more intriguing than time is timing. Why does a crisis erupt when it does and not sooner or later? Why do the successive stages of a speculative attack on the euro take place when they do?

They say many things about fighting a war. One of them is that it is hard to wait and not know when the next battle will be or from what direction it will come. Some insight can be gained by considering the following factors.

First, an awful lot of money is required to wage a successful speculative attack on a large country in the euro zone. Since financial speculators are dispersed, they require a means of deciding whether and when to place their resources on  a particular country, a direction, and an outcome. Just as in the horse races, the better your prediction, the better the payoff. Unlike the horse races, the target a speculator is trying to hit is determined not only by the target country but by the market as a whole. This is not an entirely anonymous and invisible market, but one that is dominated by a variety of financial institutions looking for opportunities for profit, and hoping that other market participants will prove them right.

That means that there must be a tipping point at which some trigger leads the first of the speculators to stick their necks out and the rest of them to follow until the rush becomes unstoppable. The question is, what is that tipping point? One thing that has emerged from the history of the financial crisis to date is that quarterly company reports are windows of time during which financial markets pay close attention to the way the wind is blowing. This makes sense from their perspective. When businesses slump, so do government finances, either because public finances will remain generally weak, or because catastrophic failures, which means the failure of a key company with knock-on effects for the rest of the economy may tempt the government to respond with costly, debt-fuelled state intervention that the market will eventually flee from.

The ebb and flow of reporting season, four times per year, is therefore central to whether investors are presented with a focal point that can lead to crisis. The full-blown financial crisis was triggered by quarterly reports on financial institutions. Attention has spread to the wider economy as well, in search of signs from strategic economic sectors.

What we need to watch and understand better is when and under what conditions the markets actually turn, when and how they can be held at bay, and what that deterrence is likely to cost (and what form it can take) if it is to be effective. Deterrence is a notoriously difficult thing to observe. If it works correctly, there is no battle.

However, it is possible to detect how public authorities marshall resources and how they position them. The EU heads of government are currently debating treaty changes that will allow the long-term establishment of the EFSF, and possibly bonds that use the EFSF as collateral to leverage even further funds. This is a risky move that I will return to in another post.

For the moment, it should suffice to say that using the funds available to the EU through the EFSF will not be enough. The EU will have to deploy those funds strategically when the time is right and where they are needed. That requires clear political authority that can be exercised within hours, if not minutes. Currently this authority is lacking in Europe. The Heads of Government must convene to fight whilst the enemy is overrunning them. There are no generals in command.

If Europe wants to defend the euro, that will have to change.

Paris, Berlin and the future of the euro

The French and German governments met together in Freiburg (Germany) today to discuss whether the euro zone countries should issue government bonds that they all back collectively. They also met to discuss whether the financial rescue fund created to save Greece and Ireland should be fortified with more cash as financial markets turn on Portugal. It is now clear that neither of these things will happen. For the moment.

The Paris-Berlin agreement comes a week before meetings with all EU member states on how to respond to the reality that they have now woken up to: that financial markets are far from finished with attacking euro zone countries.

Countries that are on the front lines of the speculative war on the euro have been understandably receptive to the idea of the new euro zone bonds. They would provide a source of cash that their more prosperous neighbours would likely end up paying for, given the disastrous nature of their own public finances. Germany and a host of other countries have been understandably relectant to commit to such a move. They understand well enough that the euro zone bonds would reduce pressure on the front line states to retrench their finances and lead effectively to fiscal transfers from northern to southern Europe. It is what some German politicians and most German economists feared would happen before the euro was created. That is why Germany insisted on the Stability and Growth Pact and the Excessive Deficit Procedure in 1995. Southern European governments would be institutionally and politically obligated to rein in their borrowing to prevent the question of bailouts from arising in the first place.

It is still possible that countries like Germany will give in to political pressue to save their southern neighbours, but blocking the euro zone bonds will ensure that they are not automatically obligated to do so, and that the pressure to cave in to southern European demands remains contained. Even a common euro zone bond would have to be underpinned by political agreements by the principal member states. The incentive structure, however, makes it difficult for a country like Germany to insist on placing conditions on other member states in return for saying yes. One would think that a bankrupt country with its back to the wall would be compliant with the demands of its saviours, but there is no reason to assume this.

For this reason, if Germany and its allies feel the need to assist the countries on the front line of this war, they will prefer to do this with the tools they have just agreed to rather than the bond proposal. The European Financial Stability Facility (EFSF) allows the donor countries more opportunity to retain the upper hand in negotiations. Governments that need the aid are failures and must submit to political demands, at least from a German perspective. The Germans have just come around to understanding that the EFSF should be allowed to exist in perpetuity, rather than until 2013. They are not willing to enlarge the amount of money it contains, and came to the talks in Freiburg insisting they would not budge on this demand. This ensures that pressure on applicant countries remains high. This runs the risk of the funds being insufficient, however.

Unlike their demand for automatic sanctions on countries that violate EMU's budget rules, Germany got its way this time. France chose to side with Berlin's demand to place increased pressure on southern Europe. Why is this consistent with France's previous position on automatic sanctions, which was to block them? Whilst the German camp and southern Europe lined up on opposite sides of this issue over the past two weeks, France remained uncommitted and sided with Germany in the end.

Those who saw Paris as the defender of southern Europe fail to appreciate the interest that France has in the policies and institutions of a strong currency. It has a history dating back to the mid-1980s of promoting a strong currency, le franc fort,  as a central component of its economic strategy for competitiveness and development. The political establishment in France is only too aware that Germany has achieved good results with its conservative policies during tough economic times.

And yet, this policy of the strong currency is sometimes at odds with the impulses that pervade French politics to ensure public intervention in economic affairs for the greater public good. This is the impulse that stood behind the French demand during the EMU negotiations for a measure of political discretion and control of economic affairs in an economic government for Europe.

The consequence of this is that whilst the German-led camp and southern Europe are very stable in their preferences and more or less balance each other out, France remains ambivalent and capable of swinging either way. Germany may have become the most powerful country in Europe in terms of resources and willpower, but it can't get its way without the help of France.

In this situation, France is not able to decide outcomes alone, but it is the fulcrum of Europe. When the inevitable fights over how to respond to an attack on Portugal, Spain or Italy erupt, France's position will likely tilt the European response in the direction it chooses.

That is power too.

Haircuts

A Franco-German agreement on haircuts that found support in the European Council was made public today. When countries require assistance from the European Financial Stability Facility, a standard agenda item will be whether and to what extent bondholders will be asked to accept a reduction in the value of their holdings.There is nothing automatic in this, but it has both precedent (it is standard in other venues) and the political support of the European Central Bank.