Shawshank, VA 10/11/2011 (PennyPayDay) – A sovereign default does not come out of the blue, without warning. A sovereign default is akin to watching an ill fated freight train speed past the “Bridge is Out” sign toward the chasm. There is always the chance that the brakes may be applied in the nick of time, but failing that, no one is really surprised by the sight of the caboose disappearing over the cliff. A change in a currency regime however is a plan best hatched under cover of darkness. For instance, you can’t foreshadow devaluation without seeing a pre-emptive capital flight drain your banks and with it wash away any advantage you had hoped to gain through such a move. The economic dislocation that results from a major change in the value or fundamental structure of a currency makes it imperative that the change comes out of the blue.
When Nixon “closed the gold window”, ending the convertibility between the dollar and gold, in August 1971, he took the decision after a closed door session with advisers without consulting any other members of the international monetary system. This was no small deal as it tore asunder the Bretton Woods system of monetary order negotiated by forty-four allied nations in July 1944 and which came into being the following year. The decision to back out of the system was so stunning it soon became known at the “Nixon shock”.
So important was the element of surprise to this announcement that it is said that the President’s advisers now recall that more time was put into how and when to spring the controversial plan than was put into creating the finer points of the deal in the first place. This is not to say whether or not this was the right move to make, but that it was a move that could only be made behind closed doors lest the problems that it was intended to solve would get much worse in the time between general awareness of the plan and the actual execution of it.
The rightly held fear was that in the interim there would be a rapid collapse of the dollar, that was already quite weak, and a flight from the US of the gold that had backed its value. Sure there were dots that in retrospect could easily be connected to one another; but then there are no surprises when history is deconstructed and you walk back from the historical outcome and review the events that led to it. For instance it was West Germany that was the first to leave the system in May 1971 and Switzerland followed their lead in early August. But the big fish in the Bretton Woods pond was the US and its dollar and its exit was truly a shock to the system.
Success of the eurozone depends on all parties living up to the agreements that have been made and for all those in the currency union to act as one. But it is fair to say that one or more members have already failed to abide by the relevant treaties and it has become clear that the system as it was constructed is not something that can work. Greece is being told that it must pay with austerity for its fiscal sins while Germany and others are being asked to provide the backstop for this and any other shortfalls.
This is not how the zone was supposed to work. This crisis has done more to clarify the differences of the members than it has done to expose it as a unified group pulling in the same direction. For all of the declarations by the various European leaders that they will not allow Greece or the larger project to fail I think there are more indications of countries going it alone than there are indications of all for one and one for all.
As the Financial Times noted in a recent editorial, “Cracks are already visible in the edifice of European unity—witness the strain on the Shengen visa-free travel scheme.”
Although there is much talk of another grand bargain being reached by Merkel and Sarkozy the lack of details is troubling. It is unlikely that Merkel has the political clout within her own country to offer up more German treasure to plug the holes elsewhere in the system. Her recent comments seem more aimed at making sure her banking system is covered than at funding a program for the larger group. If success of the eurozone is dependent on Germany going all in then there is also a problem, as it is questionable how far they can go down this road without revisiting their own constitution.
European unity is about more than a common currency and free trade; it is at the end of the day an expression of the desire to have a continent without war. Therefore the fear of a break-up of the union is about more than economics it is about the maintenance of peace. But that does not mean that Germany and the others will stick with a system that does not work, because that could make any eventual problems from dissolution all the worse. I don’t know how this tension will be resolved, but it does not appear the status quo is the long-term solution. Some have said Greece should go back to the Drachma.
Others, such as hedge fund manager Kyle Bass, said it is Germany who will exit first. Alan Greenspan says that it is the chasm between the northern European countries and the South that must be bridged for the euro to remain viable. “Above all, leaders must create the political conditions for good policy;” say the editorial writers at the FT. “Monetary union can only survive if each of its members wants it to: without voter support Europe will fail.” But what are the odds that a referendum on the currency would pass in Greece or Germany at the current time?
Last week Mohamed El-Erian, CEO of PIMCO, said that “the unthinkables have become a reality.” He was not referring directly to the situation in Europe but it is a comment that may be applicable to the continent. The path forward is far from clear, but the one thing that can be said is that if there is a change coming in the structure of the common currency the announcement will be a surprise when it happens. And even though it may be one of those unthinkable outcomes, there are plenty of dots that could be connected.
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