10/5/12 – How Europe Fails: The Haves

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Oct 5, 2012 12:49:02 PM

and tagged Europe

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I talked in the previous post on Europe about how the departure of a significant country could lead to the demise of the eurozone. Significant would obviously mean Germany, but also France, Italy, Spain, and, arguably, the Netherlands. These are the five largest economies in the eurozone, which together comprise more than 80 percent of the total economy. To break it down a bit further, Germany is 28 percent of the eurozone economy, France is 22 percent, Italy is 16 percent, Spain is 11 percent, and the Netherlands is 6 percent. Everything else amounts to 4 percent or less—in most cases, much less.

What is striking about this list is that only two of the big five are in good condition, fiscally speaking: Germany and the Netherlands. Combined, they account for 34 percent, or a bit more than a third of the total. All figures are as of 2011, as reported by Eurostat, and obtained from Wikipedia.com.

Much of the commentary on a potential collapse of the euro is based around the weaker countries—the have-nots, if you will— being forced to leave. This might well happen, and in the case of Greece, it is almost certain to. For this post, though, I want to think not about forced departures, but elective ones. What if one of the countries paying the bills decides “enough already”?

As you can see from the analysis above, we really only have two countries to discuss—Germany and the Netherlands. This is why the combination last month of the ruling by the German constitutional court on the European Stability Mechanism, and the Dutch elections, which briefly looked likely to produce a wholly different government, was watched so closely; both important creditor countries were considered in play. Of these, though, only one, Germany, is truly material. So the discussion about the end of the euro from an elective departure of a creditor country is really a discussion about whether, and under what conditions, Germany would leave.

Just as the euro is, first and foremost, a political project, any decision to withdraw would be a political decision. In Germany’s case, from a political perspective, the elites have been supportive of the euro. But there is a growing section of the financial community, led by the head of the Bundesbank, Jens Weidmann, that is increasingly opposed to the measures adopted to save the euro. The general elite consensus still favors eurozone membership, but it is not nearly as overwhelming as it once was. At the average citizen level, although a narrow majority supported the euro during the summer, sentiments seem to be moving the other way.

Driving these trends are the costs to Germany, which are mounting daily. What is driving continued elite support in the face of these costs is the realization that the benefits of membership are enormous. Germany is an export-driven economy and sends much of those exports to other European countries. Moreover, because the euro is a weaker currency than a purely German deutschemark would be, the German productivity advantage combined with the advantage of a weak currency results in economic performance far superior to what it would be outside the eurozone. While the costs are great, the benefits are as well, in the form of jobs, profits, and international standing.

The problem is, the costs are mounting and the benefits are eroding. Credible economic commentators are now openly saying that the economic costs of staying and leaving are approaching parity, while the political costs continue to mount. The German court ruling, although it approved the existing plans, also explicitly required legislative approval for any additional costs—approval that might not be forthcoming.

In short, while the cost/benefit equation still supports German membership in the euro, and the political discourse is still based around Europe, both equations are changing. We are approaching, if we are not already there, a point where Germany will say “no more.” Other creditor countries are already there, such as Finland, where the foreign minister recently stated that a eurozone breakup should be prepared for.

The fact that such a point is approaching does not mean it will be reached, nor does it mean that the cracks cannot continue to be papered over. What it does mean is that the room for maneuver is narrowing and that if Greece, for example, needs or demands additional support, that support will probably not be available. It also means that any pending bailout, such as for Spain, will test the limits of the possible—and may exceed them.

The fact that one-third of the eurozone economy is now being relied on to support the remaining two-thirds also points out that regardless of the politics, the economic limits of such support are fast approaching. One of my favorite quotations is that “If something cannot go on forever, it will stop,” by Herb Stein. The current economic process in Europe cannot continue forever, and it will stop soon. If things continue as they are now, the stop may well be imposed by a German departure.

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