4/18/13 – The European Gap Gets Wider

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 18, 2013 9:12:25 AM

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As I wrote after Cyprus, I moved from a not-at-all-certain belief that the euro would make it, for political reasons, to a just-as-uncertain suspicion that it would not (also for political reasons). Recent events continue to widen the gap between the “make it” and “not make it” conclusions.

When Greece first defaulted, the narrative was all about irresponsible Greek borrowing, with the clear implication that they had it coming. News coverage focused on early retirement, state pensions at 50, and low tax compliance. In fact, when default hit, imports of necessary goods such as medicines also essentially stopped for most of the population. Very little of that made it into mainstream coverage.

With today’s front-page story in the New York Times about Greek children going hungry, the tone has changed. From tax cheats and pension spongers to front-page hungry kids, the narrative shift is about as big as it gets.

The fact that this coverage is showing up in U.S. media suggests that it’s much further along in Europe, where the populations are directly affected. Austerity has hit Ireland, Spain, Greece, Portugal, and Cyprus so far, or more than 20 percent of the eurozone population. That matters. If you include Italy and France, it’s almost 60 percent of the population. That’s not politically sustainable.

The cracks in the eurozone are widening. We saw the northern countries’ willingness to write checks crack over Cyprus. Now, we’re seeing the deficit countries’ willingness to cut spending crack as well. France, the biggest of them, announced Wednesday that it was slowing its deficit-reduction plans to avoid a recession. The conflict here is between deficit spenders, who need regular currency devaluations, and balanced-budget countries, who don’t. For the euro to hold together, one of the two groups has to change.

So far, only small countries have hit the wall, and they could be bullied. Greece and Cyprus, for example, chose to sacrifice their local economies as the lesser of two evils (versus leaving the eurozone). This wasn’t a choice they made willingly; they were forced into it.

Spain has also made that choice, but more slowly and more unwillingly. Larger than Greece, but still relatively small economically, it could also be pushed around—just not so much and not for so long.

Now, France has to make that decision—and, as one of the big two along with Germany, it’s too big to be bullied. This will be the point at which austerity lives or dies as the core of the euro project. France’s recent decision to slow austerity plans suggests which way the decision will go.

So far, Germany has been unwilling to push the issue. With elections coming this fall, the government is desperate to avoid presenting voters with a hard choice on more spending or, worse, the failure of the euro. Nonetheless, that is the decision ahead, as France and other countries simply will not continue to sacrifice their economies and their people on the grounds of balanced budgets—historically, a concept they’ve never believed in or complied with.

So, post-election, Germany will also have a choice to make. Open up the spending faucet, or let the euro in its present form go. Thus far, the Germans have consistently opted to keep spending, and there are sound economic reasons for them to continue to do so. Politically, however, domestic opposition keeps building, to the extent that a new party has been created specifically to oppose more spending.

As the gap between Germany and France, in particular, widens, it becomes more and more difficult for leaders to stand astride it. In the next several months, I suspect all of them will have to jump to one side or the other, or collapse into the middle and take the euro with them.

As I said, a collapse seems the most likely option. Either way, we are looking at turbulence ahead.

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