Rivas-Micoud: Three Potential Euro Zone Outcomes
If Angela Merkel had been president of the U.S. in 2008 and 2009, the Federal government would not have invested $700 billion to bail out the financial and automobile industries.
Merkel would have lent the money instead to New York and Michigan, forcing these states into bankruptcy and subsequently ejecting them from the dollar zone.
If this sounds far-fetched, take a look at what is happening in Europe. The $125 billion bailout of the Spanish financial sector has been added to the Spanish government liabilities, a 10 percent increase of its debt to GDP ratio, not to mention an unemployment rate of 25 percent.
Bondholders are voting with their feet, with Spanish government debt yields reaching historic highs — soaring above 6.8 percent the Monday after the announcement.
So what happens now? Here are three potential scenarios:
European leaders agree to force all European financial entities to conduct a realistic “mark-to- market” of their balance sheets in conjunction with a new European wide supervision and deposit insurance.
The European Stability Mechanism (ESM) is granted a bank charter, backstopped by the European Central Bank (ECB) , and leverages its €400 billion untapped equity through ECB lending to increase its size to €2 trillion.
The ESM recapitalizes financial entities throughout Europe, through equity and warrants, massively diluting existing shareholders.
European financial entities, no longer burdened with fictitious balance sheets, can raise cash through asset sales, and are able to “re-boot” into entities that lend to the private sector.
The Fiscal Compact is refined to take into account the difference between “structural” deficits that would exist even at full employment, and “cyclical” deficits that are due solely to a downturn.
Greece exits the euro zone, and six months after a 50 percent devaluation and mass defaults, starts to grow again with a sustainable debt level and a competitive exchange rate.
The euro zone starts growing again, debt to GDP ratios stabilize, and deficits are reduced.
The ESM makes a profit when it sells its shares and warrants in recapitalized financial institutions.
Angela Merkel is elected President of a new Federal Europe.
The 'Bad' Scenario
European leaders including Germany agree to a common fiscal policy and banking system supervision.
They also agree to share exposure to the amount of the current debt load that exceeds 60 percent of GDP for every euro zone country except Greece, which exits the euro zone (euro bonds).
In return for partially backstopping debt, Germany enforces even stricter fiscal policy throughout the euro zone.
The ECB from time to time offers additional three year low cost financing to banks, in return for sovereign debt, thus becoming the lender of last resort to euro zone governments through the back door.
Euro zone financial institutions book large profits by arbitraging cheap borrowing from the ECB (1 percent) and lending expensively to their national governments (4-6 percent), thus leaving each euro zone nation state deeply entwined and interdependent with its respective financial system, with large accounting profits for financial entities but no incentive to lend to the private sector.
Greece, after a 50 percent devaluation and mass defaults, starts to grow six months later as the private and public debt to GDP ratio reaches a sustainable level. Its economy attracts investment and starts exporting due to a newly competitive exchange rate.
The rest of the euro zone continues to slump, except for Germany, which continues its economic growth through a massive influx of private capital from the rest of the euro zone, as well as an artificially advantageous exchange rate.
Angela Merkel exhorts the rest of the euro zone to emulate German competitiveness
No change in what passes for policy in Europe.
Italian and Spanish bond yields continue to climb.
Germany continues to benefit from a financial and interest subsidy from the periphery through an accelerating bank/nation run to the safety of Germany.
The rest of the euro zone continues its accelerating slump.
The ESM/EFSF puny power (€400 billion of free capacity) cannot meet the needs of Italy and Spain through 2014 (€ 990 billion), let alone the rest of the periphery and even France.
Germany, Austria, Holland, Finland exit the euro zone, their currencies appreciate 30 percent, leading to their own banking problems as debtors in Italy, Spain, Greece, Portugal, Ireland and France default.
Angela Merkel reiterates that there is no “big-bang” solution, and that dealing with the fallout requires “stamina”.
Alejandro Rivas-Micoud is a serial entrepreneur who has founded, restructured and successfully exited from a number of European telecommunication operators, such as Clearwire Spain. Rivas-Micoud is currently managing a San Francisco-based video feedback Internet startup, Userlytics Corporation. He is a Nuclear Engineer, a U.S. Navy Veteran, and has an MBA from INSEAD.
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