COVER STORY

Too Late for the Euro?

A decade into its ambitious currency experiment, the Eurozone is in trouble. Business school professor David Beim, a financial-markets expert and former investment banker, says the euro's hour of reckoning is at hand.

Published Winter 2011-12
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Columbia: Is the Eurozone too big to fail?

Beim: I don’t know who would bail it out. It’s too big for the International Monetary Fund (IMF). I don’t think the United States could spend scarce resources trying to bail out Europe. As for the Chinese, I was teaching a group of about thirty senior Chinese executives who had come to the business school’s executive-education program recently. I gave them my little talk on the euro, and they were visibly angered at the thought that the euro might fail. They said, “We want it to succeed; it must succeed.” They want to have an alternative to the US dollar. That’s their game. But are they going to put money into the euro? I don’t think so.

Illustration:  Mark Smith 

Columbia: Could the European Financial Stabilisation Mechanism or a unified European bond help?

Beim: These are both ways of raising new money that might be lent to the stressed governments of Southern Europe. But because this kind of lending is temporary, its success depends on the theory that the underlying imbalances will quickly self-correct. They are not self-correcting, though. Once you see that the payments imbalances are structural, and are the result of the euro itself, you realize the folly of lending ever-larger amounts to states that already have too much debt. These are called bailout loans, but they are not bailouts at all: they only increase the debt of countries that have too much debt already. They pour more water into the boat, they don’t bail it out. If countries have too much debt, there’s only one rational solution: reduce their debt. 

We had a comparable situation in the 1980s, when almost every government in Latin America was over-borrowed and in default. Everybody thought they’d grow their way out of it, but they didn’t, and the crisis only got worse. The interest due was never paid but got rolled up into ever-higher amounts of principal. Those countries were just strangling. In Mexico it was called the lost decade. The crisis was brought to an end in 1989 by Nicholas Brady, the US secretary of the treasury, who told the banks that they had to negotiate major reductions of Latin sovereign debt. And so they did. New “Brady bonds” with secure principal but lower value were exchanged for existing loans. Latin sovereign debt was reduced by 50 to 85 percent, depending on the country. US banks and other big banks took a huge loss, but prosperity quickly returned to Latin America. Southern Europe urgently needs that kind of relief.

 

Columbia: How would that work?

Beim: It would basically be an offer to all those who hold Greek bonds, for example, to exchange them for a new instrument of greater security but lower value.

 

Columbia: Isn’t a deal like that being negotiated?

Beim: Yes, but it’s too little and too late, and it involves only private-sector lenders; that is, it exempts the ECB, IMF, and other state organizations. Also, they are trying to make it voluntary, which is extremely difficult to negotiate. The euro leadership has said they never want to do this again. But they will have to do something, some day.

My thought is to give the stressed Eurozone members true debt relief — comprehensive debt reduction that could let them restart their economies, but on one condition: those that get such relief must leave the euro. That condition gives them a reason not to ask for it; every country would want a debt reduction unless there was a penalty, and this would be the penalty, which would slow down contagion. 

I don’t think this is an unreasonable condition. Greece should never have been in the euro in the first place. Its businesses are now being crushed under a wave of cheap imports because its currency is overvalued. Re-establishing the drachma would be messy and expensive, but less messy and less expensive than staying in the straitjacket of the euro.

Columbia: But the Eurozone leadership is not going to want to do this, is it? 

Beim: No, amazingly, they are locked into a political idea that the euro must be preserved in its present form, no matter what payments imbalances it leads to. I have never seen a project with such strong politics and such weak economics. If some party has too much debt and is being economically crushed, like Greece, something needs to change — a fresh approach is needed. Instead, the leadership steams forward with more of the same, lending ever-larger sums instead of rethinking the fundamentals.

 

Columbia: How serious a problem is that?

Beim: The ECB recently announced that it will lend unlimited amounts to Eurozone banks on low-rate, three-year terms, creating the impression that Eurozone banks have an unlimited capacity to finance the Eurozone governments. But there is a huge problem: banks also need more equity capital to carry increased assets. The Basel rules require that banks hold sufficient “core tier 1 capital” — essentially, common stock and retained earnings — against various types of risks. These standards have been raised as a result of the 2008–2009 financial crisis, and now European banks do not have enough capital to counterbalance all the assets they currently have, let alone new ones. The European Banking Authority recently estimated the capital shortfall of EU banks at 115 billion euros, though if the actual market prices of sovereign bonds were taken into account, the capital shortfall would come out closer to 300 billion euros. 

In other words, unless some nice investors show up willing to buy one or two hundred billion euros of new common stock in the European banks, the banks will have to sell off existing assets and will be in no condition to go on financing the governments of Europe. Deutsche Bank estimates the expected bank downsizing at 1.5 to 2.5 trillion euros. Banks have overdosed on government bonds in the past and must now slim down. This takes out of action the main class of buyers for Eurozone government bonds.

 

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