Eurozone: 3 future scenarios

Markets will never change. They have this unbelievable ability to forget what they have been focussing on for a very long time and an even more incredible capacity to converge again towards their initial fears. We all remember the period of strong risk aversion (February 2010 – June 2010) which resulted from the sovereign debt crisis on peripheral European countries (Greece in particular) and which brought the EUR / USD rate to 1.1850. During this period, the creation of the European Financial Stability Facility briefly calmed things down.

We also remember that the fragile state of the peripheral European countries was not of interest to anyone at one point since between mid June 2010 and the beginning of November 2010, the main focus was on the American economy’s fundamentals and on the monetary policy of the Fed which pushed the EUR / USD rate at 1.43 (The implosion of the Eurozone did not seem to matter at that time).

But quickly adoring what they burned and being as quick to burn what they adored, the markets massively bought dollars against euros when they rediscovered sovereign risk in Europe (The risk was now on Ireland but tomorrow it could hit Portugal and then Spain). As far as we are concerned, we have not forgotten the structural problems of the Eurozone and we put forward once again the various scenarios that we have conceived regarding the future of the Euro zone.

The first scenario which would be ideal according to us is a true reform of the Eurozone through the setting up of an economic government and real fiscal federalism. This requires a lot of time and cannot be achieved over a weekend. Over the Eurozone’s 12 year existence and after several summits, we have not seen a single attempt to construct something that could match this solution. Some people say that big projects are built when crises erupt but this can only happen with the adequate statesmen.

We do not therefore consider this first scenario to be credible and that’s a pity since it is often through strong political action that destabilizing speculation is reined in. (We remember the actions taken to solve the crisis impacting the European monetary system at the beginning of the 1990s. These consisted in reform of the system with a broadening of fluctuation margins among currencies from +/- 2.25% to +/- 15% during August 1993. The most notable part was the acceleration of the monetary union’s construction stemming from the drive of Franco German alliance).

The exit of one or several countries from the Eurozone within a context of escalating social crises.

The second scenario, which unfortunately looks more realistic, would be the exit of one or several countries from the Eurozone (we are of course thinking about Greece, Ireland and / or Portugal). This scenario would be associated with an escalating social crisis which would worsen into a political crisis. The anger of the populations should never be underestimated nor should the ability of some politicians to exploit their discontent by blaming their woes on the Eurozone membership.

The economic cost of an exit for a member country would be exorbitant namely through the suppression of its access to the markets (You might say that the countries concerned have already seen their access to the Eurozone bond markets suppressed). Despite that, only the advantages (if they can be described as such) of an exit would be highlighted in the country concerned. These would be a depreciation of the new currency against the euro, a new denomination for debt and its rejection because of strong inflation.

The intermediary scenario would translate into a real support effort by the European monetary union of the countries facing serious budgetary difficulties. This would consist in making sure that the restrictive budgetary policies that are set up are conducted along with an accommodating monetary policy (this is the case overall) and an equally accommodating exchange rate policy (this supposes a drop of the euro against other major currencies. It is not really the case right now against the US dollar and the sterling). We also remember that at the beginning of the 1990s countries such Canada, Finland and Sweden had succeeded in bringing their finances back in shape by easing budgetary restriction through a strong decrease of short term interest rates and a similar strong devaluation of the national currency.

The problem facing the Eurozone nowadays is that there are two obstacles to the weakening of the single currency. On one hand, we cannot see why the Anglo-Saxons would accept a strong appreciation of the dollar and the sterling against the euro. On the other hand, Germany (politicians, Axel Weber and different opinions concerned) looks unlikely to accept a significant weakening of the Euro since the legacy of the Bundesbank is still very much present. Overall, we consider the probability of the first scenario happening to be very weak, fairly weak for the third scenario and quite strong for the second one.