The Eurovision Contest

October represents the three year anniversary of one of the most dramatic events of the GFC.  The “Paulson” meeting with the nine largest US banks on Monday 13 October 2008, illustrated, to me at least, just how precarious a situation the world financial system was at that time. To recap, one month after the collapse of Lehman Brothers, the then US Treasury Secretary, John Paulson ordered a meeting with the CEOs of the nine largest US banks and effectively ordered them to take USD125 billion in extra capital, even if they didn't need or want it! The meeting was a dramatic exercise in shoring up confidence in the banks - while it certainly did the job in that regard, it also created a lot of debate about moral hazard and "too big to fail". In my mind, those events added a new human dimension to how one should think about markets, namely "trust". Fear and greed drive financial markets through peaks and valleys, but all bets are off when trust breaks down and banks and other financial intermediaries cease some of their normal day to day interactions with each other. Paulson reacted decisively to ensure trust could be maintained.

And yet here we are, three years later with many calling for similar action (perhaps not as dramatic) across the Atlantic, as the perceived epicentre of risk has now shifted from the USA to Europe. The key issue for the world financial system today is to ensure that trust in European financial intermediaries (essentially governments, the Eurozone and banks) is maintained.

Everyone seems to have a different view about the future of the Euro Area. The common currency approach is being questioned and variously described as: Broke? Dysfunctional? and/or Dithering? Let's look at each of these in turn.

Broke?
According to the European Commission, gross government debt in the Euro Area is expected to rise to 89% of GDP in 2012. Viewed across the 17 member countries, the numbers don't really look that bad, particularly when you look at the US at 105% and Japan at 238% (based on 2012 projected IMF numbers). Various academics have looked at the issue of how much government debt is too much and, while there is no one answer as every country's situation is different, it seems that debt over 90% of GDP can be harmful to the future growth prospects of an economy. So while Europe as a whole is not "broke", it's the nature of the European system that is causing the current concerns.  In the current system, a default in Greek Government bonds could have big implications for Greece and also potential contagion effects across Europe. The ECB also has the power (but not the current mandate or will) to use its balance sheet like the US - one economist suggested that the ECB could create up to €3 trillion to purchase debt without unduly affecting inflation.

Dysfunctional?
Yes - when viewed from the perspective of a typical sovereign country structure, Europe doesn't make sense in terms of traditional thinking. The European central bank, the so-called ECB, has control over the currency and monetary policy yet fiscal policy is essentially left to the 17 member country governments. I would argue that just because elements of a system are dysfunctional, it doesn't necessarily mean the system can't continue to persist, or even thrive, in the real world. The US political system for example has been found to have some flaws (or some dysfunctionality), yet I'm sure that the same system will be around in the foreseeable future.

Dithering?
Certainly - part of this is the politics involved at the individual country level and part of the perceived dithering is the fact that the European Union is, after all, a complex committee structure. Major changes that are not in the current charter, such as the current €440 billion European Financial Stability Facility (EFSF), require the drafting of new rules and agreement amongst the constituent countries and, then, each country has to individually approve its participation through its own political process. No wonder the measures announced on 21 July are still not approved!

So, What's The Future For Europe? 

The Euro leaders know very well that they need to act more decisively to ensure the success of a short term rescue plan for Greece and hopefully the approval of the €440 billion funding of the EFSF.   

However, the markets believe that ultimately Greece will default - let's hope it's managed in an orderly way.

Longer term, the challenge is to put new Euro laws in place to ensure that there are clear rules on how to deal with the next “Greece” situation.

Although there have been many suggesting a break up of the Euro, the costs of any break-up just in terms of the re-establishment of new currencies, borders, defence etc, let alone the "economic" costs of massive currency swings and the fallout from not being part of the common market, would be huge. The diagram below shows some of the options for Europe.


Source: Perennial

So while I see a lot more dithering in our future, I do think that we will see some positive, concrete action in the form of a short term rescue plan, an orderly Greek default as well as some insightful longer term solutions for a new EU. I am hopeful that decisive action by the Europeans will have the “Paulson effect” and shore up a healthy level of confidence in the global financial system.