Can the euro be saved? Short answer—yes, but it will take some doing, says currency manager Axel Merk. In commentary released Wednesday, Merk examines what he calls “the dual challenges of fiscal sustainability and bank solvency” which are key to the euro’s recovery.
“To achieve a sustainable budget, the obvious levers are to increase revenue or to cut spending,” Merk (left) writes. “As Greece has shown, raising revenue through tax increases does not necessarily work; governments can also liberalize their labor market, cutting red tape. Generally speaking, there are two paths that may lead to fiscal sustainability: surrendering sovereign control over the budgeting process or embracing the brutal pressures imposed by the bond market.”
As far as surrendering sovereign control, Germany may open its checkbook to bail out the rest of Europe, Merk predicts. It may be a tall order, but the market is starting to price in that possibility. He notes the recent botched auction where the German Treasury was unable to place all of its 10-year bonds showed that investors are now demanding higher rates of return to lend money to Germany.
“Just recently, Germany’s 10-year bonds yielded less than 2%; as of this writing, the yield has risen to 2.3%,” he says. “While still low, it shows that “fiscal integration” in Europe means that a yield conversion won’t happen at Germany’s cost of borrowing level.”
Merk notes an alternative that policy makers must contemplate: embracing the brutal pressure imposed by the bond market.
“It requires dealing with the reality that low interest rates must be earned,” he explains. “It also means that governments have to embrace the reality that they may have to renegotiate some of their debt, i.e. default. Government defaults are nothing new. However, governments should take great care that a government default does not lead to an implosion of the financial system. Banks hold substantial amounts of sovereign debt–a key reason why select banking shares are under pressure in Europe.”
While the leverage makes banks vulnerable, the banking model has two advantages over the sovereign debt model, Merk says:
- Central banks can keep even a technically insolvent banking system afloat. Just look at Japan in the 1990s. Similarly, the Federal Reserve and European Central Bank can keep even zombie banks afloat as long as they choose to.
- The reason the U.S. Treasury injected money into the banking system in the fall of 2008 (the TARP program) is because the inherent leverage employed by banks allows any capital injection to support a high multiple of debt. Former U.S. Treasury Secretary Hank Paulson’s bazooka was effective because it was applied to bolstering bank capital rather than buying toxic securities outright; the latter would have turned the bazooka into a water pistol. Similarly in Europe, the focus must be on making Eurozone banks strong enough to stomach sovereign defaults.
He concludes by noting we should “expect a muddled combination of increased IMF support, increased fiscal convergence, increased focus on strengthening bank balance sheets, increased involvement to keep banks afloat (the ECB is already debating providing multi-year unlimited credit lines) and increased cost of borrowing for Germany. However, this is likely to remain a drawn out process and the tail risks that European policy makers mess this up cannot be ignored, either.”