It's Not You, It's Me

With elections looming over the EU next month, recent news over the old continent has centered around the battle against deflation.

• "The European Central Bank has let it happen. Inflation has been running at an annual rate of minus 1.5% in the eurozone over the past five months, adjusted for austerity taxes...Prices have been falling at a rate of 5.6% in Italy, 4.7% in Spain, 4% in Portugal and 2% in Holland since September. The rise of the euro against the dollar, yen, yuan and real, accounts for some of this. The eurozone’s trade-weighted index has risen 6% in a year. But that is the direct consequence of the ECB’s own monetary policy. Frankfurt could force down the euro at any time by switching gears. It has chosen not to do so, hoping that a few dovish words spoken without conviction will turn the global tide."

   

As with most European hiccups since 2008, the difficulty in battling deflation arises from the core weakness of the eurozone  - it is a monetary union without a complementing political union. From inception as the European Coal and Steel Community (ECSC) in 1951 to the Maastrich Treaty of 1992 to the modern 18-nation eurozone (and larger 28 nation European Union), the notion of a "United States of Europe" has always been more about politics than about economics.

The ECSC - an agreement between Luxemborg, West Germany, France, Belgium, Italy and Netherlands - removed tariffs on coal and steel between member countries in an effort to co-ordinate rebuilding of the war-torn countries and to foster closer ties between former enemies. The Maastricht Treaty - which laid the seed for the common Euro curency - was largely driven by France to ensure the newly united Germany remained a key stakeholder in the EU project. Following the addition of 16 million East German citizens, France feared that its neighbor to the east would gain increasing European influence in the years ahead. Tying the reunified Germany to a common currency was meant to keep Germany in check.  As with the ECSC, politics came before economics when the Maastrict treaty was crafted.

The result of politics trumping economics has created an 18-nation eurozone in which member countries share a common currency while surrendering sovereign control over monetary and fiscal policy. On the monetary side, members lost the valuable tools of money printing and currency devaluation. On the fiscal side, the inability to share a common budget and raise money with common bonds along with poor co-ordination of economic cycles has proven disastrous. This EU's underlying weakness was exposed in crisis after crisis (eg. Greek 2010, Portugal 2011, Cyprus 2012-13).

During and after each crisis, the biggest elephant in the room has been whether or not the euro would continue to exist as a currency. While the breakup of the 15-nation rublezone in 1992 and split of Czechoslovakian koruna in 1993 happened in recent times, there has never been the break-up of a monetary union that rivals the eurozone. In an effort to better understand the mechanics and consequences of such an event, I recently read former-Goldman-current-Nomura economist Jens Nordvig's book - The Fall of the Euro. Despite its heady content, the book is a blaze to read and endlessly informative.

While complete disaster has been averted in the eurozone and EU, the elections in May could lay the seed for another crisis. In this context, it seems worthwhile to revisit the implications of a eurozone breakup.

Convertibility is paramount
In looking at the mechanics of a break-up, Nordvig first touches on the concept of "convertibility" as a glue for a currency union. Taking the example of the US during its banking crisis of 1907, Nordvig explains how the suspension of convertibility of bank deposits to cash led to a black market in which physical cash traded at a premium to bank deposits. The author build from this example to explain the importance of convertibility in the Eurozone:

• "The concept of convertibility...can also be used to describe the ability to convert cash across borders without any restrictions...a defining feature of a currency union is uninterrupted ability to conduct currency conversions at par between all areas within a union. The convertibility is the glue that keeps the currency together, regardless of the state or country in which the cash is located...If the convertibility at par between cash in two different jurisdictions is suspended, an exchange rate will develop...[as] a function of the supply and demand for the local currencies relative to foreign currencies."

Nordvig uses the example of the rublezone breakup in 1992 to highlight this point:

• "...when the Central of Russia suspended convertibility of the ruble balances originating in Ukraine during 1992, the Ukrainian currency...immediately started to trade at a discount because of lack of confidence in the unit"

The banking crisis in Cyprus in 2012-13 saw the European Central Bank (ECB) partially suspend Euro convertibility as limits were placed on Cypriot bank withdrawals and transactions - in effect, a Euro in a Cypriot bank was no longer convertible for a Euro elsewhere.

Moving forward, the euro could be splintered either by edict from the ECB (as with Cyprus) suspending full convertibility of the euro from a member country or it could happen if one member country of the eurozone unilaterally decides to suspend the convertibility of the currency with other members.

Managing a breakup...
The mechanics of a breakup following a suspension of convertibility is quite straightforward; however, as with all things Europe, the difficulty comes from the political dynamics of a breakup. Who is exiting? How is the process planned? Does the exit coincide with a government default? What is the post-exit policy response? As Nordvig notes, "the implication of an Italian exit would be on a totally different scale from those of a Greek exit."

Looking to Czechoslovakia currency split in 1993, the author finds an orderly example from history based on close political and economic co-ordination:

• "[The breakup] required careful planning to overcome logistical challenges. The political decisions were taken in a single session of parliament, after which the currency separation was implemented immediately.The central bank had all the logistics set up even before parliament made the political decision. For example, the stamps used to distinguish Czech and Slovak notes after the currency split had been printed secretly in a remote location in Latin America months before...During the transition, banks and post offices were closed, borders were sealed and mail service temporarily suspended. There could be no movement of money during the transition. Thousands of government employees, police and members of the military worked around the clock to ensure all aspects [ran smoothly]. The currencies were introduced within a few days. There was no financial crisis."

Now, this is not to suggest that a breakup of a two-member currency union could easily translate into similarly orderly break-up of a 18-member union. The key point here is that political co-ordination is a must. The current eurozone is a case of too many cooks in the kitchen and, in the event of a eurozone splintering, this will be a huge problem.

...is not easy
Following the hypothetical break-up of the euro, Nordvig focuses on the enormous legal implications. Just looking at Argentina, the authors notes how more than a decade after its sovereign default in 2001, the country is still fighting over unsettled claims. How would all the eurozone countries deal with the seemingly infinite criss-crossing of international assets and liabilities?

Nordvig's research uncovered two key terms in understanding how countries would even begin to sort these matters out:

• "The first term is governing law. This essentially specifies which body of law governs a certain financial contract, whether it be in English Law, German law or New York law. The other term is the legal jurisdiction. This term refers to which courts deal with a dispute. Each financial contract will specify, sometimes in very small print, which courts - Italian courts, Japanese courts or French court - will make any needed rulings. Often but not always, the two terms overlap. If both governing law and jurisdiction are English, it means that English courts will have to make a ruling using English law. But sometimes, the situation is more complex and the governing law and legal jurisdiction of a financial  contract are not the same"

The politics of governing law and legal jurisdiction lay the groundwork for some very difficult questions:

• "What happens to the financial assets and liabilities that were outside the jurisdiction of the eurozone countries if the euro ceases to exits? For example, if the euro ceased to exist as a function of a full-blown break-up, what would happen to a loan made in euros by a US investment bank to a big industrial company in Poland? Would the loan now be in US dollars? Would it now be in Polish zloty? Or would something else happen? The lender might have one preference and the borrower another. There would be a potential dispute of this nature for every single financial contract, but ultimately a judge would decide. These disputes would be the catalyst for widespread legal warfare."

And, naturally, legal warfare would lead to something much worst:

• "...the lack of continuous settlement of the most basic instruments would freeze the global financial system for some time...In a full-blown euro break-up, the various legal systems, particularly those in London and New York, would be overwhelmed. The lack of settlement (payment of interest and principal) on trillions worth of standard financial instruments would trigger something resembling financial market anarchy, not only in Europe, but also globally."

This is Nordvig's worst-case scenario. A disorderly breakup followed by decades of unresolved legal disputes over financial assets and liabilities. The author doesn't actually believe that this is the road the euro will take but demonstrates in his book that this scenario isn't impossible either. Nordvig advocates for closer political co-operation to stabilize the region. The EU's recent history is not very encouraging on this front. Hopefully next month's parliamentary elections will move in the right direction.