German voters won’t bankroll peripheral profligacy forever

 
Philip Salter
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WHILE Greece and Italy continue to take a hammering in the bond markets, traders are today shifting their gaze to Germany, as its constitutional court decides on whether the bailouts are legal. Under article 103 of the Maastricht Treaty, “neither the Community or any other member state is liable for or can assume the commitments of any other member state.” Despite the clear infringement, the court isn’t expected to rule the bailouts illegal – although it is expected to put in place democratic oversights making it harder to send taxpayer funds south. Even this will weigh heavily on the euro and things are likely to get a lot worse for holders of the single currency.

Following Sunday’s sixth local election defeat in a row, Chancellor Angela Merkel is under pressure from voters to extricate German taxpayers from the position of the Eurozone’s backstop. These are tough times for the Chancellor. After today’s constitutional court decision, the next hurdle will be Berlin’s House of Representatives election on the 18 September, and then on the 29 September there will be a vote on the European Financial Stability Facility (EFSF) emergency bailout fund – opposition parties will likely put up a fight.

A COSTLY BREAK-UP
In their latest paper, Euro Break-Up – The Consequences, economists at UBS dare to think the unthinkable: a break-up of the euro. They conclude that because it will be costly, the probability of failure is close to zero, estimating that a weak country leaving the euro would incur a cost of between €9,500 and €11,500 per person, with a further €3,000 to €4,000 per person, per year, over subsequent years. A stronger country like Germany leaving the euro would apparently burden citizens with between €6,000 to €8,000, followed by €4,500 to €3,500 per person over subsequent years. The paper then estimates that “the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over €1,000 per person, in a single hit.”

It is good to see numbers put on a break-up, but three factors remain unexplored in UBS’s paper that are likely to throw a spanner in the works of the fiscal integration the economists expect. Firstly, there is no assurance that these bailouts would be a one-off. Secondly, if the economies of Italy and Spain join the list of countries requiring German transfer payments, UBS’s numbers would be turned on their head. The third reason a euro breakup might happen is that if economic rationality really was the driver of political decisions, the Eurozone wouldn’t have been created in the first place.

POLITICS TRUMPS ECONOMICS
Politics got Europe into this mess and it is politics that will determine the euro’s fate. The memory of fascism was the impetus behind the founding of the European Coal and Steel Community (ECSC) in 1951, as an attempt to unify Western Europe through economic reliance. And the German authorities were key in the further expansion and integration of Eastern Europe into the fold. The West Germans shouldered the costs of unification of East and West. German economic might was key to founding the euro, but bailing out the Mediterranean could still be a step too far.

Chris Beauchamp of IG Index thinks the euro has been good for Germany in making exports cheaper. “Germans are getting fed up of being the fall-guy for the rest of the Eurozone,” he says, and “Merkel hasn’t done enough to explain the benefits of the euro to the German populace, so popular support for the currency is ebbing. A return to the deutschmark could hurt German industry, but national will could easily overcome rational economic considerations.” Although Beauchamp thinks fiscal integration is the most likely outcome, he says it’s conceivable that a weak member of the euro is forced to exit. Simon Smith of FxPro thinks without greater fiscal and political integration countries will have to leave the euro, or soft and hard euros will emerge. Smith says: “Whichever road is taken, it’s going to be painful. That said, the current situation of piecemeal solutions to a broken system is clearly not working and becoming ever more painful for all involved.” Turmoil is inevitable – there are few scenarios in which there won’t be opportunities to bet against the euro.

FOREIGN EXCHANGE
The UBS report is blunt in its advice to investors worried about Eurozone collapse: “The only way to hedge against a euro break-up scenario is to own no euro assets at all.” However, because forex trading is a zero sum game, it is possible to profit from a Eurozone rout. Rishi Patel of FairFX says concerns that policy makers are failing to address the Eurozone debt crisis is already pushing investors back towards the dollar, with euro-dollar trading towards the lower end of the $1.41-$1.45 range. Beauchamp says for traders predicting Eurozone chaos, the euro-Swiss franc pair would be normally be the obvious choice, however, possible intervention puts the Swissie in the uncertain territory of the yen. As such, “boring old euro-dollar could see some moves if Ben Bernanke holds off on more quantitative easing and the Eurozone keeps getting worse.” Beauchamp also picks out the Norwegian krone and even sterling as potential profitable pairs.