The Eurozone’s Intellectual Default

By Vedran Vuk

With Greece and Ireland bailed out, the inevitable question should be “What’s next?” Perhaps the EU has placed a band-aid on the immediate wound, but the long-term plan looks basically nonexistent.

In yesterday’s Telegraph, Andrew Bosomworth, head of Pimco’s portfolio management in Europe, was quoted on the steps needed for the European Union to remain viable:

Andrew Bosomworth … said current policies are untenable in the absence of fiscal union and will lead to a break-up of the euro.

“Greece, Ireland and Portugal cannot get back on their feet without either their own currency or large transfer payments,” he told German newspaper Die Welt.

He said these countries could rejoin EMU “after an appropriate debt restructuring”, adding that devaluation would let them export their way back to health.

Bosomworth’s thought process reveals the complicated mess that the euro finds itself in. His suggestion is an extremely complicated juggling act. First the countries are bailed out. Then they leave the euro and devalue their own currencies. The economies recover with an export-driven boom. And lastly, the countries rejoin the euro, even though the euro may no longer be appropriate for an export-driven economy.

This seems highly unlikely to me, but it’s not Pimco’s fault. They’re searching for a solution to an unsolvable problem. And necessarily, any rescue plan of the euro will be far-fetched. The problematic theoretical underpinnings of the European Union don’t have a solution other than dissolving large parts of it.

Even Bernanke has a better game plan in the U.S. He hopes to pump enough money into the system to jump start the economy before inflation kicks in. In my opinion, this is a fool’s errand, but it’s still theoretically within the realm of possibility. But the European Union doesn’t really have a game plan at all.

In the EMU, each country has its own fiscal policy, but monetary policy is tied by a single currency. Naturally, some countries will overspend and will not be able to dig themselves out of debt with the use of monetary policy. As a result, the crisis of one country pulls down the whole.

The bailouts are short-term solutions, but the long-term structure is the real problem. If the euro doesn’t sever certain members from the whole, the bailouts will continue forever – even years from now. The union can only hope to stay afloat a while longer through these efforts, but eventually, down the road, it will fail. With every roll of the dice, the European Union has a chance of losing it all. And as the union must keep rolling the dice on every bailout, eventually a collapse will happen. You can only hit your lucky number so many times, as the EU has been doing thus far.

Pimco’s suggestion is based on this reality; the countries must split apart. Consider this scenario: the eurozone slowly begins to recover, inflation is picking up, and it’s time to raise rates. Higher rates aren’t a major problem for Germany and France, but Ireland, Greece, and Spain are still economically lagging behind. The European Central Bank becomes caught in a catch-22. They must raise rates in Germany to avoid inflation, but they can’t do it without crippling the already weak PIIGS. To save the German economy from inflation, they would have to cause an economic collapse elsewhere. But if economic failure happens elsewhere, the Germans have to bail out the problematic countries.

So even in the optimistic case of a European recovery, the monetary union faces big problems.

Pimco likely sees this issue, but Bosomworth is smoothing things over by suggesting that the countries could ever rejoin the euro. Once these countries are out, they’ll be gone for good. The euro has incorporated too many countries with very different economic structures and with various degrees of fiscal control. The union could only work if all the remaining members were economically and politically homogeneous – a highly unlikely outcome.

The euro’s structure as a whole is theoretically flawed. The euro will collapse or split apart for sure. It’s one of those rare cases where the end result should be obvious. The only real question is timing. If the euro gets lucky enough, it could last even a few more decades. But its ultimate fate is sealed.