Eurozone crisis: "An intense game of chicken that can be solved"

Investors are captivated by fear of default contagion, driving market liquidity to determine sovereign solvency. This is wrong, but there is reason for optimism, says Western Asset.
Eurozone crisis: "An intense game of chicken that can be solved"

A design flaw in monetary union is to blame for the eurozone crisis, although the prospect of a catastrophic breakup remains remote and there are grounds for optimism, a forum has heard.

Michael Story

Speaking over a lunch hosted by Legg Mason Global Asset Management and its affiliates in Hong Kong (in advance of the debt deal announced by European leaders yesterday), Michael Story, a London-based product specialist for Western Asset Management and a former Federal Reserve analyst, said investors had become captivated by fear of default contagion.

“This is not a crisis of too much debt at an aggregate level, nor is it a crisis of the banking system," he stressed. "While the European banking system is clearly flawed, this is a symptom more than the underlying disease.”

He pointed out that if Italy or Spain defaulted there was no amount of money that could cushion banks from such an event – in other words, a catastrophic scenario cannot be ruled out. But he said markets had been determining sovereign solvency, and that was wrong.

He pointed to a chart which he called the single best indicator of fundamental flaws in the 17-member eurozone. It showed a startling divergence in unit labour costs between periphery economies and Germany (as a proxy for core euro countries).

“This cannot happen in a monetary union,” he stated. “What we need is fiscal policy to help smooth the gap and, of course, we don’t have that."

But he suggested a false dichotomy had been created – fiscal integration or eurozone breakup – and said it was crucial for investors to distinguish the end-game, such as the potential ring-fencing of default(s) and recapitalisation of banks, from whether the eurozone will survive in its present form.

“We have heard since the beginning that either the eurozone will survive and that will require fiscal integration, or it is going to implode," he said. "Ultimately this is a decision eurozone voters will have to face, but in the short term we are focused on this crisis phase where volatility is high.”

He said investors needed to separate their investment decisions on when systemic risks might be brought under control from any decisions on the possible future of the eurozone.

Western Asset’s view is that a euro member exit remains extremely unlikely, at least in the near term, since leaving the zone during crisis would be more painful than austerity.

Story admitted it was strange that the European Central Bank (ECB) was doing the minimal amount possible at the last minute, pressurising fiscal authorities to find an alternative resolution. “This is a pretty intense game of brinkmanship, of chicken, between policymakers who should be working together in coordination,” he reflected.

Nevertheless, he said Western Asset felt comfortable that the ECB was engaging in the markets and confident that it would be there to provide emergency liquidity when required.

While he said there was no quick solution to a crisis in which systemic risk was driving asset prices, he expressed the belief that there is a potential solution to contain contagion risk.

This involves quarantining the effects of a Greek default, ring-fencing several members and recapitalising banks -- a restructuring the system can absorb. "We don't know when it will happen and it could rumble on for quarters, but we think this is the most likely scenario," noted Story.

However, he said there was a greater sense of pessimism within Western Asset over the longer term future of the eurozone. "We don't think any country will leave unilaterally, they cannot do so under crisis conditions," he said.

"But once those crisis conditions end and once there is some kind of stability within asset markets, it is certainly possible there could be a restructuring [of the eurozone]. This is a long-term question that I don't think will be addressed for years to come."

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