Travel agents started to buy tourist services in potential replacement currencies such as the drachma or lira. Central banks took precautions and one of them was said to have shopped around for banknote printing capacity. Traders even asked whether the euro would survive until Christmas.
So what has last week’s summit of European leaders offered to save the merriment of the holiday season? Some respite, but not much beyond it. Most stock markets have already resumed their declines.
To solve the current crisis, four things are needed: a deleveraging of governments; a return of growth; confidence in financial and capital markets; and an institutional framework that backs policies to achieve all of this.
There are two schools of thought on how to get there. The U.S. approach relies on monetary easing: bringing liquidity back into the markets to make them operate properly and to support growth. By contrast, the German (and now European) way calls for institutional austerity in a bid to create sound public finances as a basis for economic expansion. Each approach has its advantages and drawbacks. Ultimately, however, adherence to one school or the other has much more to do with a nation’s historical experience and political interests.
German Belt Tightening
Over the past 20 years, the Germans have tightened their belts and made their economy dynamic again. At the same time, Americans experienced bubbles that were financed by external money. Politically, President Barack Obama now needs instant economic growth to be re-elected next year. German Chancellor Angela Merkel, by contrast, looks quite safe in her position and can afford a more long-term view.
The summit delivered a lot in terms of institutional austerity, but it offered little to ease market tensions and boost growth. In essence, the heads of state agreed to enforce limits on budget deficits and government debt. In case these covenants are breached, automatic sanctions will take effect. Provided these proposals are embodied in a formal treaty next spring, and if the new rules are followed, this will bring widespread austerity to Europe.
In the short term, growth will be meager, living standards will drop and unemployment will be high. In the long run, however, we may see another German “Wirtschaftswunder,” or economic miracle.
To be fair, the summit also addressed market issues. It expanded and accelerated the European Stability Mechanism and earmarked more money for the International Monetary Fund. But this is little compared with what European leaders (in theory, not legally) could have done in terms of stimulating liquidity and confidence in markets. The real breakthrough would have been the issuance of euro bonds. It is remarkable that the summit pronounced the idea of euro bonds dead, at least for now.
So, the outcome of the summit was mixed. On the one hand, it addressed the underlying evil: the lack of fiscal discipline and too much leverage in public finances. On the other hand, it didn’t come up with an immediate solution to the growth and liquidity issues. But it made a big political statement: Europe’s governments will integrate much more with a view to saving the euro.
Before the summit, there were three scenarios: an immediate collapse of the euro; the creation of a fully fledged fiscal union with euro bonds; or more muddling through. The first and the second haven’t happened. The third option prevailed, but the summit has given it a peculiar twist: The euro will be saved by well-managed and institutionalized muddling.
Robbed of Control
There are a lot of provisos attached. The summit resolutions have to be enshrined in a legally binding contract. This is a big challenge. Not all heads of state will be able to get parliamentary approval. Fiscal stabilization also comes at a high political cost, especially for healthier and smaller nations. Being robbed of budgetary control by Merkel and bureaucrats in Brussels doesn’t please smaller democracies and governments that want to retain flexibility over their own fiscal matters. The U.K. has already walked away. Others will do the same.
The trigger for the crisis, Greece, will soon return to center stage. So while the euro might have been saved from immediate collapse, it is likely that the common currency and the European Union might disintegrate at the fringes.
Where does this leave company managers and investors? They should assume the euro will survive for a while, but there will be no immediate return to economic health. The European economy will suffer from low growth and even deflation for a long time. Many aspects of government services will be substantially reduced. There will be widespread social unrest. Some countries might leave the euro. Equity markets will remain sluggish and many companies and governments will find it hard to refinance through markets.
In managing the downside, companies should develop financial and contractual arrangements to protect against a partial abandonment of the euro and also consider what the impact of social unrest will be on their brands, operations and sales. They should also assume that there will be fewer mergers, acquisitions and initial public offerings for some time. The growth opportunities will be found within the companies themselves and managers should focus on reducing debt, cash flow and high dividend yields. Investors should be diversified and focus on capital preservation. Those with an appetite for risk should stick to high-yielding equities or well-managed real estate.
The resolve of European heads of state has saved us from a spoiled Christmas. They have yet to find a perfect solution, but companies and investors now have time to regroup.
(Peter Kurer was chairman of UBS AG from 2008 to 2009 and is now an independent strategy adviser. The opinions expressed are his own.)
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