Friday, August 26, 2011

Is This Any Way to Run a European Union?

The latest bailout for Greece has bogged down because one EU member, Finland, beset by domestic political opposition to more handouts to Greece, insisted on cash collateral for its portion of the bailout. In other words, cash loaned by other EU members to Greece would be given to Finland as collateral for Greece's obligation to repay Finland. Amazingly, Greece agreed to Finland's demand. Even though Finland's share of the bailout was only 2%, it would get better terms than other EU members. Greece violated a cardinal principle of negotiating a workout of its debts: that similarly situated creditors be treated equally.

When the word got around, several other EU members balked at participating in the bailout unless they, too, got cash collateral. Needless to say, the entire bailout package began swirling in the porcelain bowl, because funds Greece would receive from the EU's bailout mechanism wouldn't be used to repay current liabilities but instead recycled to other EU members as collateral. How, then, would Greece avoid defaulting on its current liabilities?

Germany and the Netherlands quickly planted an IED under the Finnish collateral proposal. That preserved the principle of equal treatment for all members. But it leaves Finland's political problem unresolved. Large numbers of Finnish voters want to tell Greece to take a hike. Without collateral, or some other protection, Finland may refuse to sign off on the bailout. Because EU rules require unanimity, Finland by its lonesome can torpedo the entire deal.

Germany, the most powerful member of the EU, stands by the unanimity requirement, even though a collapse of the EU from a failure of the bailout proposal could visit extremely painful consequences on Germany. The unanimity requirement protects Germany, too. Otherwise, it might be forced to relinquish a large part of its wealth bailing out more profligate EU members simply by a vote of the majority. Germany, too, wants eat its cake and have it too by preserving the option to blow up the bailout if the terms are too costly for Germany.

From a traditional creditor's viewpoint, Finland's position makes sense. Greece, for the most part, has been dealing with its sovereign debt problem by swapping maturing debt for longer term debt--i.e., rolling its obligations over. Swapping paper for more paper doesn't repay debt. It simply extends maturities. If Finland had collateral, it could seize the collateral in the event of nonpayment and step off the paper swapping merry-to-round. If Greece lost collateral, it would lose real value, and the prospect of such a loss might focus its attention on truly paying down its debts. As long as Greece has the option of swapping paper and holding onto its true wealth, it can continue to make promises instead of keeping them.

To appease the Finns and others, the EU is looking into some sort of collateral for the bailout. But how much of its wealth will Greece put into hock? Unless it pledges the Acropolis, Greece can't fully collateralize all its debts. Reality is that Greece, mostly for political reasons, simply cannot repay its debts in full. The EU won't confront this reality. Its rules, which protect its creditor members, enable this head in the sand outlook. Fully protecting creditors isn't how commercial creditors do a loan workout with a troubled borrower. They make concessions, take some losses, maybe take an equity interest to have some upside potential if the borrower survives, and hope for the best. The EU's pro-creditor governance structure makes a true workout of Greece's problems essentially impossible. Paper is swapped because it's the only way for everyone concerned to pretend they're doing something.

This is no way to run a continental union. Something has to give. The EU has no mechanism for kicking members out, even if they violate the rules. So it's stuck with Greece, which has no incentive to leave as long as it's rolling paper over. Germany isn't ready to walk, either, because it has so much to lose. Perhaps secession by other members will be next. Finland and other small member nations may conclude it's best for them to vamoose, reverting back to national currencies that may be strong against the Euro. The rest of the EU won't stop them. Europe lost tens of millions of people in two horrendous world wars in the last century. Secession wasn't accepted by the United States but 21st Century Europeans won't fight any Gettysburgs, Vicksburgs or Peterburgs. If a few small nations succeed on their own, then other prosperous EU members will be under enormous pressure to skedaddle. As more members hightail it, Germany won't be able to support the entire edifice by itself. The EU, poorly designed and too inflexible to deal with the risks of the real world, will then go the way of the Titanic.

The alternative will be for Germany to write checks to profligate EU members--big ones. West Germany did something like that once before, to finance unification with East Germany. Whether it will do that again, this time for non-German peoples, remains to be seen. But, if you're not the betting type, avoid long term investments denominated in the Euro.

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