The electoral map of Europe changed on the weekend. If there is one clear message that the people of France and Greece sent to their governments, it is that, like Howard Beale in the movie Network, they are mad as hell and aren't going to take it anymore. The election of François Hollande, who campaigned on converting the euro zone fiscal stability pact to a growth pact, and political disarray in Greece, introduce additional uncertainty to the outlook.
We live in interesting times.
Indeed, it is tempting to conclude that the one certainty in all of this is that things will get worse before they get better. This is a loaded statement: in its latest World Economic Outlook, the IMF already projects the euro zone to have the lowest growth rate of any analytical grouping, below even the once-lowly sub-Sahara African grouping, which is expected to enjoy robust growth owing to strong commodity prices. But it is fair to say that this assessment does not incorporate the potential effects of heightened volatility coming from the election results of the weekend. Such effects could be disruptive. The extreme scenario is that we have entered the endgame of the euro.
The concern here is that Europe becomes the source of another “Lehman-like” moment. Just to be clear: I think it highly unlikely that a prospective exit by Greece would be the trigger. While a unilateral Greek exit or a negotiated parting of the ways would be disruptive and costly to institutions and individuals still holding Greek debt, it would not necessarily pose a systemic threat to the global economy. To some extent, the potential fallout from Greece could be contained – though there is no assurance, of course, that the authorities would respond in a timely and effective manner to do so. Moreover, the euro zone could continue on without Greece. To put it bluntly: if Greece doesn’t need the euro, nor does the euro zone need Greece.
The reason the Lehman failure was so costly is that it generated a near-universal “market for lemons.”[1] When the decision was taken to let it fail, and the implicit bailout commitment was not forthcoming, other institutions that could not evaluate the quality of the assets on their own balance sheets because of complexity of contract design refused to lend to others with the same toxic assets. No individual senior banker was prepared to expose their institution to the risks in the balance sheets of others. As a result, the global financial system seized up as inter-bank lending froze and employment, output and trade flows all collapsed in the most synchronized example of “cliff diving” since the Great Depression. The situation only stabilized after the extraordinary measures taken by the Fed and other central banks to reassure commercial banks that they would have access to liquidity.
The real concern with respect to the euro zone is if one of the larger members exits. In these circumstances, it is possible that the future of the euro is questioned; by extension, this could lead to a revaluation of all assets denominated in the euro. And, if it isn’t made clear how the uncertainty will be resolved, another ‘markets for lemons’ economy could develop. To say the least, this would not be entirely helpful.
So, while a Greek exit from the euro zone would not necessarily trigger a Lehman moment, a French exit could. But how likely is this? After all, even if Hollande follows Mitterrand and launches an aggressive package of fiscal stimulus, this path wouldn’t necessarily lead outside the euro zone. True. Yet, the effects of such a program would be dissipated by spillovers to its neighbours – higher French spending would fall mostly on French goods, but a sizeable share would fall on the goods produced by other euro zone members and others. (This is the rationale for G20 coordinated fiscal expansion during the crisis – the effects of each members’ actions are magnified by the efforts of the others, while concerns of “free riding” are minimized.)
In this respect, it is worth recalling that the much-maligned stimulus program of President Mitterrand was aided and abetted by a very steep depreciation of the French franc. This channel is not available to President Hollande. And if the European Central Bank pursues its policy of targeting euro zone inflation, of which Germany is the largest component, it is unlikely that monetary conditions would be accommodative. At the same time, more policy induced uncertainty could lead to higher risk premium and higher interest rates. The stimulus expected to create a boom may only produce a whimper. In these circumstances, French frustrations might boil over, leading to threats of exit and the re-introduction of the franc.
Frankly, this is an extreme scenario, which is unlikely to be realized. That being said, over the past year or so, we have seen events in Europe flip from the “impossible” to the “inevitable” very quickly indeed.
[1] George Ackerlof: The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, 1970, vol. 84, issue 3, pages 488-500. The ubiquitous example of the ‘lemons problem’ is the used car market: because the seller has far more information about the quality of the car than potential buyers and buyers are unable to verify the seller’s claims (at least at a reasonable cost), buyers assume that the car is of poor quality. Prices for used cars therefore incorporate a discount for the poor expected quality. Over time, the market validates the potential buyer’s prior, since individuals with high quality cars are unlikely to put these cars on the market. The average quality of used cars for sale deteriorates commensurate with the average price.