The pressure is really on now for the Euro leaders (Germany and France) to come up with a permanent solution for the fiscal disaster that is the Eurozone. They have few options open to them and none of them are palatable to many. However, with the enormous burden of sovereign debt hanging over the Euro, they must make a move sooner rather than later or risk a complete blow up in the Eurozone debt markets which will lead to severe contagion a la 2008 meltdown in credit markets.

So what are the options?

1) One solution, which further develops the Euro project, is for full fiscal integration. This would be a major step and involve the Euro authorities taking over the management of individual countries fiscal responsibilities, outstanding debts and all future decision making over taxation and borrowing. It’s an ultimately surrender of financial sovereignty for all countries in the Eurozone. As with EU membership, this would favour the economically weaker countries as their borrowing rates would fall. Sadly for some, like Germany, their borrowing rates would rise, as there would be one single Eurobond, financed at an average rate of all the countries combined. It would most certainly be lower than the average rates now but still above where the most creditworthy (if there is such a thing) pay. The chances of this happening are slim to none, even though Merkel and Sarkozy have discussed moves in this direction. Behind this idea sits the possibility of a fully fledged Eurozone Government, the fear of many Euro-sceptics over the years. The reality is that this proposal can only work if there is a USE - United States of Europe.

It’s very hard to see this getting past voters in any country unless there is a financial meltdown of apocalyptic scale at which point “emergency measures may be justified” to coin a favorite term of “shock doctrine” watchers. For an amusing fictional account of how things may turn out, read this gem of a story “Berlin gets ready to leave the Euro”. Merkel’s electoral setback is hardly likely to shift matters forward.

2) The middle ground is for some of the weaker countries to leave the Euro and re-create their old currencies. These would be set initially at a rate which would enable some form of devaluation to help their export markets recover. This would entail quite a tricky transition process, both legal and financial, and the sheer mess it would cause logistically is enough to put many off, notwithstanding the theoretical attractiveness of a clean cut. The debt picture would be less fun: it’s hard to imagine anything less than a complete default if there was no further support from the EFSF . ANy debt denominated in local currency would face exorbitant rates meaning, in reality, those countries would not be able to borrow money. In effect, any country leaving the euro would result in default and an inability to raise money. The outcome of this would be complete financial chaos……initially. However, as with Iceland, it could lead to a complete restructuring of their economy at a completely new level.

In some ways this situation parallels that of some clients I have as a budget advisor. Some come with simple problems: a need to budget better, clear debt, sort out messy financial positions. However, some come with debts that are not possible to restructure in any way. They simply have no chance of ever repaying them, barring a lottery win. In these situations, they have been allowed to take on more debt than they can possibly service and often they have depreciating assets against an outstanding debt (a car for example). They are usually finished off by the compounding interest. It’s clear in these cases that lenders have been very, very sloppy. Often, as with professional investors, the search for yield or the desire to sell a loan overrides a proper analysis of the risk profile. This is how people end up with a debt mountain.

Insolvency is, sadly, the only answer. Life after insolvency is a, in current market parlance, an austere one. But it’s not the end of the world….life goes on. However, for the lender, it is a total loss…..though in many cases the debt has been packaged up and sold off, down the debt collection food chain.

Sovereign debt is no exception. Sure some countries can sell as much as they like (the US and Japan for example) but for others, with less collateral (whether in the form of private savings, trade surpluses or simply a reserve currency), there is a limit. Those limits have been breached and there is simply no way out. As I say to some clients: spend less, earn more or default.

This leads us nicely to:

3) Muddling along and trying to keep things as they are. This has been the course charted for the last few years: bank bailouts, sovereign bailouts and major cuts in public spending. This is akin to bailing out a sinking ship with water removed from one area whilst it pours in from another. As with option 1) there has been a reluctance to take action that would create some long term obligations for the major Eurozone underwriters (mainly Germany but also France to some extent). So funds have been created for special purposes to buy the sovereign debt of stressed countries. This has worked in part but again the markets can do the sums and see that they don’t add up.

At fault here, as usual, are the lenders. They have been happy to buy up sovereign debt on the basis that it’s too big to fail (TBTF) and that rates were attractive given the implicit support from the Eurozone. Why buy German Bunds when you can buy Greek paper at a much better yield? The market is supposed to be the restraint on government borrowing, knowing when to demand higher yields and when to say no more. But the post-EMU convergence desire for yield at any cost remains core to the investment approach of many. EMU was a big fudge to start with: how on earth did Greece, Italy and the other laggards suddenly reduce their budget deficits to 3%? It was all too tidy because it was always a political rather than economic project.

So governments spent too much and were able to borrow freely to support this. Investors were unconcerned knowing ultimately, it’s all underwritten by someone. The numbers now are too big and if underwriting as in option 1) is not the chosen path then the muddling along will have to involve some serious haircuts (read: partial defaults) in order for the system to continue to function. And why not? Investors have made poor decisions and have to pay the price. So why the reluctance to proceed down this route?

Well here’s where we get to the crux of the matter. European banks, and others, have invested heavily in sovereign bonds. If we see partial defaults or major restructuring then banks will be in trouble again and we will be back to 2008 in a flash. The reality is though that banks should have been allowed to fail back then with investors taking their losses as would be expected in a market system. Bailing out the banks in Europe and the US, whilst making no real reforms, has simply multiplied the problem and led us to where we are now.

At some point, the loss has to be taken by the investors and not the public.

It’s clear that none of the 3 options are palatable. But as I say to my budget clients, that’s the whole point. They never are. Debt is a miserable beast at best and when it climbs all over you there is no easy way out.

The Euro was always a pet project of Germany and France, a chance to unite Europe and create a powerhouse to rival the US and the ASEAN block. It was a project birthed from centuries of conflict and huge loss of life. Europe’s leaders stand at a crossroads. No path is easy to take: to go forward would see the European Project move towards its eventual conclusion, a true European Union. To go sideways means and end to the dream and a system in tatters.

The former is most unpopular, the latter a financial disaster. There really is no room for soft solutions here. It could be the end of the dream or the start of  a new future. Either way there are hard times ahead.

Tags: currencies, debt, emu, euro, europe, financial crisis, france, germany, greece, monetary union, money, piigs