Euro zone: Growth first, austerity later

LONDON, U.K. — Convergence:

More than a decade ago, the founding of the euro meant the coming together of currency values in the various nations who signed up to join the single currency.

Once the currencies converged — aligning business cycles, having central banks raise or lower interest rates — the nations would be able to convert their francs, deutschmarks, pesetas, liras and drachmas into euros.

Now, we live in a new moment of convergence — convergence of conventional wisdom.

Six months ago, austerity was all the buzz. Cut government spending, reduce deficits and the economy will recover. The result: economic slowdowns in the United States and the United Kingdom, and recession looming in the euro zone.

Today, policy-making opinion has shifted: Go for growth and save austerity for later.

This position was articulated recently by Christine Lagarde, head of the International Monetary Fund, in an interview with German magazine Der Spiegel: "We recommend countries to adjust their austerity programs to a changed situation and consider measures to drive growth," she said.

Most of the developed countries are doing just that. As ever, the exception is Britain, where the Chancellor of the Exchequer George Osborne is secure in his belief that taking money out of the economy now is the only way to deal with the crisis — a collapse in manufacturing and service output not withstanding.

Friday, Osborne and Lagarde shared a platform at London's leading international think tank, Chatham House. The chancellor reiterated his position. "Britain will stick to the deficit plan we've set out. It's the rock of stability on which our recovery is built," he said.

Lagarde responded diplomatically: "The policy stance remains appropriate, but this heightened risk means a heightened readiness to respond, particularly if it looks like the economy is headed for a prolonged period of weak growth and high unemployment."

Britain is on course for both.

When it comes to the euro, however, the question is: Will bond traders and currency speculators in hedge funds adjust their strategies to reflect the shifting trend toward growth?

The evidence at the end of the week is: no. On Friday, the euro reached a six-month low against the dollar, and Italian bond yields ballooned again.

Recent events have done nothing to address the fact that even if austerity is shelved for a while, there must be swift moves towards a closer fiscal union among the 17 countries in the euro zone — an unlikely development given that the 17 have yet to implement a pledge made two months ago to create a stabilization fund for countries like Greece and Spain. Nor has there been coordinated action on bank capitalization.

Throw in continued carping from German economists about the European Central Bank's handling of the debt crisis — a German member of the Central Bank's board Jurgen Stark resigned on Friday, reportedly because he disagrees with the bank's policy on buying bonds — plus growing anti-euro sentiment among Germans, and that is reason enough for the markets to be bearish about the euro.

Except, there is more at work. This week, a team of researchers at giant Swiss bank UBS published a paper looking at the cost of breaking up the euro. It makes fascinating, if alarming, reading for populist politicians and anti-euro public opinion within the euro zone.

Using the experience of Argentina in the years after it decoupled its currency from the dollar as the basis for their methodology, the economists estimate that for an economically weak country like Greece, the cost of leaving the euro would be a loss of around 50 percent of GDP, or between 9,500 or 11,500 euro per person. ($13,000 to $15,700 pp).

It is only slightly better for Germans. The authors write, "If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20 percent to 25 percent of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR1,000 per person, in a single hit."

That reality should affect not just German public opinion but market-making opinion as well.

But there is a critical factor missing when it comes to discussing markets and the euro, one that analysts prefer to stay off the record about because it is not something that can be expressed in numbers. It is cultural and political: the Anglo-Saxon factor.

One head of research at a global bank points out, "From the beginning of the euro project, the Anglo-Saxon view has been that it was a stupid idea and should never have been set up."

The euro is the symbol of the statist, social-democratic kind of society that many Anglo-Saxon (Anglo-American might be a better term) conservatives despise. When the euro was being designed, Margaret Thatcher and John Major were prime ministers. There was never a chance that Britain would join. 

The speculators who have been trying to pick off Greece and then Italy, and driving French bond yields to levels out of proportion to the fundamentals of the French economy, are from this Anglo-Saxon world. Many share the conservative worldview of Thatcher and Major.

Because they can't attack the euro as a whole, the speculators' preferred method for messing with the euro is to pick off individual countries via that most deadly of financial weapons of mass destruction, the credit default swap, applied to a nation's debt. What is allegedly happening is that some hedge funds in New York are buying CDS, a kind of insurance on buying Greek or Italian or even French bonds.

They then sell the CDS on at a higher price — so they have an interest in creating doubts about the euro zone nation's ability to meet its bond obligations because this makes that country's cost of borrowing in the bond market go up. Which in turn makes the price of insuring the debt via a CDS go up … and on and on.

Friday, as Greece struggled to reach the latest benchmark on its debt-restructuring plan, the cost of a CDS on Greek bonds went up 280 basis points. The Financial Times reported it now cost 3 million euro to insure every 10 million of Greek debt.

In a recent report on Britain's respected Channel 4 News, American Jim Rickards of Omnis Corporation said the CDS trade had national-security implications for the United States and, in the case of Italy, was akin to "attacking a NATO ally."

The next convergence in the rolling economic crisis that defines our era may be governments in Europe and the United States coming together to fiercely regulate the market in CDS on sovereign debt.