Euro wreckage reloaded

. It was later ‘reformed’ into a toothless tiger that allowed for much more fiscal flexibility.  Thus, we worried about an increasing divergence of fiscal policies with widening bond yield spreads and increasing political pressures for an easier monetary policy stance, which could make the monetary union unpalatable for countries like Germany.

…and why it has become more likely now: Obviously, we have not reached the end-game yet.  However, with the recent developments, such a break-up scenario has clearly become more likely, for two reasons.  First, the lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation.  Fiscal slippage in other countries has now become more rather than less likely.

Second, the ECB’s climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures.

Don’t get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire.  However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.

What are the signposts that would indicate our break-up scenario is in fact unfolding?

• First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments’ resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.

• Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.

• Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound.  If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.

Bottom line: To be clear, we neither advocate a euro break-up, nor is this our main scenario. However, the risk that it happens is far from negligible and the consequences for financial markets would be very severe. Hence, investors ignore the euro break-up risk at their own peril.

Source: Joachim Fels, Morgan Stanley Global Views, April 16, 2010.

* Joachim Fels co-heads Morgan Stanley’s Global Economics Team (with Dick Berner) and is the Firm’s Chief Global Fixed Income Economist, based in London. His research focuses on monetary policy, the global liquidity cycle, and inflation.

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