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What Comes Next for the EU: Three Scenarios

The European Central Bank says it is backing both Italy and Greece despite not having the funds for it. Push is coming to shove for the EU. If it's to survive, it will have to be as a radically different entity.

On Monday, the markets did a quick bounce because Athens said it had had "a productive and substantive discussion" with its creditors. In diplomat-ese that means absolutely nothing. The market bump was a combination of desperation and the fact that the media/investors have the long-term memory of a mayfly smoking crack. (By the way, when Greece does get the $8 billion in bailout funds now under discussion, expect a big but brief jump in the markets. Some people might think that would be a good time to sell stocks.)

So here's a quick recap of the situation in Europe:

  • Greece is totally broke. Bailouts make it possible for the nation to pay its bills, but add to its total debt. There is no plausible scenario in which Greece can earn enough money to repay its current debt, let alone new ones. If it were a person or a company, it would already have declared bankruptcy and tried to start over. There is a lot of debate over whether the Greeks should jump out of the EU or be pushed.
  • Ireland and Portugal: See above.
  • Italy isn't broke but may run out of money anyway. Because it is the euro zone's third-largest economy (behind Germany and France), it is far, far too big to fail. If it runs into the same kind of problems as Greece, Portugal and Ireland, no one can afford to save it. While it has a relatively low budget deficit, it has a lot of debts. Like $2.6 trillion, which is nearly 120 percent of GDP. It has to borrow a lot of money to pay for that debt. Almost $380 billion needs to be rolled over by the end of 2012. All that debt is making investors nervous and that is pushing up the returns on Italian bonds. This just makes servicing that debt all the more expensive. The ECB has tried to drive down the yield on Italian bonds by purchasing $7 billion to $15 billion euros in riskier euro-area bonds over the last five weeks. This hasn't worked.
  • Spain is damn close to broke. The nation is teetering on the brink of becoming Iceland with better food and beaches. It did all the same stupid real estate stuff the U.S. did, but with an even weaker economy supporting it. Spain is also too big to bail out.
  • Euro-zone banks are thought to be dangerously under-capitalized. Former U.K. Prime Minister Gordon Brown says, "The European banks as a whole are grossly under-capitalised: they have liabilities far in excess of American banks." (If true that is truly terrifying. Most U.S. banks resemble zombies so much they could be extras in Day of the Dead.) This problem isn't limited to the crisis nations, either. One report has Germany's banks needing $175 billion more in capitalization. As Mike "Mish" Shedlock points out: "That is just German banks. French banks are also severely undercapitalized. Also note the target is a mere 5 percent equity ratio, implying a leverage ratio of 20-1, still hugely over-leveraged from a common-sense standpoint."
If any one of these balls drop then all the others will be in danger of doing likewise. So in the words of noted soul singer/economist Sam Cooke, "A change is gonna come." Here is a look a three possible outcomes for the EU.
Option A: Defend the euro »

United euro stands or united euro falls!
The approach to now has been to defend the euro -- common currency for 17 nations -- no matter what. The idea here is that we're all in this together and we're only as strong as our weakest link and a few other cliches. Bonds have been bought and bailouts bargained for in an effort to keep the currency strong and working for all EU members.

There are many problems with this approach. For one thing, everyone can't be bailed out. The ECB doesn't have the money for Greece let alone the other crisis nations. A lot of people are referring to them as the "periphery nations" because they are all on the EU's external borders. This has unfortunately made people think that the crisis can be limited to those nations somehow. There is much talk of "containing the contagion" and building moats and firewalls. If only it were true. Exposure to debt doesn't pay much attention to political borders, especially in this day and age.

Another problem is that this approach rids the system of that whole "moral hazard" thing (like the U.S. and the banks). Former head of the Federation of German Industries Hans-Olaf Henkel put it this way: " If everybody is responsible for everybody's debts, no one is. Competition between politicians in the eurozone will focus on who gets most at the expense of the others." In other words, the EU will resemble Congress putting together a budget.

Even if defending the euro at all costs was sustainable from a fiscal perspective, it would ultimately force the economically healthiest nations to quit. The increasing debt to keep this going would cause more inflation. Countries would have to quit or accept being dragged down by poorer neighbors.

Option B: All power to the ECB! »

Give the EU a true central government
What the EU needs is a central government (or monetary entity) that can raise taxes and sell bonds by drawing on the resources of all its members.

The most notable proponent of this idea is financier George Soros -- although he is far from alone in supporting it. Soros and friends argue that avoiding financial Armageddon (or Ragnarök, take your pick) will require keeping banks in defaulting nations alive and recapitalizing the entire European banking system.
As Soros wrote:

All of this would cost money, but, under the existing arrangements agreed by the eurozone's national leaders, no more money is to be found. So there is no alternative but to create the missing component: a European treasury with the power to tax and, therefore, to borrow. This would require a new treaty, transforming the European Financial Stability Facility into a full-fledged treasury.
This would also mean moving banks from under national supervision and into supervision by a continent-wide regulator which would oversee the whole system. That in turn would probably force the creation of a real trans-European government as opposed to the current silliness based in Brussels.

Speaking of Belgium, that's an example of the biggest flaw in this argument. Getting to that point would require coordinated effort between states and within them. Last week, Belgium announced it was finally forming a government after not having had one for 15 months. This was owning to some intractable disputes between the Walloons, who speak French, and the Flemish, who speak Dutch. Belgium is the size of Maryland and has been a nation since 1830 -- and those two groups still can't get along.

Europe is made up of a lot of nations that only exist because of fragile compromises between different groups, sometimes going back centuries. In Germany the Bavarians are still cranky about the Prussians getting rid of King Ludwig II in the 19th century. The northern Italians would be more than happy to saw off the southern half of the nation and let it float away. As French President Charles DeGaulle said of his own nation, "How can you govern a country which has 246 varieties of cheese?"
Also, this new inter-Europe treasury is far from a sure thing. Edward Harrison of the blog Credit Writedowns says:

The fiscal crisis in California demonstrates that a federal treasury is no panacea. After all, the U.S. has a federal treasury and California contributes more in transfer payments to that treasury than it receives. Yet, it too must cut spending like mad and raise revenue in order to pay its bills. Having a treasury would not have ended the economic pressures for Spain, Greece or Ireland â€"- and I am dubious about a United States of Europe because of the greater fundamental differences within the EU.
By the way, this scenario also envisions Greece, Portugal and Ireland leaving the EU. Soros says the defaults and departures could be done in an "orderly" way that would give those nations an advantage in rebuilding. Ah, George ever an idealist. This is how H.L. Mencken defined idealists: "One who, on noticing that a rose smells better than a cabbage, concludes that it will also make better soup."

Finally: The fewer, the prouder, but not the EU »

We're taking our economies and going home
If the problem is all those other messy, profligate nations, then why hang out with them? Instead, form a new club of those who can come closest to balancing their checkbooks. That would be Germany, Austria, Finland, the Netherlands, Belgium and possibly France, Denmark and one or two of those cute little Baltic nations. But only if they ask really nicely.

Along with the new club would come a new currency -- let's call it the Uber-Euro. Hans-Olaf Henkel says this would be best for all involved:

If planned and executed carefully, it could do the trick: a lower valued euro would improve the competitiveness of the remaining countries and stimulate their growth. In contrast, exports out of the "northern" countries would be affected but they would have lower inflation. Some non-euro countries would probably join this monetary union. Depending on performance, a flexible membership between the two unions should be possible.
The new club would be the Hanseatic League & Co. (What, you're not up on your 13th century trading alliances? OK, then click here.) But in order to succeed as explained above, it really requires the participation of these nations as they are now -- not as they would be after all those defaults.

Banks in all the European nations -- including those making up this new union -- are under-capitalized. Those economic firewalls and moats you here people talking about? That's just a euphemism for putting more money in banks so they can better cover their debts.

That would require a lot from the various governments involved. It is difficult to believe that all the governments involved in the new Hanseatic League can or will be able to shore up their banks enough. In the event of defaults everyone is taking the hit and everyone is coming out in a lot worse shape.

That doesn't mean this won't happen. Just that it won't be the nice happy situation outlined above. If worst comes to worst, I believe the EU will reconstitute itself in smaller sub-groups. The citizenry will demand their governments sever ties with the organization which they blame (unjustly) for their economic problems. This could be aggravated by people in each nation unhappy about all the foreigners "allowed" into their nations by the EU's lack of internal borders. Racism will have its day. Hopefully nationalism will not -- at least on a level involving armies.

In time these smaller groups could unite into a larger group similar in some respects to the EU. Maybe.

Image courtesy of Hanseatic League Historical Re-enactors