Posted by: Andrew Bell
Friday 15th April 2011

A leading attraction at this year's Hanover industry trade fair was a mechanical seagull, which took off every hour, flew to the top of the exhibition centre and then came back to roost.

When I worked for Shell in the Middle East 25 years ago, the term "seagulls" was reserved for senior management visitors to the oilfields, who flew over, carped (sic) over most of what they saw then returned to base.

In this sense, peripheral European governments could be forgiven for seeing strong parallels between the Shell management “seagulls” in the 1980s and the operating of European monetary policy in what appears to be the interest of a dominant Euro member (Germany) whose economy is close to overheating, rather than the swathe of countries whose efforts to confront their past fiscal profligacy and loss of labour competitiveness are producing deflationary forces in their economy and prolonging the recession.

Peripheral countries have seen their labour costs deteriorate by up to a third relative to Germany over the past decade (since their currencies became locked together). Whilst this is largely their own "fault", the scale of the resulting fiscal deficit problems and losses of international competitiveness have become so dauntingly large that markets doubt the ability of countries such as Greece, Ireland and Portugal to manage their way through without in some way defaulting on their existing national debt. This could either take the form of a "can’t pay, won't pay" haircut on the outstanding amounts, repayment in a different currency if they had to leave the Euro or an agreed extension of the term and reduction of the coupon on current debts (akin to the Brady bond route taken in restructuring Latin American debt in the 1980s).

If European policy were being run for the problem stricken economies with competitiveness issues it is hard to imagine a worse policy than allowing the Euro to appreciate by 8% from the lows it touched last summer. Although the currency is at a similar level to 12 months ago, the argument in favour of its summer fall (that it was a means of helping the periphery cope with austerity and at least boost their competitiveness outside Europe) has not changed, only Germany’s willingness to compromise its own current economic interests in favour of preserving the Euro. It seems uninterested in a policy of allowing the struggling periphery time to pursue fiscal tightening at a realistic pace, offset by easy monetary conditions.

Apart from indifference to the stronger Euro (which will help cool off the booming German economy), the European Central Bank [ECB] has raised interest rates, again a prescription which might be right for Germany and a few others but is calculated to make managing through the Euro's current tensions without a sovereign default harder.

With Greece having seen its 2 year interest rates soar from 4% in early 2010 to 18% now, a default is now being not only priced in but almost forced. The sums are different for Ireland and Portugal (2% and 10% in each case) but the message is the same - the markets are unwilling to lend at realistic rates to certain sovereign states because they perceive their fiscal problems as incapable of solution without help from the ECB and they perceive the ECB as either opposed or vacillating.

It is possible that the ECB is distinguishing between the (interest rate) tools needed to cool off inflation pressures in some economies (e.g. Germany) and the asset purchase and special lending arrangements needed to save the PIIGS' bacon. However, confidence in the ECB's ability to achieve such a balancing act with aplomb has taken many knocks over the past year. The likelier conclusion is that it is fundamentally divided, with pragmatists (probably including M. Trichet) recognising that extreme measures are needed to achieve an orderly workout of the existing casualties’ problems and prevent the falling of further dominoes, while orthodoxy thrives in the seagull colonies of Northern Europe.

The solution will be found when the authorities concentrate on the current problem rather than whose fault it is. Having admitted some countries to the Euro before their economies had converged with the core economies and failed to address (or recognise) the developing economic divergences over the past 10 years, blame is fairly widely spread. Economic morality (perhaps an oxymoron) and avoiding moral hazard would argue for making the profligate suffer - hence the pressure for fiscal retrenchment and the penal interests exacted from the periphery.

However, if the resulting adjustments are politically undeliverable then some governments will change policy, devalue or default. If some do, markets will speculate on the next. This will bring the periphery's financial problems right to the heart of the core, because the banking sector (notably in Germany) has substantial exposure to the sovereign bonds of peripheral economies (having been attracted by the slightly higher rates they used to offer before the current crisis saw risk premia balloon outwards).

If sovereign defaults or debt restructuring are the ECB's preferred route there is a risk of the process becoming quite disorderly, with recriminations between the seagulls and the "seagulled", significant economic repercussions in core countries whose banking sectors would be affected and (especially if the Euro remains strong) a wholesale unwinding of the basis of German prosperity, risks about which the authorities seem complacent.

A year ago, the presumption was that shared interest should aim to minimise the countries denied access to markets, ring-fence the problem, provide credit at low cost in exchange for fiscal rectitude and hope to grow out of the problem. The debate now seems to include active speculation of at least one government default and argument over where to draw the line (Spain?) in providing unconditional support, pandering to certain countries' domestic electoral prejudices rather than addressing the problem. What threatens is either a political train-wreck or an acute crisis followed by the adoption of more pragmatic policies, at much greater cost than if they had been put in place a year ago. Perhaps the German seagull sees the Euro as an albatross.

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