Comment: Why and how the eurozone got into such a state

Rajesh Shant, manager of the Newton Continental European fund, takes a closer look at the circumstances surrounding the eurozone crisis.

The sound and fury around the crisis in the eurozone can be both confused and confusing. Why have we got to such a sad state of affairs? And why the eurozone when the region’s aggregate economic data is better than that of the US or the UK?

The root cause must be the inherent contradictions and paradoxes under which the euro was launched. A common currency, with a common Central Bank but no common Treasury, and divergent economies and economic polices. As interest rates converged to German levels, certain countries found themselves over-borrowing and over-spending whilst others whipped up property bubbles of epic proportions.

With Western economies finally deleveraging, markets naturally move to seek out the weakest links: countries over-burdened by debt, without the ability to print their own money or devalue.

Panic in the equity market

Is the recent European equity market panic really solely due to the fear of default by Greece (which the bond markets tell us is a near-certainty)? Is that why trillions have been wiped off asset values all around the world? Markets know how to deal with defaults: Russia, Brazil, Mexico, Argentina have all defaulted in recent memory. The effects vary, but are calculable.

Thus, the crescendo of fear that peaked around the G7 summit on 10-11 September was also reflecting the accompanying fear that Greece would be forced out of or perhaps remove itself from the euro. Senior figures in Germany joined US & UK voices already speculating about this.

Why should this matter? Imagine a small state in the US defaults on its municipal bonds. If everything else stayed the same, the damage could be calculated, priced in and the market could move on.

However, if that state was to leave the US dollar and fall out of the United States the damage could be incalculable. The markets would have to question: what if it were a far bigger state (like California)? Is there a different fate for a New York bank or a California bank? Will deposits held in a California branch or a Texas branch be treated differently? It would become almost impossible to value the equity of a national bank, so investors would probably give up trying.

Falling valuations

In effect, by mid-September eurozone equity investors pretty much gave up trying to value the eurozone banks. Valuations fell to below 0.4x book value, approaching March 2009 lows. While the media ranted and raved about “solvency worries” and “liquidity crises” the real unspoken (and inchoate) fear of the market was more existential than that: the seemingly impending break-up of the world’s second most commonly held currency.

Apparent discord between Germany and the ECB sparked fears that the legal framework of the eurozone was about to collapse. When Germany’s Jurgen Stark resigned from the board of the ECB, speculation reached fever pitch.