It is now almost fashionable to bemoan that the European Union was always an ill-fated project. Many of the naysayers argue that Germans are culturally very different from the Greeks, the underlying levels of productivity varies widely across the 17 countries that make up the Eurozone, the macroeconomic inclinations of sovereign governments are radically different and so on.

Of course, none of this is manifestly false or an implausible reason for the failure of this project. To some the Eurozone is just a currency board struggling to find relevance. But the world is full of large sovereign states where one region doesn't resemble the other, be it culturally, economically or historically.

Yet, if one reads about the fierce independence and differences of the tribes in the Hejaz and Nejd regions in the early years of unification under King Abdullah Bin Abdul Aziz Al Saud of Saudi Arabia there were many reasons to be pessimistic about the possibility of unified country in an "ungovernable" land.

Further east, a behemoth like India is choc-a-bloc full of diversely endowed states such as a small agricultural niche like Himachal Pradesh in the North and the industrial powerhouse like Tamil Nadu in the South.

The two couldn't be more different. Similar intra-regional differences apply in China, the United States, Nigeria, Russia, Brazil etc., The long and short is that there are no a priori one-size-fits-all theoretical reason as to why large states emerge, survive and eventually wither away.

Problem of liquidity

The Eurozone or the European Union is no exception either. It is historically naive to see its failure or success as a foregone conclusion based on a debt crises, albeit a terrible one. What we can, however, investigate is the principal incentives that it's major players have today.

It may shed light on their possible future actions. For investment approaches, the key is to not look for grand theories but work one's way through evolving situations. Epistemological humility and nimbleness in strategy is critical.

The future of the bloc clearly lies in the hands of its politicians and how the problems they perceive are communicated to their electorate. The current European crisis is typically understood as a problem of liquidity.

This is only partially, and alas fleetingly, true. Liquidity is an issue that European banks face when they try to do business in Asia, Africa and Americas. If they can't borrow in dollars or yen, their daily businesses are likely to suffer.

Another view

But, these are easily solvable problems. And the central banks in the world have largely done the right thing. The US Federal Reserve recently has agreed to open up its dollar swap lines for euro. So, European banks can switch their euro into dollars, and conduct business elsewhere.

There is another view that the European crisis is simply one of the large debt burdens. The corollary to this view is that if the recurring interest payments on debt can be rolled over the immediate problems will tide over.

In order to facilitate this, many have begun making arguments that countries like China or those in the Gulf, with substantive foreign reserves, ought to buy newly issued debt.

These include influential scholars like Arvind Subramanian at Peterson Institute. Perhaps, China et al will out of geopolitical self-interest. But it is incredible to imagine that sovereigns would wilfully lend to other sovereigns who are unlikely to pay back.

After all, if the real source of instability is the possibility of default by Greece or Portugal, why should China or UAE treat it any differently than say private bond managers would?

They would however buy new debt, if German taxpayers backstop the new issuances. In this case, Germany would take it upon itself to ensure that the rest of peripheral Europe improves its taxation abilities & macroeconomic functioning.

A subtlety however is that Europe as a zone, in general, is a net capital exporter. With a single currency, and by increasing the levels of foreign borrowings, the Euro is likely to only appreciate vis-à-vis its principal substitute, the dollar. And this would be disastrous for the peripheral European countries that need to grow/export their way out of the present crises.

 

Keerthik Sasidharan manages risk on credit derivates portfolios for an investment bank in New York City.