Taipan Daily: Plate-Glass Europe Could Crack and Shatter by Justice Litle, Editorial Director, Taipan Publishing Group
For those of you wondering “where’s Adam,” he is off somewhere in the wilderness today. (Quite literally, I think – or at the very least unplugged from telephones and the net.) But have no fear. He’ll be back later this week.
Today I’d like to share with you my view on a grand experiment... an experiment that just might be doomed.
There are plenty of candidates these days when it comes to big ideas in big trouble. TARP... TALF... Quantitative Easing... the Federal Reserve system... public option healthcare (ahem, cough). But this one is even bigger. I’m talking about one of the conventional candidates for the next global reserve currency – the euro.
Few realize it, but the euro, as a still-young currency, could be on the verge of the greatest challenge it has ever faced. Given what’s coming next, odds are strong that the euro will crash. And beyond the event of a currency crash – which would be a hugely impactful event but not life threatening in itself – there is reason to question whether the euro will ultimately survive.
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I’ll begin by explaining what I mean about the euro being an experiment.
The euro is unique in that it is one currency, under the (theoretical) rule of one monetary policy authority (the ECB, or European Central Bank), administered to many different countries. Out of the 27 member states of the European Union, 16 have adopted the euro.
This makes the euro a sort of Frankenstein currency. Unlike, say, the dollar or yen or yuan, the euro is stitched together from the organs and limbs of 16 different countries... 16 different cultures... 16 different governments.
What this means, in practice, is that the euro does not have true political viability in a time of extreme crisis. Imagine an army run by 16 different generals, or a mega-corporation run by 16 CEOs, and you will start to get the picture. A memorable line comes from Henry Kissinger, who as U.S. Secretary of State in the 1970s once quipped: “If I want to call Europe, who do I call?”
But wait a minute, some of you will object. The euro has been a going concern for more than a decade now. It is used daily by 327 million Europeans... 150 million people in Africa use currencies pegged to it... all in all the euro is the second-largest reserve currency after the greenback. How can it be argued that the euro does not have political viability?
Crisis Is The Thing
Don’t forget the qualifier, “in a time of extreme crisis.” The euro has proven to be a success thus far... but the question is how it will respond to a truly harrowing test.
Reserve currency candidates are all about survivability in a time of crisis. This only makes sense, because extreme crisis is bound to pop up sooner or later. (In this particular case, very much sooner.) It’s a bit like building a beach house on the ocean coast. The type of storm big enough to threaten the beach house may only come along once every 10 or 20 years. But you still build the house to weather it.
To understand why the euro is vulnerable, perhaps fatally so, let’s talk about the United States for a moment.
The 50 states are all united under one overarching political system – one constitution, one military, one federal government. The 50 states are also united by a high degree of cultural cohesion. If someone loses a job in, say, Michigan, it would not count as a major cultural shock for them to move to Minnesota. There are regional differences, of course, but mobility is more or less high. People and capital can flow from one region of the U.S. to another with relative ease.
Now compare that to the euro zone. As mentioned, the euro covers 16 different governments. Though the euro zone has one central bank at the helm, this also means 16 different heads of state... 16 different attitudes toward government debt, domestic monetary policy, and even the proper shape of capitalism itself.
What’s more, mobility in the euro zone is not exceptionally high. For an American to move from Michigan to Minnesota is one thing. For, say, an out-of-work Italian to try and move to Germany would be quite another.
These little differences can be papered over when things are going well. Just as poorly run companies can chug along making profits in a boom, papering over weakness in a time of relative prosperity, poorly run countries (or questionable currency zones) can do the same thing.
But when the proverbial stuff hits the proverbial oscillating device, that’s when cracks and divisions start to matter. Crisis is the ultimate “stress test” – for a business, a country or even a currency zone.
Another big problem with the euro is that various euro zone economies are running at very different speeds. For a long time, countries like Ireland and Spain were red hot even as France and Germany were cold. Now the PIGS – Portugal, Ireland, Italy, Greece and Spain – are all in dire straits even as the more mature euro zone members (France and Germany again) appear to be clawing their way out of the hole.
The Economist has likened this problem to pots on a stove. Imagine you are trying to cook a large meal with multiple pots on multiple burners, but there is only one knob that controls all the burners. Three pots are too cold and need more heat. Yet three other pots are threatening to boil over at the same time. You only have one knob... what do you do?
In the above analogy, the single knob that controls all the burners is the interest rate set by the ECB (European Central Bank). There is no way to apply a uniform temperature level (interest rate) that suits everyone.
Then there is the problem of bailouts. As the global financial crisis came to a head in late 2008, the true political weakness of the euro zone became apparent for the first time.
A currency union between sovereign governments is like a marriage in some ways. When multiple countries decide to share a currency, it is a bit like taking the ancient vow: “in sickness and in health, for better and for worse...”
The trouble is that, when push came to shove, countries like Germany decided to say forget all that “for better and for worse” stuff. German citizens decided they would be damned before any political leader could convince them of the need to write checks to, say, Italy or Ireland for the good of the euro zone’s sake.
German Chancellor Angela Merkel, widely recognized as the most powerful woman in the world, developed two distinct reputations in the depths of the financial crisis. On the one hand, many viewed her as a rock of fiscal fortitude for saying “nein” to all the check-writing bailout requests. On the other hand, others viewed her (and Germany) as a selfish actor... a bad spouse whose refusal to honor “for better or for worse” could wind up killing the euro zone.
When times are good, in other words, the euro zone is very much a united front. But when times become exceptionally hard, “we’re all in this together” morphs into “every man (or every country rather) for himself.”
Nor does the trouble only lie with stingy countries like Germany. On the other side of the equation, debt-laden countries like Italy (and soon others, like Ireland and Spain) are faced with the temptation to greatly abuse their fiscal privileges.
For a country like Italy, the great advantage of being part of the euro zone is an ability to trade on other countries’ credit. Again like a marriage, when two or more countries share a currency, those countries with a poor credit rating get to hitch a ride on the higher credit rating of the partner.
If Italy were to try and issue bonds in Lira, for example, the interest rate demanded would be sky high, due to Italy’s profile as a poor credit risk. But by issuing debt in euros, Italy gets the benefit of Germany’s good name.
So when things get well and truly ugly, Italy (and the other semi-basket-case euro zone countries) will have two options. As a first option, they can go to their richer euro zone partners (Germany and France, etc.) and say “please help us.” When Germany and France say “No,” Italy can then say “fine”... and just issue massive quantities of euro-denominated debt, or otherwise let the government budget plunge deep into the red. When this happens, fiscal chaos ensues. The euro gets trashed in result.
So really, in a way, one could say the euro is like an arranged marriage headed for the fiscal rocks. Many a husband and wife have seen their union come a cropper over financial differences. The same could be true for the euro zone.
The Crisis Catalyst
Your humble editor is further of the opinion that this euro crack-up could happen soon – perhaps very soon.
The catalyst will be a sharp and shocking realization that the global crisis is not over... that, in fact, it is far from over. As Winston Churchill said in November 1942: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
Right now, investors are displaying the exact same outpouring of hope and optimism (and touching faith in government) that they did in the aftermath of the crash of 1929. The great doomed rally that followed ’29 was based on the utterly false belief that the world’s problems could be solved quickly... that a few short-term measures would heal all wounds... that the old prosperity was just around the corner.
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The reality is that financial markets are hopelessly naïve at times because desire makes them so. Desire corrodes objectivity in the same manner that acid corrodes metal. In hindsight, the idea that the global financial crisis could have resolved itself in less than two years will seem utterly silly... just as it seems silly now to imagine the excesses of the 1920s could have been shaken off with just a quick drop.
As Tudor Investment Corp recently observed, “Impressive counter-trend rallies are a feature, not an oddity, of secular bear markets.” These rallies tend to die violently when reality reasserts itself. In terms of foreign exchange, the euro’s present strength is a function of global recovery hopes and historically precedented naiveté. When the realization sinks in that swift global recovery is a mirage... and, furthermore, that the greatest tests are still ahead of us, not behind us... the experimental currency that is the euro will be smashed.
There are a number of additional reasons, left unexplored here for the sake of space, as to why plate-glass Europe could soon crack and shatter. Trouble in the Baltics... European banks still drowning in toxic derivatives... the reality of deflationary pressures masked by short-term upticks in the data... the list goes on and on.
All of this feels especially poignant, too, given that September and October are just around the corner. What’s more, a number of powerful speculators with multibillion-dollar war chests are keenly aware of this opportunity. “Currency raids” are a time-tested means for ruthless fortune hunters to rack up spectacular gains. The men who know this game are waiting to pounce on the euro like a pack of bloodthirsty hyenas on a wounded wildebeest.
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