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The biggest victim of the global housing and credit bubble may be the euro — the single currency of 16 European nations. Having just celebrated its 10th birthday in a free-fall, the euro is being exposed for all of its structural weaknesses.
The euro is managed with a common monetary policy. But a fractured fiscal and political structure has left it without a full toolbox to fight hard times. And this chink in the armor is threatening to make the euro’s life-span short.
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| The EU just celebrated its 10th birthday. But with the euro taking a header, there’s not much for members to cheer about. |
The U.S., China, the UK, Japan, and Australia have made aggressive, downward adjustments in interest rates. Some have boosted their money supply to fight the economic crisis and have formulated specific fiscal stimulus plans to inject growth into their economies.
Meanwhile, members of the European Union’s monetary system (the single currency) are left frozen in a rigid, inflexible and arguably faulty regime.
But lack of flexibility is not even the most dangerous problem the euro member countries are facing. Even more dangerous to the euro’s future existence is the death-spiraling plunge of neighboring eastern and central European “non-euro” countries.
The New Iron Curtain …
For the outliers in emerging Europe, many of whom are ex-communist economies, the impenetrable curtain is membership into the European Union’s monetary system, the euro. Most importantly, membership in the common currency gives these countries refuge from speculators launching attacks on their currencies.
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| Exports for many emerging European countries have come to a screeching halt. |
Keep in mind that it’s hard enough for even the most powerful countries in the world to sustain through the biggest economic downturn since World War II. But economies that are highly dependent upon exports and foreign direct investment — both of which have dried up — plus debt obligations that increase in value by the day, have even more obstacles to overcome.
You see, when companies and consumers in these small “periphery” European countries borrowed money, they borrowed in euros and Swiss francs, not their local currencies. In fact, the level of borrowing in foreign currencies by countries like Latvia represents as much as 90 percent of the bank loans made in that country.
And why not … After all, euro-denominated loans were cheaper and interest rates were more stable. What’s more, these periphery countries assumed that they would be joining their rich neighbors in the euro in the near future.
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That’s why I see two black clouds threatening the euro’s survival …
Black Cloud #1 —
Pressures from
Non-Euro Countries
When the economic engine of your economy stalls (i.e. global demand for your exports evaporates) and the fragility of your financial system is glaring, investors flee and speculators wage an attack on your currency.
And this is precisely what’s taking place in the currency markets right now …
Emerging market economies in Europe have been hammered, driving DOWN the value of their currencies and driving UP the value of the foreign-currency denominated debt that consumers and institutions in these countries are holding.
When a currency devalues, foreign-currency denominated debts become more and more expensive. For a perspective on how much these debts are escalating, here is an indication of the sharp decline these at-risk currencies have made.
Source: Bloomberg
So how does this affect Europe as a whole and more specifically the future of the euro?
The aggressive lending practices in the global, credit-led boom were just that — aggressive. Now, add into the equation:
- The slowing (if not collapsing) economies in this emerging European region,
- Plus the increasingly unstable political environments,
- Plus the currency-driven debt inflation …
… and the likely outcome is indeed bleak.
So how much are the rich, Western European banks, that made these loans to emerging Europe, on the hook for?
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It’s in the $3.6 trillion range. And add to that, European banks on whole have debt levels that dwarf every other developed market country, even that of the United States.
Black Cloud #2 —
Vulnerability of the
Euro Concept
Aside from the pressures being cooked up on the periphery, the euro member countries are in trouble for all of the reasons Milton Friedman, one of the most influential economists of the 20th century, cited prior to the euro’s inception 10 years ago.
I’ll paraphrase four of Friedman’s statements and follow each with what is going on now:
- A one-size fits all monetary policy doesn’t give the member countries the flexibility needed to stimulate their economies.
- A fractured fiscal policy forced to adhere to rigid EU rules doesn’t enable member governments to navigate their country-specific problems, such as deficit spending and public works projects.
- Nationalism will emerge. Healthier countries will not see fit to spend their hard earned money to bail out their less responsible neighbors.
- A common currency can act as handcuffs in perilous times. Exchange rates can be used as a tool to revalue debt and improve competitiveness of one’s economy.
The European Central Bank has been behind the curve on lowering interest rates because of mandated benchmarks on inflation and without attention to growth.
France, Spain, Malta, Greece and Ireland have disregarded the EU’s Stability and Growth Pact by running excessive deficits.
Hungary has walked into the latest EU summit, hat-in-hand, asking for a mere 190 billion euros; Germany has rejected the notion of big spending to bail-out countries, and German citizens are in protectionist mode.
Under the euro, weak member countries are helpless. Italy has a history of competitive devaluations of the lira during sour times. Now, in the euro regime, its economy is left flapping in the wind.
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| Milton Friedman predicted that the euro would collapse within 10 years of its inception. |
As Jack has written in past Money and Markets columns, Milton Friedman saw the vulnerability of this concept coming and predicted the euro’s demise within a decade.
Today, the most challenging issue facing the euro might be addressed in this statement:
“Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.”
Germany, the core of the euro and the rich uncle to its euro-member partners, appears increasingly intolerant of the less responsible, less viable partners. Could they make an unexpected departure from the currency union?
Is the next target for the euro the 2000 lows?
Source: Bloomberg
In late 2000, just short of two years following its launch, the euro hit an all-time low of 0.8230 — off 30 percent from its January 1999 opening level.
The chart above suggests the euro could soon revisit that level. And with the events unfolding as I’ve laid out today, it could be sooner rather than later.
Regards,
Bryan Rich
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