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The Eurozone Demise?



May 26, 2011 – Comments (0)

Location: JakilaTheHun's CAPS Blog

Author: JakilaTheHun

I've been a critic of the Eurozone's basic structure for awhile.  In essence, the Euro is a 17-nation currency peg, that strips away the independence from each central bank's monetary policy.  This is almost like a reversion to the gold standard, in that nations that need to increase money supply can not.  Therefore, they get stuck in a deflationary spiral.  

Some thoughts:

(1) The Eurozone crisis will end ugly.  I originally had some faint optimism that Eurozone policymakers might realize what is necessary to make the Eurozone work, but all signs point to this not being the case.  Instead, we're seeing an increase in populism, nationalism, and radicalism across the Eurozone.  This is frightening. 

(2) If Greece and/or Ireland leaves the Euro and restructures their debts, the German banks are in deep trouble.  Therefore, the German banks would prefer for the German government to keep Greece and Ireland on life support.  This is also why Germany desperately wants Greece to stay in the Eurozone; because the German government might suddenly find itself propping up its own banks. 

(3) The other alternative is that Germany semi-permanently starts paying for Greece and Ireland's government obligations.  While the Euro dramatically helps boost German exports via artificially weakening their currency, eventually, the German government is going to rack up quite a debt if it continues to subsidize the PIIGS.  This alternative, while unappealing, might be better than allowing Greece, Ireland, and others to default actually --- but it's unlikely that the German populace will support this or go along.

(4) The idea that Germany has been responsible and prudent, while the PIIGS have been reckless spendthrifts is complete rubbish (with the exception of Greece). Four years ago, Spain, Portugal, and Ireland had very low government debt.  The financial crisis is what has destroyed them.  You can't fund government oligations with 20% unemployment (as in Spain) or with zombie banks (as in Ireland).  And you can't dramatically cut government spending when you have 20% unemployment and zombie banks; lest you make the crisis even worse. 

(5) If you live in the US, you should be thanking God (or the deity or non-deity or your choice) every day that your nation has independent monetary policy.  Spain and Portugal would probably be alright if they had that.  However, being stuck in the Eurozone will likely doom them without significant reforms or an eventual exit. 

(6) Another solution to this mess would be to start financing all government debt through the ECB.  Part of the problem is that the Eurozone not only artificially boosts exports for the stronger nations; but it also artificially lowers interest rates.  It does the complete reverse for the PIIGS.  However, once again, Germany has steadfastly opposed debt financings through the ECB ... even though it's the most logical solution and the solution that is also least likely to cause disaster.

(7) The Eurozone should also implement current account surplus tax that redistributed money from CA surplus nations to CA deficit nations.   This is necessary because the Euro artificially redistributes wealth from the weaker economic nations (the PIIGS) to the stronger nations (Germany, Austria, Netherlands, Finland).   This will also never happen, but it makes sense economically. 

(8) One of the purposes of the Eurozone was to tie together the European nations closer and to avoid the issues of the first half of the 20th Century with rampant nationalism and economic protectionism.  Instead, the Euro has, ironically enough, re-ignited European nationalism.  

(9) Spain, Portugal, Ireland, Greece, and Italy would all be better off if they left the Eurozone entirely. 

(10) However, the idea that the PIIGS leaving the Eurozone would save it might be flawed.  Rather, a PIIGS exit is more likely to give the Eurozone a temporary stay of execution.  The flaws of the currency union are significant enough so that another decade down the line, we could see the exact same issues.  

(11) I would not invest in Germany right now.  In some ways, it's the most vulnerable Eurozone nation, because the market is already pricing in a lot of distress in the PIIGS, but Germany is considered "safe".  This is completely untrue. Germany is very vulnerable to the changes that will inevitably occur over the next few years. 

(12) In a worst case scenario where the Eurozone dissolved, the German banks would be in deep trouble due to debt restructurings in Greece and Ireland.  Moreover, the Deutsche Mark would dramatically strengthen, thereby killing German exports.    Right now, Germany's economy is held up by an artificially weak Euro (from the perspective of Germany's natural currency) and artificially low interest rates.  Any interruption in that could change things for the Germans. 

(13) I'd be terrified to invest in most Eurozone banks.  The only Eurozone investments I have considered are telecom companies and big international firms (e.g. ABB, Siemens).  Only a few banks might be worthwhile.

(14) Banco Santander is my one and only Eurozone investment right now.  Even Santander is not immune, but they hold about 30 billion in Spanish government debt securities with around 80 billion in equity.  Their capital levels are significantly higher than most Eurozone banks and they have much greater diversification, with a huge Latin American presence, as well as a US and UK presence.  I'm betting that Santander can survive the worst-case Eurozone scenario, but I could be wrong.  I would not make this bet with any other Eurozone bank. 

(15) The thing that makes the Eurozone situation so difficult to invest in is that no one really knows what's going to happen in the end.  The ultimate outcome will be driven by a combination of political considerations and economic realities and it's difficult to predict where the two will meet.  The Euro, itself, could be saved if the Eurozone nations eventually decide it's in their interest to change the mechanisms behind it.  If not, the Eurozone will either dissolve, a few nations will split off from it, or it could just become a big zombie for the next few years. 

(16) If I had to wager, I'd bet that within the next five years, at least two nations will leave the Eurozone.  But this is a shot in the dark, given the potential number of outcomes.  My main reason for believing this will occur is that I see virtually no desire to cooperate within the Eurozone in order to make the Euro sustainable.  So what seems more likely is that eventually, some populist movement in particular nations push the government to end austerity policies and exit the Eurozone. 

(17) Btw, austerity is only making things worse.  People like to think of governments like individuals, but this is a poor comparison.  Here's the problem:  the PIIGS have artificially overvalued currencies because the Euro includes stronger economic nations like Germany, Austria, and Finland.  This means that assets in the PIIG nations are artificially overvalued.  This means there are downward price pressures until equilibrium is hit, so there are major deflationary pressures.  Austerity means higher taxes and lower government spending.  Higher taxes mean that assets are worth less.  Lower government spending means that assets produce lesser cash flows, and hence are also worth less.  So you can't solve an issue of artificially overvalued assets by beating down the intrinsic values further.  

That's all for now.  Or at least, that's more than enough for one post.

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