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Big Troubles for the Euro

by: David Merkel October 07, 2008 | about stocks: ERO    
David Merkel

David Merkel

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The Euro has been falling recently versus the Dollar.  Why?  There have been many theories proposed, but I want to offer my own theory this evening.  Fiat currencies are political creatures, and are only as strong as the political entity issuing the fiat currency (fiat — it’s currency because we say that it is).

The intersection of politics and economics is tricky.  Currencies, and confidence in currencies are ephemeral.  I look at the Eurozone and ask a simple question: Who stands behind the Euro?  Who will lay out tax revenues to support it in a crisis?  Who will be the lender of last resort?

Much as I did not like the bailout plan because I think there were many better plans to pursue, nonetheless, the US has the benefit that the US Treasury and Federal Reserve are acting like one unit.  In the Eurozone, there is no central taxation, regulatory banking, or police authority; there is no lender of last resort.  Individual governments or “coalitions of the willing” may bail out financial companies, but there are no guarantees because the ECB and European Parliament are toothless.  If the same conditions existed in the US, regional Federal Reserve Banks would do the bailouts, and not the Central Bank.

When I was on “The Ron Smith Show” two weeks ago (sorry, no podcast), I commented that the credit crisis was a global phenomenon, and the European banks were more levered than US banks, though with less credit stress as a percentage of assets.  I pointed out that there is no lender of last resort, and that many countries have different goals for currency policy, and bank regulation.  I also noted that the criticisms of American finance were valid, but applied to Continental Europe as well.

At present, those Europeans that dissed Anglo-American finance have egg on their faces (including the lady who shares my surname).  With the competitive rush in Europe to guarantee bank deposits, even Germany switched its policy and guaranteed deposits.  That hasn’t happened in the US yet, but I wouldn’t rule it out.

It is possible that the current crisis could destroy the Euro, and possibly the EU.  I think of the Confederation, where the economic pressure became so great that an extra-constitutional coup took place to create the Constitution, and implicitly, the fiat Dollar that we live with to this day.  WIthout political unity, fiat currencies have short shelf-lives.  Alternatively, the crisis could create a Federal Europe where the central government has significant powers to the degree that France in the Eurozone would be similar to Texas in the US.  I don’t see that as likely; there is not the same degree of trust across the Eurozone as there is in the US.

What’s my upshot here?  Extreme volatility does not favor the Euro; it calls their system into question.  Better to be in the Dollar, or better yet, the Yen, Swiss Franc, or Norwegian Kronor.  Carry trades are play on low volatility; when volatility rises, the low interest rate currencies tend to do well because the ability to hedge bad currency outcomes is diminished, and carry trades collapse.

That’s where we are now.  Neither the US nor Europe should gloat over the other’s bad providence.  They have their own unique weaknesses.

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This article has 19 comments:

  •  
    Oct 07 12:14 PM
    Good thoughts and valid points but Europe does not have the mountain of debt we have here so they can manage their finance with more freedom that us at least for the moment!
    Reply
  •  
    Oct 07 12:23 PM
    David,

    Good article, altough I would disagree that there is no lender of last resort - the ECB has been playing that role providing liquidity for European banks - however agree that they are much more constrained in pursuign agressive out of the box solutions such as the Fed has had to pursue in the States (and rightly so in my opinion).

    It seems we reached a similar conslusion at he same time. Check out my article earlier today:

    seekingalpha.com/artic...
    Reply
  •  
    Oct 07 12:25 PM
    Yes you are right. Europe has been heading down for years with its high unemployment rate and high debt. These countries have little in common with each other.

    Nato is all but dead. Germany just gave Russia the green light to expand. Germany gets most of their energy from Russia and knows where its bread is buttered.
    Reply
  •  
    Oct 07 12:46 PM
    Drive a nail into the Euroweenie coffin. Withdraw all US troops from Germany and England, force the "EU" (or EEEEEwwwwwww!) to pay for its own defense. The Euro would tank, the continent break out in hives at the prospect of actually having to fight the Russkies themselves, and the budget savings in the US would send the dollar soaring.

    cyclingscholar
    Reply
  •  
    Oct 07 12:53 PM
    One thing is theory about coordination, or lack of it... the other is practice about support. Until the end of this crisis, whenever it ends, the European governments are going to inject a staggering ammount of money to bail out the financial system flushed with the toxic waste of american foreign debt. At the rate they are going 1 triillon euros looks just the ammount. And, apparently, without recourse to the debtor.

    In Europe they tax heavily and do not have the capitalistic mentality applied to their governments. To imagine Europeans calculating if in the end, after spending 700 billion of dollars, the government may end up making money, or investing in preferred shares in banks with warrants attached, so in case there is latter an uspwing in share values the "taxpayer" benefits, is unthinkable. That is why they will spend heavily and debtors will have a free ride.

    As at now Governments in Belgium, Germany, France, UK, Iceland, Holland have already paid. This crisis is going to cost a lot of taxpayer money. If the US governement really spend real money salvaging the mortgage backed bonds, finishing this chicken game of who foots the bill, the crisis will end soon. The rest of the world are already paying more, and in the end, they know, they will have the largest loses. That is why the euro looks week.

    Reply
  •  
    Oct 07 01:19 PM
    Better to be in the dollar?? Better to be in GOLD. We are going to see intentional inflation of *all* currencies for a WHILE.
    Reply
  •  
    Oct 07 01:27 PM
    To David and Talin.

    David is right about the German pm Angela Merkel who now suddenly came forward with putting an infinite ceiling of saving deposits. I think that in the panic this has emerged because contrary to the USA all rescue funds are filled with real money paid by the European banks themselves.
    The US FDIC fund is only an accountancy vehicle, all money needed to rescue banks had to be borrowed. There are no reserves anywhere in the system.

    Another example: Here in Holland in 2009 likely workers do not have to pay for unemployment insurance because the fund is overfull. We name that 'anti cyclical taxing', in the good times you save for the bad.
    The USA can only stimulate the economy with more new debt.

    To Talin: If you think the US government will make money out of their 700 billion investment better think twice: if they buy stuff on the cheap than losses have to be taken by the banks. This is not very realistic, Bernanke has stated that a lot will be bought at near maturity levels because otherwise 'it will not work'.

    And believe me, it will not work because elementary calculations indicate there is at least another 3 trillion in toxic waste coming from the housing correction only. Under numbers like that I do not see any profits for the borrowed 700 billion US$ bailout fund...
    Reply
  •  
    Oct 07 01:38 PM
    CLH,
    Europe has far less debt than the US by any measure - including as proportion of GDP. That's part of the reason why the Euro grew in price so much this decade as the US national debt ballooned due to the wars. High debt = weak currency. The current correction makes it about even with this time last year - about 40% over 2000 levels.

    Talin,
    At times like these, I don't think we can lecture anybody about their lack of "capitalistic mentaility." We just nationalized Freddie, Fannie, and AIG and provided taxpayer funds for several other bank mergers. The conservative central planners in the Bush administration's treasury department are no doubt the envy of Hugo Chavez.

    Also, with the exception of Great Britain, Europe never experienced the real estate spree of California, Nevada, Arizona, and Florida circa 2005. The bad debts on their books are mostly American mortgage backed securities, so we can assess the extent of the problem by identifying how much of their assets are in these investments. We should have learned by now that the quality of the investments matter a lot more than leverage. Unfortunately, this article offers no such analysis.
    Reply
  •  
    Oct 07 01:47 PM
    Tou are right, Reinko. But I am not thinking the US will make money, or could or should. The problem is big. I was just stating that there is an argument going on about how to limit the exposure and how clever all can be devising solutions. The sooner the government spends the money -reasonably- the better. They will not do it all bad.
    Reply
  •  
    Oct 07 02:20 PM
    Socialism cannot compete!

    I don't know about metals like gold... If things really got bad, I doubt gold would be of value. In fact, I think a can of tuna to someone who is hungry would be much more precious than gold if "this sucker goes down."

    Anyhow, most economist think Europe is maybe four months behind us. When Europe goes bust, Germany, et.al., will pour through any surpluses they have in days or weeks.

    That's interesting... It does appear, especially when you look at volume, that there is some form of shill buying to support the markets. Sure hope they have a lot of money AND I sure hope I'm not paying for it!
    Reply
  •  
    Oct 07 02:22 PM
    Agreed - nobody should gloat, but there is one thing about the Euro, that people seem to forget. When it was introduced, many critics called it a failure to begin with. It should never have been as high as it was according to these critics. The lower Euro vs US should help exporting countries such as Germany.


    Also, Merkel and her administration favored more oversight over the financial sector for a couple of years now at every G8 summit. The U.S. and Great Britain - if I remember correctly - opposed any such attempt.
    Reply
  •  
    Oct 07 02:35 PM
    And now they (the EU members) are bickering much like our Congress was just in the last few weeks. Politicians around the globe are being challenged by this mess. Let's all hope they don't screw it up!
    Reply
  •  
    Oct 07 02:37 PM
    Talin,

    -the Dutch government bought a decent bank (ABN AMRO/Fortis Netherrlands) at a decent price, which can be privatized in a couple of years. The dividends will pay for the interest payments, and it's unlikely tax payers will have to take a loss.
    -the Belgian government will own 10% of BNP Paribas (large European bank, through a stock swap, in which BNP took over Fortis Belgium.

    With all the government intervention we will never know what the cost to the taxpayer would have been without intervention. It's probably choosing for the lesser of two evils, no perfect solutions.
    Reply
  •  
    Oct 07 04:01 PM
    Interesting that the Swiss Franc is singled out as a superior currency. Why?
    Reply
  •  
    Oct 07 04:25 PM
    Wadhamite, there are still a gob of people out there that think the Swiss Franc is still backed by gold.
    I have a question for anyone, if any of these foreign banks that have a branch in the United States can transfer all their U.S. originated toxic mortgage backed assets to that branch and thus making it available for the the Fed to buy as part of their bailout-why is Europe going to be hurt by this debt?
    Reply
  •  
    Oct 08 12:32 AM
    I tend to be critical of most of the financial commentary I find out there, but Merkel is worth his weight in gold. I'm curious as to how the cyclicals' earnings will come out given the positive movement of EUR/USD during Q3. Weak dollar used to boost earnings but that won't be the case much longer, and not many analysts have cut estimates due to f/x changes. Personally, I'm short an auto supplier with huge EU business.
    Reply
  •  
    Oct 08 09:31 AM
    Fiat Money, the US is awash in it. What "full faith", or full faith in what? Trillions being created out of thin air without collateral of any sort. Trust me... heh, say what?

    Yeah, sure, sure, sure.
    Reply
  •  
    Oct 08 10:07 AM
    Disintegration of the eurozone would make the collapse of Lehman Bros et al seem minor in comparison. However the current EU politicians and bankers are doing a good job of appearing like the deckchair attendants on the Titanic
    Reply
  •  
    Oct 08 11:19 AM
    The fall of the Euro will bring the dollar back as the undisputed world super-currency. I love my gold watch but I wouldn't try to buy doughnuts with it.
    Reply
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