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“We can make four obvious replies to Mr Wen [complaining about demands China hike its currency]. First, whatever the Chinese may feel, the degree of protectionism directed at their exports has been astonishingly small, given the depth of the recession. Second, the policy of keeping the exchange rate down is equivalent to an export subsidy and tariff, at a uniform rate – in other words, to protectionism. Third, having accumulated $2,273bn in foreign currency reserves by September, China has kept its exchange rate down, to a degree unmatched in world economic history. Finally, China has, as a result, distorted its own economy and that of the rest of the world. Its real exchange rate is, for example, no higher than in early 1998 and has depreciated by 12 per cent over the past seven months, even though China has the world’s fastest-growing economy and largest current account surplus.”

                             Martin Wolf

FX Trading – Uht oh—Euro!
ECB fiddles while Athens riots. It just doesn’t work as well as “…Rome burns.” But I think you get the picture:

“Greece’s case could present the European Central Bank and the European Union with a dilemma: whether to bail out the country or possibly see a euro-zone member face a debt crisis. The first course could reduce the pressure for fiscal discipline, while the second could damage the credibility of Europe’s great single-currency experiment,” according to a story today from The Wall Street Journal.

Below are some excerpts from Black Swan Capital’s June ’09 special report, Preparing for a Breakup in the European Monetary Union:

Despite significant concern being raised about the US dollar’s world reserve currency status, and for good reason, we believe there are major structural changes taking place within the global economy. We call it global rebalancing. Some of these changes, we believe, will lead to many years of subpar growth in the major industrialized economies of the world. And this is threatening the status of the euro to a much greater degree than the US dollar and its reserve currency status. In fact, we believe the structural change in the global economy will lead to a relatively sustained period of risk aversion* which will ultimately lead to a surprising degree of support for the dollar. It is precisely this risk aversion that we believe is now exposing, and will continue to expose, the major underlying flaws within the European Monetary Union effectively representing the euro.

… Thus, we are now in the midst of the euro’s first real test. So far the currency has weathered the storm, but there’s blood in the water and sharks are circling.
One of our favorite economists, Milton Friedman, was never a fan of the euro or the idea of Europe ever being a good place for a common currency. In 1999, Mr. Friedman said the following:

“It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart.”

Milton Friedman

Well, the global economy has hit a real bump; it’s been dubbed the credit crunch. We think the credit crunch has already begin to usher in multi-year structural changes to the global economy … changes that will continue to threaten the euro in particular because they go right to the heart and soul of multi-nation economy– Germany.

The globe is in the process of rebalancing the excess production of the big trade surplus countries against the overconsumption of the big deficit countries. In short, those countries and regions where growth is primarily dependent on rising global demand for their exports will be hit the hardest. The world’s consumers are permanently hiking up their savings rates instead of spending beyond their means. Germany is the engine of growth for Europe and the world’s largest exporter. They are in the cross-hairs of global rebalancing.

… Core requirements for success of any common currency:

  1. Common culture and political unity
  2. Synchronized business cycles
  3. Harmonized fiscal discipline

The euro fails the test on all three counts to date. And the by the way, no common currency used by different countries that has lasted even a handful of years was ever based upon pure fiat currency, i.e. paper money. Those that did have staying power historically had a metallic backing—gold and/or silver.

The EMU is lacking in each of these areas:

(1) Common Culture and Political Unity. Despite much power being shifted to Brussels and the Union, member countries to the EMU still retain a great deal of sovereignty in areas of financial regulation and ability to issue bonds, among a host of other non-financial areas. And because business cycles among members are not synchronized (the next topic below), countries will do what is best for them first, rather than the Union as a whole. National politics trump ties to the Union when push comes to shove. And because of the local sovereignty of each member, there is no single, cohesive, cross-border mechanism available to the European Central Bank (ECB) to handle a crisis when one arises.

As financial pressure grows and rising unemployment leads to increasingly austere measures across the Eurozone; it has already sparked social unrest (Greece, France, and Ireland, for example). Here is how The Independent newspaper described the vicious riots in Greece in December 2008 [our emphasis]:

“After firing 4,600 tear-gas canisters in the past week, the Greek police have nearly exhausted their stock. As they seek emergency supplies from Israel and Germany, still the petrol bombs and stones of the protesters rain down, with clashes again outside parliament yesterday.

“Bringing together youths in their early twenties struggling to survive amid mass youth unemployment and schoolchildren swotting for highly competitive university exams that may not ultimately help them in a treacherous jobs market, the events of the past week could be called the first credit-crunch riots. There have been smaller-scale sympathy attacks from Moscow to Copenhagen, and economists say countries with similarly high youth unemployment problems such as Spain and Italy should prepare for unrest.”

Interesting terminology used by The Independent, the first “credit crunch riots.”
The issues of individual country sovereignty are now front and center. Citizens look to local politicians to solve real problems associated with the inherent problems of the European Union, highly inflexible labor markets and concerns sparked by the credit crunch.

And recent news on the employment front isn’t going to make your average protestor very happy: “The 16-country euro zone lost a record 1.22 million jobs in the first quarter of 2009, highlighting the depth of recession and boding ill for any quick turnaround,” Reuters reported.

Increasingly the blame for the economic troubles of individual states, by both citizens and local politicians, is being cast at the edicts flowing from central power wielded in Brussels and the policies of the European Central Bank. Political pressure is growing, as evidenced by the recent European Union elections.

… (3) Harmonize fiscal positions. Despite treaty obligations and plenty of money distributed to the fiscally challenged countries affectionately known as the PIGS (Portugal, Italy, Greece, and Spain), there has never been fiscal harmonization. And in the midst of the very nasty downturn in the business cycle, the fiscal position of the PIGS is deteriorating rapidly and now represents the biggest single threat to the EMU.

“Past experience therefore tends to suggest that asymmetric fiscal problems—often, but not necessarily generated by war—quickly cause monetary unions between politically independent states to dissolve. In the case of present-day Europe, it seems quite possible that the strains caused by unaffordable social security and pension systems could have a similar centrifugal effect: the Hasburg scenario, with welfare substituting for war as the fatal solvent.”

Niall Ferguson, Cash Nexus

Welfare state guarantees coupled with a rising demographic pension nightmare for several key EMU countries is the ticking time bomb to a euro breakup. This is precisely why we are seeing the bickering among member states within the European Central Bank for the first time in history; the fiscally weak states within the EMU, and those with massive exposure to the rising banking crisis (Austria in particular) within the Eurozone are in desperate need of liquidity; they have no other way out.

“The fact remains that history offers few examples of democratically agreed budget adjustments on the scale necessary in certain European between sovereign states disintegrating when the exigencies of national fiscal policy became incompatible with the constraint imposed by a single international currency.”

Niall Ferguson, Cash Nexus

What’s interesting to keep in mind is the fact that the PIGS were given ample opportunity to get their fiscal house in order. As part of the prize for initial entry into the EMU the PIGS were able to issue government bonds, denominated in euro, at about the same interest rate as Germany. Think of that: these fiscal basket-cases borrowing at German rates simply because of the EMU backing. This provided a massive tailwind of liquidity for many countries—part and parcel to the powerful last upswing in the cycle. Designed this way in order to buy time for the PIGS to use these funds to reform, but they didn’t.

The budget of the PIGS is expected to well exceed the 3% of GDP Maastricht Treaty requirement for EMU membership. And now the “emergency wiggle room” provided by the Union will come into play. The current account deficit for these countries is soaring, with Greece leading the charge approaching a whopping 15% of GDP!

… The risks of default are rising. Latvia, a small country in Eastern Europe, but one that was riding high on western bank loans during the boom, is on the edge of devaluing its currency relative to the euro in order to avoid draconian austerity measures and sovereign bankruptcy. Swedish banks were big lenders to Latvia, and this latest news is hitting Swedish banks very hard. This we believe is the canary in the coal mine for many of the Eastern and Central European countries that relied so heavily on western lending that has dried up.

The ECB has made available emergency lending to try to stem this crisis, as they understand the danger and possible domino-effect across the region.
But what the ECB will not be able to contend with is the reality of one of the core EMU countries deciding they want to leave the EMU—and most have handicapped Italy as the first country that may decide to say goodbye.

… We leave you with one last quote and one basic idea for the average investor to utilize as the euro is held to the fire. The quote comes from Criton Zoakos, a man who has an incredible depth and understanding of global macro economics and history, and is a true independent thinker — all characteristics we worship at Black Swan Capital.
He recently wrote:

“The Eurozone will thus continue to drift in ad hoc policy responses, moving from one piecemeal bailout to the next, from one piecemeal tax revenue hike to the next, from one anti-popular austerity measure to the next. Piecemeal ‘death-by-a-thousand-cuts’ is what lies ahead for the Eurozone economy—until drastic political changes topple the decision-making mechanism of the modern European Union and replace it with something else.”

We think that “something else” is inching closer by the day.


Euro – US$ Weekly: