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The Consequences of a Eurozone Breakup

A perfect storm is brewing
Wednesday, July 18, 2012, 1:17 AM
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Executive Summary

  • European banks have shifted their priority from supporting national governments to combating captial flight
  • Hollande's policies are accelerating France's path to insolvency, thus advancing the date of the Eurozone collapse
  • The euro can fall MUCH farther from here
  • We are currently at a stalemate being forced by Germany, but it will soon end and downward momentum will quickly build

If you have not yet read Part I, available free to all readers, please click here to read it first.

In Part I, we examined the economic pressures likely to blow the Eurozone apart and concluded that there is increasing disquiet in Germany over the cost of supporting stricken economies and her increasing reluctance to write open-ended cheques. The first creditor country to leave will probably be Finland, or perhaps one of the other smaller members less committed to the Eurozone project. Let's now explore how this might come about, along with the consequences for the rest of the world.

Sovereign Debt Markets

It is obviously not possible to anticipate tomorrow’s events with any certainly, but we can lay down some pointers, the most obvious of which is changing yield levels in sovereign debt markets. Let's focus on Spain because she currently causes the most concern.

Before mid-November last year, Spain’s ten-year bond yield had run up to 6.58%, up from the 4% level that prevailed before her debt crisis became an issue (see chart below). At end-November, the yield fell in anticipation of the ECB’s first long-term refinancing operation (LTRO), because Eurozone banks used some of the money to arbitrage between Spanish bond yields and the considerably lower cost of funding from the ECB. This way of making money is encouraged by Basel 3 rules, which define short-term sovereign debt as being the highest quality, so no haircut is applied. This regulatory quirk has been conspiratorially used by the ECB, commercial banks, and governments themselves to ignore fundamental lending realities...

 

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Executive Summary

  • European banks have shifted their priority from supporting national governments to combating capital flight
  • Hollande's policies are accelerating France's path to insolvency, thus advancing the date of the Eurozone collapse
  • The euro can fall MUCH farther from here
  • We are currently at a stalemate being forced by Germany, but it will soon end and downward momentum will quickly build

If you have not yet read Part I, available free to all readers, please click here to read it first.

In Part I, we examined the economic pressures likely to blow the Eurozone apart and concluded that there is increasing disquiet in Germany over the cost of supporting stricken economies and her increasing reluctance to write open-ended cheques. The first creditor country to leave will probably be Finland, or perhaps one of the other smaller members less committed to the Eurozone project. Let's now explore how this might come about, along with the consequences for the rest of the world.

Sovereign Debt Markets

It is obviously not possible to anticipate tomorrow’s events with any certainly, but we can lay down some pointers, the most obvious of which is changing yield levels in sovereign debt markets. Let's focus on Spain because she currently causes the most concern.

Before mid-November last year, Spain’s ten-year bond yield had run up to 6.58%, up from the 4% level that prevailed before her debt crisis became an issue (see chart below). At end-November, the yield fell in anticipation of the ECB’s first long-term refinancing operation (LTRO), because Eurozone banks used some of the money to arbitrage between Spanish bond yields and the considerably lower cost of funding from the ECB. This way of making money is encouraged by Basel 3 rules, which define short-term sovereign debt as being the highest quality, so no haircut is applied. This regulatory quirk has been conspiratorially used by the ECB, commercial banks, and governments themselves to ignore fundamental lending realities.

From the first LTRO, Span's banks took up €105bn, Italy’s €110bn, France’s €70bn, Greece’s €60bn, and Ireland’s €50bn. Much of this money was required for the banks’ own liquidity and to cover deposit withdrawals and loan losses, but there is no doubt that significant amounts of this LTRO money went into government bonds.

Since the first LTRO round, the only significant buyers of these sovereign bonds have been Eurozone banks and captive investors such as local pension funds and locally-regulated insurers. The first LTRO for €490bn was followed by a second LTRO in February, adding another €530bn. However, this second round was not invested in sovereign debt to the same extent, and Spain’s cost of funding rose from a low of 5% on February 29th to current levels of about 7%.

The lesson here is that banks’ priorities have now shifted in the crisis economies, from supporting national governments in their borrowing programmes to meeting customer withdrawals. And this is confirmed by the rapid escalation of capital flight, reflected in the TARGET 2 credits accumulating mostly at the Bundesbank and at Banque Centrale du Luxembourg, and which for Germany alone have increased by some €300bn since the second LTRO.

There was hope that the ECB would consider a third LTRO, but if it does so, it will be only to bail out banks suffering from capital flight, because the opportunity to provide sufficient funds for banks to arbitrage between sovereign debt yields and LTRO borrowing costs has now passed. It has become obvious that much of the sovereign debt posted as collateral at the ECB is of dubious quality, despite what the regulations say. And the ECB is the most highly geared central bank you can imagine on the back of this debt.

The zombie states excluded from the bond markets, without collateral capable of being posted at the ECB and having lost the support of Germany, are Greece, Cyprus (which historically is tied to Greece), and Portugal. Greece faces paralysis on all fronts: Public servants have not been paid and in many cases are refusing to work, leaving professionals, such as doctors in the health service, only working through a sense of duty. Attempts to collect taxes through utility bills have led to their non-payment, and very little tax has actually been collected. There is no way Greece can comply with her austerity commitments. Portugal has less of a problem on the surface, but perhaps most worrying is that the young are leaving in droves for Brazil and former Portuguese colonies, where there is a future for them and they are welcomed. The abandonment of Portugal by her young condemns the state to a future with a diminishing tax base and escalating retirement and health costs. Her society is slowly but surely being destroyed.

When the state, through its actions, destroys society itself, there is little to hope for. The ranks of the zombie states are swelling, with Spain and Italy treading the same path to eventual social collapse.

The help the ECB can actually give these sovereign debtors is coming to an end, with further help likely to undermine the currency itself (more on this below). The alternative solution for these zombies, of destroying savings by subordination of state pensions and insurance funds, will rapidly become exhausted if they haven’t already. Bond yields for troubled states, now including Spain and Italy, can be expected to rise rapidly from here on.

France Is a Game-Changer

The election of a socialist president in May has far-reaching implications for both France and for the balance of power in the Eurozone. Hollande’s election was a populist rebellion against economic reality, and he has rapidly sought to satisfy public opinion, totally ignoring the economic cost. By reducing the retirement age by two years, introducing punitive taxes on the rich, and making it more costly to employ people, he has destroyed future government finances. Officially he expects that tax rises on the rich plus economic recovery will reduce the deficit to 3% by next year, though whether he really believes this is not clear. This is the stuff of Keynesian dreams applied to a failing economy; the reality is that the deficit will simply accelerate as a result of his actions. Industrial production, having been stagnant since the introduction of the euro, suffered badly in the wake of the banking crisis and is showing signs of turning down again.

France’s difficulties differ from those of the other problem states. State control has meant that the private sector’s credit boom and subsequent contraction has been generally modest. Her problems are more about economic distortion and malinvestments by a central-planning state, akin to those of Eastern Europe before it embraced greater economic freedom. By taking France backwards into greater socialism, Hollande has brought forward the day when France’s problems will be reflected initially in her government bond yields, and then in France’s own bankruptcy.

Eurozone-wide politics have also been fundamentally changed with his election. Previously there was Sarkozy for France and Berlusconi for Italy, who at least could pretend to work with Merkel towards a common objective. Berlusconi has been replaced by a place-man and Sarkozy by a throw-back French socialist. French socialism is introspective at a time when community spirit is called for. Cooperation is now replaced by confrontation, and unless that changes, the break-up of the Eurozone system has also been brought forward.

The Euro

What happens to the euro has the potential to have a seismic effect on the Eurozone and to be the biggest wild-card. To understand why requires some discussion about price theory.

The euro, like any other fiat currency, is at risk of losing some or even all of its value simply because its only value is vested in a vague multi-government promise. The concept of the quantity theory of money does not apply, and it is only the erroneous but general acceptance of this theory that prevents any paper currency, whose government guarantee becomes questionable, from collapsing towards its intrinsic value. Both modern economists and market participants assume a link between the general level of prices and the quantity of money in issue. This is true of commodity money, such as gold, because both gold and the goods it is exchanged for have value in all communities. If one community changes its use-value, goods and gold will flow between communities to absorb any differences. Put another way, when gold was used as money, you could use it to pay for goods in both Japan and Spain, but you cannot use euros in Japan or yen in Spain. The promised value in the euro is only accepted by those who habitually use it.

It is therefore conceivable for the euro to lose all its value without an increase in the quantity in circulation, and this explains why there is often no correlation between changes in the quantity of money and changes in prices in modern fiat-money systems. The mistake that modern economists and market participants make is to believe that theories of supply and demand are valid for a currency entirely valued on faith. It is true that an increase in the quantity of money in circulation might lead to an increase in prices, but equally, it might not.

In any transaction for goods and services, the price paid is subjective. That is, the decision is the consumer’s choice. In making the decision to exchange money for goods, the consumer normally assumes that there is no change in the value of money itself, the change being entirely in the goods, so its value is objective. The valuation of a fiat currency is therefore based on both the experience of what it bought yesterday and an implicit acceptance of the issuer’s promise. But in the case of the euro, the issuer is a central bank acting as agent for no specific government. This fact will become more pertinent in the foreign exchange markets as the cohesion of the Eurozone unglues.

So far, the EUR/USD rate has declined about 24% from the time of the banking crisis (see the chart below), when governments everywhere committed themselves to stand behind their banks. The euro’s peak coincided with the end of the global credit expansion, suggesting that the fundamentals behind the credit bubble were also driving the euro. This is logical, since at a time of excessive credit expansion, the US dollar can be expected to be weak.

The subsequent reaction is little more than a return to normalcy, with solid support on the chart at the 1.2000 level. If this level is breached, the euro has the potential to fall substantially, because the euro has hardly begun to discount the possibility of a Eurozone break-up, and the underlying confidence in its currency has not yet been questioned.

The effect on the euro of a government guarantor leaving the Eurozone -- a growing possibility -- is therefore generally unexpected and not discounted. We are travelling in hope without considering the consequences of our arrival. If the euro weakens substantially in the foreign exchange markets and the “full faith and credit” of the Eurozone governments behind the ECB is questioned, domestic users may no longer assume an objective value for the currency in their day-to-day transactions and increasingly seek to dump it in return for goods. That is hyperinflation.

Already, it is obvious that the future withdrawal of Germany from the Eurozone is becoming impossible without undermining the currency. It is a paradox, perhaps, that many observers within the Eurozone believe Germany’s exit to be possible, yet they have not thought through the potential consequences beyond a vague understanding that a replacement mark would rise somewhat against the euro. Politics dictate that Germany cannot walk away and set up a new deutsche mark because she would not want to become the focus for everyone’s blame, suggesting that this will not happen. If that thought is comforting, it ignores the possibility that another government such as Finland is less constrained when it comes to protecting the rights of her own citizens.

When the euro starts sliding, the ECB will be defenseless. The traditional response to a currency that weakens unexpectedly is to increase interest rates, but that will merely intensify the debt crisis. Other central banks may try to lend support, but that can only work for a short time. Whatever is tried cannot replace a loss of confidence in a currency supported only by the fallacy of a central bank’s promise without the committed support of any single government.

Conclusion

There are a number of factors intensifying the Eurozone crisis, which can be summarised as follows:

  • The lack of any resolution of the difficulties facing Greece, Portugal, and Spain means that tax receipts are falling below expectations, bills are being left unpaid, and welfare commitments are escalating. The young, who always represent the future of any society, are leaving when they can, turning these countries into zombie states. Other countries, such as Italy, Ireland, Cyprus, and Belgium are in acute danger of becoming zombies themselves.
  • The bail-out mechanisms do not actually exist. 41% of the proposed subscriptions are from countries in difficulty themselves, and the others are increasingly reluctant to come up with the money.
  • France has rejected financial restraint in favour of socialist policies that will intensify her own problems, bring forward her own crisis, and replace any consensus with her Eurozone partners with ideological conflict. This has increased the likelihood that other members such as Finland, who is already dragging her heels, will abandon the Eurozone project.
  • The euro itself, whose currency-value depends solely on confidence that its issuer, the ECB, is fully backed by the promises of all the Eurozone governments, is at a growing risk of collapse. The difference between a currency that has a definite, single government commitment behind it, and the weaker case of a currency that depends on a number of unreliable governments has not yet been thought through. When it is, which is bound to happen as the crisis progresses, the loss of value can be expected to be dramatic.

For the moment there is a stalemate, with Germany seeking to protect her interests by proposing new controls that will take time to implement. There is too little time for this, and the factors listed above will begin to feed upon each other. Countries are becoming the walking dead, bad political consensus is being replaced by confrontation, and the contradictions behind the euro itself will become increasingly obvious. If ever there was an example of a perfect storm brewing, this is it.

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