Sunday, January 18, 2009

The Crisis of the Euro

Ambrose Evans-Pritchard writes in the Daily Telegraph, "Monetary Union Has Left Half of Europe Trapped In Depression"

Events are moving fast in Europe. The worst riots since the fall of Communism have swept the Baltics and the south Balkans. An incipient crisis is taking shape in the Club Med bond markets. S&P has cut Greek debt to near junk. Spanish, Portuguese, and Irish bonds are on negative watch.

Dublin has nationalised Anglo Irish Bank with its half-built folly on North Wall Quay and €73bn (£65bn) of liabilities, moving a step nearer the line where markets probe the solvency of the Irish state.

A great ring of EU states stretching from Eastern Europe down across Mare Nostrum to the Celtic fringe are either in a 1930s depression already or soon will be. Greece's social fabric is unravelling before the pain begins, which bodes ill.

Evans-Pritchard is one of the few mainstream writers who manages to get things right on occasion. With this article he is bang on. The euro is in disastrous shape. Back to the article:

This week, Riga's cobbled streets became a war zone. Protesters armed with blocks of ice smashed up Latvia's finance ministry. Hundreds tried to force their way into the legislature, enraged by austerity cuts.
"Trust in the state's authority and officials has fallen catastrophically," said President Valdis Zatlers,
who called for the dissolution of parliament.

In Lithuania, riot police fired rubber-bullets on a trade union march. Dogs chased stragglers into the Vilnia river. A demonstration outside Bulgaria's parliament in Sofia turned violent on Wednesday.

While American news has been transfixed on Barack Obama's coming inauguration and spends countless hours on pundit roundtables debating how long his "honeymoon" will last, the real world is still turning. Nearly every night on German television I see the riot footage. It is not just a few benign rabble-rousers. These riots are displays of society-wide malcontent with the results of the worldwide depression. Many of these countries were goaded into joining the EU with promises of greater economic stability. All they got was an enormous influx of foreign capital causing huge asset inflation - which has now subsequently fled and is leaving a path of destruction in it's wake. The Latvians, Greeks, Bulgarians, Irish and many others are now finding that they are worse off than they were before the EU, yet their own governments are toothless to do anything because of the many international treaties they signed.

The European Union itself is a representation of positive social mood. Now that many of the other symptoms of that high social mood are coming undone (rising prices, low unemployment, rapid growth) the logical conclusion is for the EU and by extension the Euro to come under increasing attack as well.

These three states are all members of the Exchange Rate Mechanism (ERM2), the euro's pre-detention cell. They must join. It is written into their EU contracts.

The result of subjecting ex-Soviet catch-up economies to the monetary regime of the leaden West has been massive overheating. Latvia's current account deficit hit 26pc of GDP. Riga property prices surpassed Berlin.

The inevitable bust is proving epic. Latvia's property group Balsts says Riga flat prices have fallen 56pc since mid-2007. The economy contracted 18pc annualised over the last six months.

Leaked documents reveal – despite a blizzard of lies by EU and Latvian officials – that the International Monetary Fund called for devaluation as part of a €7.5bn joint rescue for Latvia. Such adjustments are crucial in IMF deals. They allow countries to claw their way back to health without suffering perma-slump.

This was blocked by Brussels – purportedly because mortgage debt in euros and Swiss francs precluded that option. IMF documents dispute this. A society is being sacrificed on the altar of the EMU project.

Nobody thought to question these contradictions on the way up. Just as nobody really thought to question the trillions worth of promises made to the newly retired and the elderly in the form of Social Security and Medical Insurance. All of the economic "models" made by Harvard graduates suggested that everything would be just fine. All they needed to do was take the last 10 or 20 years of data and extrapolate that over the future. Presto! You're all going to be rich!

Oh. What's that? The models were filled with faulty assumptions? That can't be right. My Harvard PhD advisor says it's okay to make assumptions. He's wrong? Uh oh.

Many of Europe's economies and most of the world's financial system has been having an "uh oh" moment for the last year. As a result, small countries (ones we've been schooled to believe only exist in geography class) are erupting into anger and chaos.

Yet somehow, there is still a vast consensus that President Obama will fix everything. That some policy change in Washington will all of a sudden cause Europeans to start speculating on condos in Riga again. That MBS will be repackaged with new derivatives and home prices will bounce back. Does anyone else see how this common logic is absolutely insane? At least try to tell me that some science experiment will change the world. Or we'll find a miracle drug. Don't try to tell me we'll just go back to making the same stupid mistakes. More from the article:

Italy's treasury awaits each bond auction with dread, wondering if can offload €200bn of debt this year. Spreads reached a fresh post-EMU high of 149 last week. The debt compound noose is tightening around Rome's throat. Italian journalists have begun to talk of Europe's "Tequila Crisis" – a new twist.

They mean that capital flight from Club Med could set off an unstoppable process.

Mexico's Tequila drama in 1994 was triggered by a combination of the Chiapas uprising, a current account haemorrhage, and bond jitters. The dollar-peso peg snapped when elites began moving money to US banks. The game was up within days.

Fixed exchange systems – and EMU is just a glorified version – rupture suddenly. Things can seem eerily calm for a long time. Politicians swear by the parity. Remember John Major's "soft-option" defiance days before the ERM blew apart in 1992? Or Philip Snowden's defence of sterling before a Royal Navy mutiny forced Britain off the Gold Standard in 1931.

Don't expect tremors before an earthquake – and there is no fault line of greater historic violence than the crunching plates where Latin Europe meets Teutonia.

Greece no longer dares sell long bonds to fund its debt. It sold €2.5bn last week at short rates, mostly 3-months and 6-months. This is a dangerous game. It stores up "roll-over risk" for later in the year. Hedge funds are circling.
Traders suspect that investors are dumping their Club Med and Irish debt immediately on the European Central Bank in "repo" actions.

In other words, the ECB is already providing a stealth bail-out for Europe's governments – though secrecy veils all.
An EU debt union is being created, in breach of EU law. Liabilities are being shifted quietly on to German taxpayers. What happens when Germany's hard-working citizens find out?

Indeed. The German people are not stupid. They know they were being swindled by the south. But as long as unemployment kept falling, nobody had any reason to speak out. As I pointed out in Manufacturing Weakness Spreads to Germany, that is no longer the case. People are being thrown out of work here too.

Germany has a general election later on this year. I fully expect that at some point, the issue of Germany's ties with the rest of Europe will become front and centre. The euro cannot survive without Germany's support.

Those betting on the imminent collapse of the US Dollar are missing the boat entirely. The euro is the real problem child. And when it falls, US Dollars rise. Paper money is still the medium of exchange, and as long as it is mandated so by law, demand for that medium will continue. Conventional wisdom has it that the US Dollar is on the verge of an inflationary nightmare due to the exploding Fed balance sheet. Conventional wisdom is not generally correct.


Think Big said...

Great read. I often thought, if as a country you cannot control your own immigration policy and you cannot control your own monetary policy do you have a country? You are right everything goes swimmingly when times are good but in times of crisis the Eurozone will not be able to last. Too many fault lines. Maybe we should sell Euro's short? Make some real money.

DAVID said...

Great article!
So what do you think of Peter Schiff's theory .... which seems to be opposite to yours?

Matt Stiles said...

Most of my income and savings are in US Dollars, and my expenses are in Euros. So in effect, I am short Euros.

Peter Schiff is someone I respect a lot - we both consider ourselves Austrians. However, his view on the US Dollar is biased in my opinion based on political motives. He is focusing on the massive increase in the Fed Balance sheet and the growth in the budget deficit - which to me amount to a drop in the bucket compared to the wealth that has been destroyed in global equity, real estate, bond and derivative markets.

He'll eventually get his dollar collapse. But it might be years or decades before that happens.

"The market can stay irrational longer than you can stay solvent."

The structural, demographic and social ingredients are in place for deflation to rule the day. The only thing I see potentially changing that would be American participation in a major world war.

Let's hope it doesn't come to that.

RRB said...

Great blog, Matt - I check it out daily.
Question: Why wouldn't the government/ Fed simply keep printing dollars until the deflationary spiral is stopped? i.e. Why wouldn't the government keep bailing out debtors by exchanging their debt for equity and keeping asset prices either inflated, or substantially owned by the govt?
In other words, is a deflationary environment simply carte blanche for the a money-printing government to become a monopsony buyer who gets great deals?

Matt Stiles said...

RRB: I don't believe they can. In order for printed money to have an inflationary effect it needs velocity. Banks don't want to lend because it doesn't make sense. Consumers don't want to borrow for a number of reasons. So it just sits there.

If the Fed had been doing the same thing in 2002 - boom - hyperinflation. But it's not 2002. It's 2009. People's attitude toward debt has changed. Therefore, all of the Fed's efforts do very little. The supply of money+credit contracts as people and business increase their savings.

RRB said...

I understand your point about velocity... but then wouldn't it be logical for the government to pay off the accumulated debt of major corporations etc. with printed dollars?

A reduction in people's debt loads might also change their minds about saving Vs spending? And the government would be in a win-win because in exchange for paying off the debt, they would accumulate equity in those assets, i.e. greater control and power.

I'm not in favor of this outcome, but I can't help wondering why the government wouldn't do this, and use the printing presses to eliminate/ reduce outstanding debt substantially?

Matt Stiles said...


All of that is possible. However:

When the Fed 'prints' money, they are printing debt. So if they are printing in order to pay off debt, it is a net/net. Debt is created, debt is destroyed. It just moves from one pocket to the other.

Same thing occurs when they 'give' money to the big banks and the banks use it to write down the value of their level 2 or 3 assets.

It's also illegal. But that hasn't seemed to stop them thus far...

In essence, what your asking (I think) is: Will the US government nationalize every corporation, every debt or derivative of debt, and essentially render private property a thing of the past?

I wouldn't put it past them. But no, I don't think they'd get away with that or anything close to that.

mannfm11 said...

They don't print money in the sense of merely printing money, which is why all the inflation/hyperinflation nonsense doesn't work. I agree with Matt that we are going to face the collapse of the dollar, but it will be at the end of the collapse of everything else. Deflation arises because you can't defeat the compound interest problem that deprives the debt money system of a mathematical solution. Paper money has to be secured by something so it has value at all and cannot be merely printed and dropped from helicopters. I sense the next really bad crisis in the dollar could in fact threaten its value in the sense that the Fed may have bought more crappy assets than it can swallow and need a bailout. When they had the $700 billion bailout bill, I got a sense from the way Bernanke was acting as if he had in fact bankrupted the Fed. The Euro mess is a big one because the next game that creates depressions out of bad recessions is some kind of international monetary fallout, as I have learned from different posts I have been linked to over the past months. I am thrilled to find this site. Keep up the good work.

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