A Dysfunctional Alliance

Europe is in a very public way taking another step to try and outdo Japan as the most dysfunctional global economy. Lead by Monsieur Jean Claude Trichet, the European Central Bank head, scorned quantitative easing, thinking that their socialized economies were above succumbing to deflation. In my personal opinion, if they had opened the QE spigot a year ago the PIIGS (Portugal, Italy, Ireland, Greece and Spain) would be funded to some extent, partially invisibly to the rest of the world. The current situation indicates a lack of confidence that leads to contagious meltdown the same way the subprime mortgage meltdown caused banking failures. Here we have the sovereign debt version and another credit crunch, this time in Europe that feeds back to us as LIBOR rates rise.

S&P and Moody’s add fuel to the fire by downgrading countries that the markets already knew should have been downgraded. The traders go into a feeding frenzy as they know everyone will jump on board going in the same direction. They can make an easy buck by following the herd of sheep under the shepherdship of the momentum enabled by the said rating agencies.

Let’s get down to the facts and the potential result. The big question is whether the euro will survive followed by who will pay the bill and how much is going to be needed.

Source: Bank for International Settlement
Data as of December 31, 2009

Who Pays the Bills?
The European Package of EUR 750B has 15 countries contributing EUR 440B. The other big piece, EUR 250B, will come from the International Monetary Fund (IMF) and the remaining EUR 60B will come from other European funds already allocated to this debt.

The IMF membership ratios also indicate the percentage the member states will pay to the IMF’s fund of “usable resources” that will be used to bail out Europe. Those percentages are: U.S. 17.1%, Japan 6.1%, Germany 6%, France 4.9%, UK 4.9%, China 3.7%, Italy 3.2%, Saudi Arabia 3.2% and another 178 countries make up the other 50.8%.

With that run down it appears that the amount involved in the interconnected loans almost looks like a Ponzi scheme, but it is what it is and that is what Europe has to deal with. The situation, with the talk of contagion for Spain, Portugal, Italy and Ireland, will cause continued uncertainty for the euro.

Markets do not like uncertainty, especially when it is added to by decisions that lower credibility. One such instance was ECB’s Head Trichet’s 180-degree turn on the Greek bailout, when earlier last week he said the ECB would take all kinds of Greek debt as collateral against the bailout. In the past he had said the ECB would only accept rated debt as collateral. In the ECB meeting statement from last Thursday he did stand by his position on quantitative easing, confirming for now the ECB would not go down the road of the Bank of England and the Federal Reserve buying debt from banks to inject liquidity into the system. Over the weekend Trichet and the ECB did a 180 on this policy, saying they would buy both government and private sector debt. He then explained that this was not quantitative easing! I suppose it’s shark fin soup, their credibility must be just about shot.

Where Does This Leave the Euro?
Fragile at best. Many customers have asked us if the euro could disappear. I would say no; it will continue to exist, but the structure could be very different. One alternative would be to get Greece, Ireland, Italy, Portugal and Spain to leave the euro and go back to using their legacy currencies of the drachma, punt, lire, escudo and peseta respectively. When they entered the euro there was a conversion rate to their currencies. Those currencies could be reestablished using that euro/legacy currency rate and these countries could be re-admitted at some time in the future when they get their houses in order. The other Maastricht Treaty rules on cross border trade and tariffs could be left in place unless after the split it becomes clear to the countries left in the euro that the exited countries are abusing the system, then further action would have to be taken. The point is that a reversal of what was enacted to create the euro can be unwound.

 If these actions were taken, there would be the euro with the primary member states of Germany, France, Belgium, The Netherlands, Luxembourg, Austria and Finland, followed by the other secondary states like Slovakia and Malta, excluding the PIIGS. This gets totally blown apart if one of the core states such as France wanted to withdraw from the euro. One could argue the euro could still survive without a core state, but if we make suppositions that go that far we are into no man’s land, not only for the euro but also for the European Union.

If the split should happen the euro would likely strengthen, but only marginally against the dollar as the core states would still be owed the debt by the PIIGS. The story for the legacy currencies of the PIIGS would be a very different story with devaluation of their currencies likely in varying degrees. This devaluation would make goods sold by the PIIGS more competitive. This, in turn, would help these countries economies pick up, but would then leave these countries with euro debt that has to be paid for with a devalued currency. Their only viable way to  return to the euro zone, would be if they time their repayment for just before they try and reenter. This means there would to have to be a repayment suspension, otherwise crucial timing would not happen. It appears I have just suggested exactly the debt swap that Greece put in place to build this house of cards!

The big concern is that the breakup would mean the end of Europe in its current form financially. I think this is very unlikely. Yes, there would be a temporary disruption of a couple of months before the new system would be in place. The PIIGS could then line up with the other countries that want admittance into the euro and the process would start all over again.

This weekend we saw definitive action. This will help the euro zone for now, making the above scenario less likely.  The dust has not settled yet though. To get these bailout funds a lot of austerity has to be put in place and we saw what happened in Greece last week with the rioting and deaths.

The conversations over what has to be put in place and the appetite of the citizens to digest them are another story.

The response of the euro to the news was for it to rise to 1.3100 from 1.2800 and then fall back to 1.2800, demonstrating the fact that there is still a lot of work to be done. If unrest should ensue, this weekend’s good intensions will be viewed as being too late as the loss of credibility is a lot more difficult to reverse than policy. 


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