The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.
European Central Bank (ECB) leader Mario Draghi blew his credibility up in dramatic style over the last couple of weeks by first saying he would forcefully do whatever it takes to preserve the euro on July 26 at the London Global Investment Conference — a very public arena to make such a carte blanche promise. In the ensuing week’s European Central Bank policy meeting after many meetings with different European leaders, he announced, “The ECB may undertake outright open market operations of a size adequate to reach its objective.” This would also include action with the use of the ESFS fund and he repeated, “The Euro is irreversible.”
There are a couple of problems with those statements. One, since when have “may” and “forcefully”, words used in the two statements, been compatible? Two, the ECB and the EU can say how much they want the euro to be irreversible, but they have to serve up the actions that get them out of the corner into which they have backed themselves — a corner where they no longer control the outcome of the euro end game.
The markets control the euro’s destiny. Whether it is next week, next month or five years from now economics will determine the end result. The markets trade off of economic influences — some real, some perceived and some that in retrospect seem predictive. Traders manage their positions against these expectations. That’s how they make money. A decline in credibility as described above puts the ECB in a position of weakness vs. the markets. Another way of putting this is the markets have been given the upper hand by the ECB and they are willing to take on the Central Bank.
After the ECB meeting my immediate question was why the world is waiting for the Europeans to do something definitive and constructive. They only bootstrap solutions that hold a dysfunctional system together and nothing changes, including most importantly, their ability to repay any of the mountains of debt they owe. The markets should just sell the euro through the floor. When it gets to parity we can start talking about how under normal circumstances countries with huge debt problems get themselves out of the hole by purposefully devaluing their own currency. In the case of the euro none of the countries has its own currency; they have a shared currency, which is why they have their current problem. If the market devalues the euro for the ECB because they can’t do it themselves, it would create the same situation as if the euro structure were not in place. European goods would be on a 20 percent fire sale to the rest of the world.
The problem arises if the euro zone countries have to import the commodities they use to make new goods. They would have to import the goods and pay a higher price as commodities are priced in U.S. dollars , although it would probably not be the 20 percent increase caused by the currency devaluation. The action of the devaluation would effectively lower the global commodity prices slightly because the markets would factor in the devaluation’s effect as lower demand brings prices down even though goods are priced in dollars. While the commodity price increase will significantly offset the price advantage created by the devaluation, European goods will still be more competitive as their employment cost and the other domestic costs in the production chain will also be lower.
This is where I put my conspiracy theory hat on and ask whether Mario Draghi made the promise and then came up short as a calculated move to enable the markets to take the euro lower. This strategy would help him and the ECB to get the support of the market and the public for a course of action that would not be officially sanctioned. After all, Draghi is getting nowhere with Germany and the Bundesbank, which, adamantly insist that the ECB should not be allowed to buy the sovereign debt of Italy and Spain. In a newspaper interview ECB Council Member and Head of the Belgium Central Bank Luc Coene said, “It makes no sense for the ECB to start financing the debt of Italy and Spain. It will only lead to the ECB taking the whole of their debt onto the ECB’s balance sheet.”
European exporters would earn more as a result of the devaluation. As production rises they pay higher taxes and the government can begin to get its house in order. The debt would have to be restructured. If a significant percentage was moved out to a much longer maturity than scheduled at the moment, the PIIGs would have more breathing room to pay the debt down.
The Maastricht Treaty was the basis for the foundation of the euro and set out the rules under which the euro was established. One of the most important points being that the sovereign debt of any country was not to exceed more than 2 percent of debt to GDP. Interestingly enough, the writing was on the wall as early as eight years ago when it was revealed that France and Germany — who had regaled Italy for not meeting the debt to GDP ratio — were themselves over the 2 percent level.
There are so many different ways the European story can play out. But there are a few pointers to watch out for as it does. The markets have shown us how they react. On news that is seen as positive for the euro, the reaction is a quick knee jerk move higher for the euro and risk assets, only to be followed by the realization that nothing very much has changed and the move reverses as the focus changes from short term to the longer time horizon.
One of the news bytes to which the market reacted was that the Germans would have a referendum to change in the German constitution that prohibits the use of German funds to bailout other countries. The reality is the German people have never had the opportunity to vote on the euro as directly as this. The markets rallied and soon ran out of steam because if the polls are to be believed it is not very likely the German populous would pass such a measure. Before the August holiday, the German constitutional high court said they would rule on the constitutionality of using German funds to buy bonds of the PIIGs on September 12, using the permanent European Stability Fund (ESM) as the pass-through vehicle. The referendum measure was cited as a possible way for the court to add conditions to its ruling as it is currently scheduled. The measure would take time to be enacted and would allow Germany the flexibility in navigating itself through the negotiation process.
The ECB members cannot seem to agree on the guidelines that should be imposed on countries that need funds. The balance between palatable austerity , fiscal responsibility with an attainable end game seem to be no closer and if the market gets the bit between its teeth and runs out of patience with how long the negotiations are taking. Time is a luxury Europe does not have.
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