February 9, 2010
Euros

In its short existence, the Euro has achieved its goal of establishing itself as a rival to the dollar.  But many analysts see trouble ahead, with some wondering if it can survive much longer.

Writing for the FT, Peter Garnham, Victor Mallet and David Oakley report that "Traders and hedge funds have bet nearly $8bn (€5.9bn) against the euro, amassing the biggest ever short position in the single currency on fears of a eurozone debt crisis." They explain that "It suggests investors are losing confidence in the single currency’s ability to withstand any contagion from Greece’s budget problems to other European countries" and add, "Amid growing nervousness in financial markets over whether countries including Spain and Portugal can repair their public finances, Madrid on Monday launched a PR offensive to try to assuage investors’ fears."

Simon Johnson, formerly chief economist of the International Monetary Fund and current MIT professor, raised some eyebrows his Sunday posting "Europe Risks Another Global Depression." He predicted the current selloff and warns,

[T]he Europeans are not being careful – and it’s not just about Greece any more.  Worries about government debt and associated public sector liabilities (e.g., because banking systems are in deep trouble) have spread through the eurozone to Spain and Portugal.  Ireland and Italy are next up for hostile reconsideration by the markets, and the UK may not be far behind.

What are the stronger European countries, specifically Germany and France, doing to contain the self-fulfilling fear that weaker eurozone countries may not be able to pay their debt – this panic that pushes up interest rates and makes it harder for beleaguered governments to actually pay? The Europeans with deep-pockets are doing nothing – except insist that all countries under pressure cut their budgets quickly and in ways that are probably politically infeasible.  This kind of precipitate fiscal austerity contributed directly to the onset of the Great Depression in the 1930s.

[...]

The IMF cannot help in any meaningful way.  And the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings.  Unconditional bailouts are simple – just send a check.  Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.

The financial markets know all this and last week sharpened their swords.  As we move into this week, expect more selling pressure across a wide range of European assets.

As this pressure mounts, we’ll see cracks appear also in the private sector.  Significant banks and large hedge funds have been selling insurance against default by European sovereigns.  As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).

BBC business correspondent Joe Lynam picked up on this and got this from Simon:

"Now Greece is an an extreme example - there I think you can see that it's going to get very messy very quickly - but unfortunately the budget situation in these other countries is also weak.  And I have to add the UK to this list. Unless you can persuade the markets that you're really going to bring the budget under control within the foreseeable future and you're going to have some credible actions - and you're going to have to do some persuading - you're going to have big trouble."

And:

"The G7 countries are completely asleep at the wheel. I looked at the information they put out from their meeting I was absolutely shocked," he said.

"They seem to show no awareness at all that much of Europe is facing a serious crisis and it's not limited to Spain, Greece and Portugal, it's also going to include Ireland. I think Italy is also very much in the line of fire. There's a very serious crisis inside the Eurozone."

Guardian assistant editor Michael White agrees that his fellow Brits shouldn't feel too comfortable:

And don't think we can pull up the drawbridge at Dover or close the Channel Tunnel. A eurozone crisis would be very bad for us too. Our debts are a problem and lemming-like speculation on the financial markets is contagious. A fresh pummelling for sterling or a collapse in confidence in the British government's ability to fund its banker-driven debt mountain would be horrible.

While White acknowledges that external factors, including the rise of Pacific economies, play a role, the major problem is the inability of Brussels to intervene with sufficient vigor.

Yes, I know the EU – as it became – interferes in all sorts of silly ways (it gets blamed unfairly for all sorts too), but on things which matter most – war and peace, the plight of the Greeks – it has usually been too weak.

The euro, now under potentially lethal threat because of the looming sovereign debt crisis in Greece, Spain and Portugal, was the main vehicle for rectifying Europe's collective inability to punch its weight.

Had Tony Blair persuaded Gordon Brown to stage that referendum on sterling's entry I would have voted no, though I wished – still wish – the zone well. Not right for us, not quite right for them. Currency unions are the product of political unions, not the other way around.

Hence the agonising in Brussels and Paris, Frankfurt and Berlin, about how best to rescue Greece and its feeble government from the country's folly: overburdened with euro-denominated debt, no domestic savings, poor productivity and an inability to devalue in response to the financial crisis, as Britain has.

Quite the reverse, the euro is over-valued. Sensing weakness and hesitation speculators are betting on a eurozone debt crisis and shorting the currency. We're doing you a favour, they say, to help you make your mind up. They always do. Let's hope they catch a bad cold because Brussels does act decisively. Don't bet on it.

This is echoed by Telegraph international business editor Ambrose Evans-Prtchard.

The EU's refusal to offer Greece anything beyond stern words and a one-month deadline for harsher austerity – while admirable in one sense – is to misjudge how fast confidence is ebbing. Greece's drama has already metastasised into a wider systemic crisis. The world risks a replay of the Lehman collapse if this runs unchecked, this time involving sovereign dominoes.

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The risk is the EMU version of Mexico's Tequila crisis or Asia's crisis in 1998. This Ouzo crisis is coming to a head just as tougher bank rules cause German lenders to restrict loans, and it touches on the most neuralgic issue of our day: that governments themselves are running low. Britain, France, Japan, and the US are all vulnerable. All must retrench. The great "reflation trade" of 2009 is over.

Far from containing the crisis, Europe's response recalls the Lehman/AIG events of 2008 when Brussels sat frozen, and Germany dragged its feet. On that occasion France took charge, in the nick of time.

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There are echoes of early 2009 when East Europe blew up, with contagion hitting global bourses, commodities, and iTraxx credit indices. That episode was halted by the G20 deal to triple the IMF's fire-fighting fund to $750bn. The odd twist today is that Greece cannot turn to the IMF because that offends EMU pride, yet no other help is on offer because the EU has no fiscal authority. Greece lies prostrate between two stools.

Both the City and Brussels seem certain that Europe will conjure a rescue, crossing the Rubicon towards fiscal federalism and a debt union. The emergency aid clause of Article 122 is on everybody's lips. Insiders talk of a "Eurobond".

On balance, such a rescue is likely. Yet leaving aside whether North Europe can afford to guarantee Club Med debt – or whether a bail-out pollutes more countries, as HBOS polluted Lloyds – there is one overwhelming fact missing from the debate: Germany has not endorsed any such rescue.

Jurgen Stark, Germany's champion at the European Central Bank, said markets are "deluding themselves" if they think others will pay to save Greece. He shot down Article 122, saying Athens was responsible for its own mess.

 ECB governing council member Ewald Nowotny,  in an interview with FT's Tracy Alloway, offers little reason for optimism.

The ECB have a clear mandate. [Under the statute of the ECB] we have a clear no-bailout clause. So the ECB as such cannot intervene. Whether there are some intervention from the side of individual countries, let’s say bilateral or some kind of concerted action, this is a political decision. But it’s not, with regards to the ECB. What is of course now in discussion is the question that the ECB for the time being, as part of our crisis prevention programme, we have lowered the quality requirements for collateral. And we have made the decision that this will be in place until the end of the year. Then of course, we’ll have to decide. But we must be very clear; the policy of the ECB is a policy that has to be oriented towards the totality of the euro area and we cannot take into account specific problems of specific countries, or specific banks. So our task is to look at the euro area and the needs of the euro area totality.

Investment consultant Yves Smith, however, thinks action is inevitable:

We do have a factor here that could get the reluctant Europeans, meaning the Germans in particular, to act, namely, that Eurobanks are still wobbly and are not doubt exposed directly and indirectly to a European sovereign debt crisis. There is no way to avoid rescue operations of some sort, it’s merely a matter of picking which poison. Do they want to face the ugly bailout of countries they see as profligate, or wait till it morphs into a crisis and have to put their banks on emergency life support? The problem is the latter is politically more palatable, even though ultimately more destructive, since a lot of collateral damage will occur in the wave that hits the banks.

This is all true, although one fears that action will come too late.  The fundamental problem is one that White touches upon:  The EU remains, fundamentally, a trade and economic zone rather than a political union.   It's exceedingly difficult, then, to get Germans  — already feeling the deprivations of the global recession — to do harm to themselves to help the Greeks and others out of problems of their own making.  They remain the Other, not fellow countrymen.  The only hope is that Smith is correct and they'll see that not helping will eventually cause even more harm.

James Joyner is managing editor of the Atlantic Council.

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