By John Browne
Euro Pacific Capital, Inc.
Wednesday, February 10, 2010
The European experiment with a trans-sovereign currency is facing its first acid test. The flashpoint today is Greece, which looks set to default on its debt barring some outside intervention. While many commentators have been squawking about the immediate crisis as if it were the end of life on Earth, I would like to zoom out and discuss the history and longer-term outlook for the euro and its parent, the European Union.
The launch of the euro was a major milestone in the sixty year process of European federalization. Economic considerations have always led the charge, from a normalization of tariffs to a free-trade area to a customs union. Still, the launch of a pan-European fiat currency and central bank without a unified political apparatus behind it was always considered a risky move.
Since its launch, the euro has outperformed expectations, establishing itself both as the world’s secondary reserve currency and the second most traded currency after the U.S. dollar. Because of this stellar introduction, the euro has been proposed as the new primary reserve currency in place of a devaluing U.S. dollar. However, its unusual foundation presents risks to which most investors are unaccustomed.
In essence, the euro was created as a lever to encourage a complete European political union rather than as a currency representing a call on an already unified economy, as with the U.S. dollar. Jean Monnet, one of the EU’s founding fathers, is reported as saying, “Europe’s nations should be guided towards the super-state without their people understanding what is happening. This can be accomplished by successive steps, each disguised as having an economic purpose but which will inevitably, and irreversibly, lead to federation.”
The currency has largely succeeded in creating the will for a federal Europe among the member states’ political classes; however, the citizens have voted again and again to maintain their countries’ independence since 2005. Thus, the Union was already losing momentum when the latest financial crisis struck.
The combination of tight credit markets and high debt-to-GDP ratios caused bond yields for the EU members collectively known as PIGS (Portugal, Ireland, Greece, and Spain) to fly upward. As a result, Greece is now in acute jeopardy of officially defaulting on its debts. Because a political union was never implemented, Greece cannot be compelled to slash its budget, nor can it assume the Union will prevent its fiscal failure.
This explains why investors are making short-term trades out of the euro and into the dollar. While the Greek deficit-to-revenue ratio is roughly equal to that of California in 2009, the latter functions with an implicit (although untested) guarantee that the U.S. government will step in before they are forced to default. The EU offers no such backing to its member-states. In fact, recent questions have arisen out of Germany, the primus-inter-pares of EU members, concerning the legality of the European Central Bank (ECB) or the European Union ever giving direct aid to the Greek government.
While many assume that either Germany, an ad-hoc group of European states, or the IMF will bail out Greece, such a result would represent a temporary fix rather than a policy precedent. The move would pose more questions than it answers. If Greece were to be thrown a lifeline what would happen if Portugal, and then Spain, were to ask for equal consideration? Will Greece be spared expulsion from the eurozone if it fails to take the austerity measures necessary to restore solvency? If not, what message does that send to Ireland, which chose to slash its budget rather than wait for a bailout?
These problems did not spring from the æther. The architects of the euro, in pursuit of their political agenda, willfully disregarded the historical divide between the Nordic economies, which have practiced low inflation and fiscal discipline, and the Mediterranean, high-debt, easy-money economies. While there were strict economic, monetary, and budgetary criteria for entry into the currency, one can reasonably suspect that enforcement was lax or the numbers were fudged. After all, the southern states’ balance sheets tilted deep into the red soon after acceptance in the Union. Now, however, the ECB prevents them from monetizing the debt.
So, we are witnessing the results of this inherent contradiction.
If the EU becomes the “bailout union,” a free-ride area where entitlement spending in Greece is underwritten by German taxpayers, then the euro will stabilize in the short-term, as investors face reduced uncertainty. However, this will lock the Union on a trajectory to gradual monetary collapse – the path currently being followed by the U.S. dollar.
If Greece is left to face the consequences of its profligacy, then the integrity of the euro will be preserved. The key in this scenario is whether Greece leaves the euro, or the Union, when it defaults. If it does, we could see weaker economies cast out one-by-one until Europe returns to a system of national currencies, with perhaps a rump euro uniting the Nordic block. If Greece defaults but remains in the block, then short-term shock will give way to a renewed confidence in the euro as a lasting reserve currency.
The future of the EU is being tested severely, together with much of the wealth of investors who have diversified into its currency. Likely, this crisis will draw the EU member states into a covert political struggle over the future of Europe. As this battle ebbs and flows, both the euro and the U.S. dollar likely will suffer great volatility. Those of us parked in the safe harbor of gold may benefit greatly from this transatlantic turbulence.
John Browne is the Senior Market Strategist for Euro Pacific Capital, Inc. Reprinted with permission.
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For further reading:
"Things Fall Apart in Eurozone", John Browne, Euro Pacific Capital, Inc., January 12, 2010