I suggested in last week's article (Dead
Dollar Sketch), that the end of the US
dollar hegemony as the global reserve currency has ended. It is only out of
habit (meaning a complete lack of either competence or imagination or both)
rather than economic rationale that Asian central bankers continue to hold US
dollars and indeed even talk about the currency when describing reserves.
In the same article, I dismissed out of hand the notion that the euro could
possibly replace the US dollar as the world's reserve currency. On second
thoughts though, it is clear to me that a cursory dismissal of the notion may
be misconstrued as an exercise in the authors' prejudiced view of the world.
Quite to the contrary, the idea certainly has been evaluated at some length
across the markets and its adjunct professions with a unanimous
conclusion on the lack of suitable merit
for the candidacy.
It is fair to say that two main sources of objection are the European Central
Bank (ECB) and the political system of Europe. On the former, while the ECB has
been unique in its focus on inflation at the expense of economic stimuli, its
actions belie its words - in effect, it can be proved that the primary source
of inflation that may confront Europe in the next few months is the one created
by the ECB itself. Things are worse on the political front. Be it the tax
pursuits of Germany and Britain, political imbroglio of Spain and Italy or the
circular logic loop of French reforms, there is no reason for hope across the
Old continent.
Trichet's hypocrisy First, look at the ECB. By refusing to cut interest rates in the wake
of substantial decline in both investment and consumption across Europe, ECB
president Jean-Claude Trichet has raised a banner of sorts for a return to the
simple past of inflation targeting that served as the primary purpose of a
central bank.
This course of action has led him to be one of the most unpopular central
bankers in the world, particularly in his own backyard. Not a week goes by when
a French politician of some hue or other doesn't take a potshot at the
venerable president for failing to do enough for the European economy. Much the
same venom is delivered on Trichet from other quarters including Germany and
Italy. Everyone likes an underdog, and all the political attacks make Trichet
the poster-boy of monetary economists, assuming they still have space on their
walls after posters of Alan Greenspan and Ben Bernanke.
This adulation, though understandable, is also completely illogical because the
ECB is the body that has unleashed the very forces of inflation that Europe
will have to confront in coming months. This has been done through the enhanced
liquidity facilities made available for European banks since last summer.
It is no secret across the banking world since the time that the first rumors
of a UK bank being in trouble surfaced that the ECB has been quite generous in
providing cheap liquidity access for banks. Over the course of the last
one-third of 2007, the facilities were expanded to include all kinds of dud
collateral.
When the US Fed last week made an announcement that it would expand its Term
Auction Facility (TAF), the idea was greeted with sardonic smiles across the
boardrooms of European banks. After all, the Fed had only made operational in
March what the ECB had been doing since last summer.
How it operates is quite simple. Banks gather all the collateral on their books
that cannot be sold into the wider market and provide it to the ECB against
which, following some minor valuation adjustments, the central bank provides
immediate liquidity. This has proven quite useful in the current climate of
poor liquidity in various market instruments.
Thus, we have found out that European banks have continued to issue billions of
euros-worth of residential mortgage backed securities (RMBS) that are never
sold to any investor. After securing the rating, the securities, which are
simply paper representing actual mortgages in the books of various banks, are
pledged as collateral to the ECB and liquidity lines are drawn.
In turn, this borrowing from the ECB is used to support the uneconomic overseas
operations of European banks, ie their investments in US subprime collateral,
poorly constructed collateralized debt obligations (CDOs) and the like. By not
being forced to sell such assets, European banks continue to pretend that they
have taken fewer losses than their US counterparts when the truth is the exact
opposite.
German banks are in hot water and have been so since last summer. Indeed, many
industry observers believe that all of the fabled Landesbanks are bankrupt if
they adopted mark-to-market valuation on the US collateral as well as other
problem assets, including European leveraged loans currently on their books.
French banks, in addition to the problems of low-quality collateral being held
by their banking books also have large mutual fund operations where exactly the
same investments are made. And just in case they had too few challenges on the
balance sheet front, their risk management has also shown up as a key weakness
(see
The Rogue and the Pogue,
Asia Times Online, January 26, 2008) in the form of rogue traders. Some risk
managers working in American banks have taken the surreal step of performing
secondary audits on the positions of all their "French" trading desks, ie the
ones where risk is taken by anyone with a Francophone accent.
Italian banks dodged the bullet because their central bankers refused to allow
them to buy CDOs. However Spanish banks have not been as lucky - while they
avoided the headlines concerning structured investment vehicles and the like,
they do have very substantial overexposures to poor-quality mortgages both in
the US and Spain itself - the latter boasted the same type of price boom that
was witnessed in the Hispanic parts of the US such as California.
Thus, European banks were forced neither to sell down the problem assets nor
change their behavior. Many European banks still operate as if there was no
year called 2007, and it has always been business as usual. In this respect,
they are more dangerous than American banks because the latter have realized
their failings and are at least swiftly moving to counter the declines, while
the former are still engaged in the same kind of "bubble inducing" behavior.
That is the reason there will be inflation in Europe. Despite all the evidence
of a global economic slowdown, European companies are still going around
purchasing uneconomic assets and making stupid investments, financed by their
banks. Even with sky-high costs of manufacturing in Europe, instead of trying
to move production offshore the companies are turning to increased investments
at home, in the vain hope of a better tomorrow that will never arrive.
In turn, banks are able to finance these hare-brained schemes because of the
blank check provided by the ECB. It is therefore no surprise to me that Trichet
worries so much about inflation, because he knows himself that it is at the
very liquidity window of the ECB that it is being created to spread like Ebola
across the European economy.
Taxing times With the central bank unable to help provide monetary easing that
could ease their own interest costs this year, European governments are left
confronting the stark math of falling revenues, rising expenses and obdurately
high coupon payments on their burgeoning debt load. In this situation, it is
but natural that some quarters would be tempted to go for politically expedient
targets.
Although it is not part of the euro, the experience of Great Britain may prove
telling for the rest of Europe. Public spending rose for every one of the past
12 years or so, in effect wiping out the fiscal benefits of the sustained
economic boom over the period. At the end of the boom, the UK government has
been left holding various worthless pieces of paper, including most tellingly
its ownership of Northern Rock (see
Rocking the land of Poppins,
Asia Times Online, September 22, 2007).
In order to fight this decline, the government has unveiled sweeping tax
increases on its expatriate population, ie the very people who moved into the
UK over the past few years and ushered in the services-led boom that has helped
to damp down the costs of a sustained manufacturing decline since the Thatcher
reforms of the '80s. The moves are immensely unpopular, which, combined with
the current carnage in financial markets, would mean that thousands of banking
professionals stationed in London and other cities may choose to leave the
country.
Much the same threatens to happen in other jurisdictions such as Germany. The
recent flap over the tax haven of Liechtenstein adds to the ongoing problems
that European governments have with other such areas such as Monaco and the
Isle of Man. Even as the biggest tax haven of all, Switzerland, now cooperates
on such matters with European governments, other locales may be forced to fall
into the European mold of taxation.
This leaves the plutocrats in a quandary. Their business interests are located
across the Old continent, but the math simply doesn't work when they have to
pay short-term taxes on essential long-term investments and strategies. This
means that more of them - such as the Russian oligarchs - will choose to fall
at the feet of the Kremlin and move back to Moscow. Others not of Russian
origin will have to make similar arrangements and most likely away from Europe
to favor other destinations such as Dubai and Singapore. Indeed the latter is
quickly evolving into a 24/5 financial center, attracting all hues of private
banks and hedge funds into its fold. The rest of the market, the so-called
"real money", will not be far away.
The main reason that European governments are preoccupied with taxes is that
structural reform efforts have fallen flat. Reformists such as Angela Merkel
and Nicholas Sarkozy have instead turned to accept gradual steps led by
compromise between the various interest groups. This in turn leaves Europe
without much ability to combat the US slowdown by staging a dramatic recovery
on its own terms.
If the euro were to be acceptable to global central banks as the new reserve
currency, it should bring with it a promise of superior performance against
what is being replaced. The US dollar certainly offered all that and more when
it pushed the pound sterling away in the years following World War II and
certainly by the mid-60s.
In contrast, while the euro has been moving higher against the US dollar, much
of this can be explained by the behavior of its own banks. The financial system
of Europe is broken even more than that of the United States while its
political system chases its own tail. Neither of this can help the case of the
euro. If anything, the opposite is true - anyone buying the euro is doing so
merely to avoid the recent problems of the US economy. When the problems of
Europe come to the fore, the mad rush to the exit will leave the region and its
currency unmasked as the frauds that they are.
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