The European experiment with a trans-sovereign currency faces its first acid
test. The flashpoint 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 60-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 US dollar. Because of this stellar introduction, the euro
has been proposed as the new primary reserve currency in place of a devaluing
US 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 US 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 (gross domestic
product) 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 US federal government will step in before the
state is 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 International Monetary Fund 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 ether. 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 US 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 US 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 senior market strategist, Euro Pacific Capital. Euro
Pacific Capital commentary and market news is available at
http://www.europac.net. It has a free on-line investment newsletter.
(Copyright 2010 Euro Pacific Capital.)
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