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Europe Is Being Held Together With Duct Tape

Posted by commendatori on June 13, 2009

by Justice Litle, Editorial Director, Taipan Publishing Group
June 10, 2009

Among its many other sins, the greenback is a press hog. The world’s reserve currency, loved and loathed as it is, simply gets most of the ink these days.

In that light many a U.S.-based commentator, not least your cynical Taipan Daily scribes, have repeatedly waxed eloquent on the long-run death of the dollar.

But in our zeal we sometimes forget that, in order for the dollar to die, it has to die relative to other fiat currency offerings… and some of those others are looking pretty sick too. (The main exception, of course, being gold – the one and only “stateless currency” not subject to the whims of a printing press. As Grant’s Interest Rate Observer quips, “Show us a monetary asset whose value is not subject to governmental debasement and we will show you a Krugerrand.”)

In short, the dollar is not the only basket case out there. Take the euro, for example. Now there’s a troubled currency if ever one existed.

As pollyanna stock market bulls are finding out the hard way, rising interest rates (via falling bond prices) can have ugly consequences. The same is true of a rising currency when coupled with a weak economic backdrop.

In this particular case, the stronger the euro gets, the more it cuts into European export sales. At a time when most all of Europe is sick, the economic pain of a too-strong currency becomes intense above a certain threshold.

On top of that, various bits of Europe are in the process of blowing up… or falling apart… or both. There is deep trouble brewing in multiple corners of the continent. Let’s take a quick look on a country-by-country basis to see why Europe is being held together with duct tape.

Britain on the Brink

We’ll start with Britain – not an adopter of the euro, but a member of the EU (European Union) nonetheless.

Britain has been hurled into political chaos, thanks to an unholy combo of deep financial crisis, explosive Labour Party scandals, and the hapless lame-duck status of embattled Prime Minister Gordon Brown. Cabinet Ministers are resigning left and right in protest as Brown’s popularity plummets, calling for the PM to step down. Election results tallied this week showed the Labour Party (Brown’s party) putting in its worst showing since 1918.

Philip Stevens, chief political commentator for the Financial Times, sees an ominous chain of events now set in motion. “Everyone thought the [election] results would be bad,” Stephens reports. “But these [results] are calamitous… the Prime Minister was prepared, if you like, for very bad results. He’s now got to grapple with absolutely terrible results.”

If the Brown government fails, Britain will be left rudderless in the midst of the worst fiscal storm in decades. In a worst-case scenario where bad events lead to worse decisions, opines Stephens, the domino chain could even lead to a British exit from the EU.

This outbreak of chaos is awful and unsettling for the British economy – and by extension awful and unsettling for Europe. As of this writing, it is not yet clear whether Prime Minister Brown can survive a political coup… or even whether he would be better off resigning, Dick Nixon style, in the interest of sparing greater turmoil.

Latvian Pressure Cooker

Elsewhere in Europe, Latvia, a tiny country of 2.2 million, threatens to unleash havoc on the entire continent.

Latvia’s currency, appropriately known as the lat, is officially pegged to the euro. Latvia set up the currency peg to speed up official entry into the EU. But now the fiscal discipline of maintaining the peg is crushing the Latvian economy.

At one time, Latvia was an Eastern European tiger, growing by leaps and bounds. But, like many other countries, Latvia found itself badly caught out by the financial crisis. Just when credit lines were needed the most to shore up a cratering home front, Latvia found it suddenly impossible to borrow. Credit was desperately needed. An attempt to issue $100 million worth of lat-denominated bonds resulted in no takers.

Normally, a small country with an imploding economy would simply devalue the currency to make exports more competitive. But if Latvia devalues now, all kinds of ugly fallout will follow.

For one, the Swedish and Austrian banks that lent heavily to Latvia would take huge, destabilizing losses. Worse, other Eastern European neighbors, like Lithuania and Estonia (and Bulgaria farther south), would see their own currency pegs threatened.

And even worse still, a wholesale lat devaluation would crush many Latvian businesses (due to loads of foreign currency-denominated debt on the books) and kill Latvia’s shot at eventual EU acceptance.

So, with the help of emergency financing from the IMF and European Union, Latvia has vowed to keep on keeping on. The currency peg will not go undefended. But in order to maintain that peg in the face of economic hardship, Latvia will need to cut wages and spending to the bone. This, too, is dire medicine for a small country struggling under the weight of great debt.

Some believe Latvia will be forced to devalue, in spite of all the pain it would cause for both the tiny country itself and many surrounding neighbors. The pressure might just prove too great, as the pressure was too great in 1992 when Britain was forced to devalue the pound and drop out of the European Exchange Rate Mechanism (ERM).

In a way, Latvia is damned if it does and damned if it doesn’t. Some argue that the peg must be defended at all costs, lest the whole of Eastern Europe be lost. If Lithuania and Estonia are sucked into a currency pain vortex, the EU could lose its political hold on the region – and Russia could rush in to fill the torment-filled vacuum.

It would be so much easier (and simpler) if the value of the euro were to fall from current high levels. This would ease Latvia’s pain, as well as a number of other struggling countries. But there is a huge and intractable obstacle there – Germany.

Germany in a World of Its Own

As the global financial crisis has unfolded, Angela Merkel, the Chancellor of Germany, has been looked on with increasing amounts of admiration and horror, depending on the observer’s vantage point.

Those who admire Merkel do so because Germany has appeared to completely go its own way in the midst of turmoil. As other countries have stimulated and relaxed and eased to fight the fires of slowdown, Germany has said “Nein!” to anything that smacks of lax fiscal policy.

In a speech last week, Chancellor Merkel even went out of her way to slam the Federal Reserve and the Bank of England, stating plainly that “I view with great skepticism the powers of the Fed… and also how, within Europe, the Bank of England has carved out its own line.” Within the subtle context of diplomacy and statecraft, those are amazingly blunt words. Merkel has all but called the stimulators a bunch of out-of-control fools.

Many admire Germany’s fiscal backbone. But others are horrified, and terrified, by Germany’s lack of willingness to show any type of bend or flex in monetary policy.

Remember the Latvia problem? Many other rapidly imploding European economies, like those of Ireland and Spain, are also struggling with the weight of a too-strong euro hurting export prospects. But in its zeal for fiscal responsibility, Germany will probably remain steadfast in its opposition to any loosening of the purse strings.

The stance is cultural and historical. Having lived through the horror of hyperinflation in the Weimar Republic in the 1920s, Germany emerged from its baptism by fire as a zealous hard-money advocate. Rigid fiscal discipline has been a political rallying cry in Germany ever since. So when Chancellor Merkel takes an especially hard line against the easy-money inflationists, she is doing so with an eye for public approval ratings at home.

The trouble is, even Germany can barely afford its own righteousness. The German economy still depends heavily on exports… and so an overly strong euro hurts Deutschland too.

The Rise of the Far Right

Last but not least, a surprising new trend has arisen from the EU-wide elections held in the past few days.

“Conservatives raced toward victory in some of Europe’s largest economies Sunday,” the Associated Press reports, “as initial results and exit polls showed voters punishing left-leaning parties in European parliament elections in France, Germany and elsewhere.”

The rise includes not just the right, but the far right. In Britain, the British National Party – an openly racist party that only admits whites – gained a seat for the first time. In various other countries, openly nationalist parties gained fresh power either for the first time also, or for the first time in quite a long while.

“It is not clear why a chunk of the blue-collar working base has swung almost overnight from Left to Right,” says Ambrose Pritchard of the U.K. Telegraph. “But clearly we are seeing the delayed detonation of two political time-bombs: rising unemployment and the growth of immigrant enclaves that resist assimilation.”

A Poisonous Stew

There are still other problems in Europe we haven’t really touched on, like the Spanish real estate markets headed for freefall, the dire state of the Irish economy (joke du jour on the Emerald Isle: What’s the difference between Ireland and Iceland? The letter ‘C’) and the toxic leverage still lurking in European banks.

Put all this together, and what you get is a truly poisonous stew. Half of Europe is still committed to fiscal stimulus and economic coordination… while the other half has swung inward and hard right, towards a nationalist and isolationist stance, at a time when exports are weak and the whole continent is in trouble.

If Pritchard is right in his gloomy assessments, we could be witnessing a scenario where steely fiscal discipline, though a virtue early on, becomes a terrible vice this late in the game. “The irony is that those fretting loudest about inflation may themselves tip us into outright deflation, with all the perils of a debt compound trap,” Pritchard opines. “It is Angela Merkel who plays with fire.”

By now the trading takeaway should be fairly obvious. The dollar is not the only paper currency with crash and burn potential. The euro could make for one hell of a great short when the time is right. Whether that time comes sooner or later depends on how events unfold… and how quickly the threat of deflationary vice grip leads to inflationary panic (as ultimately occurs in all unsound paper regimes, when the desperate hope of the printing press is embraced as last resort). Macro Trader will be watching the charts with keen interest.

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