Author : John E. Charalambakis
Date : January 11, 2015
The Euro – the epitome of what is known as a dysfunctional currency- is shaking. It seems that the Fed no longer needs to support it at those irrational levels, given that the price of oil has dropped so dramatically. Given the tremors of the EU debt crisis between 2010-’13, the shaky EU banks, and the high oil prices, the Fed had no other option but to support the Euro through swap agreements. Now that the EU claims that its banking union is the panacea of its shaky banking system (which remains full of non-performing loans and questionable assets), while it proclaims that a firewall has been in place to protect her from financial earthquakes (such as a Greek turmoil) and the price of oil has declined dramatically, the Euro is destined to find its real trajectory.
Over the course of the last six months the Euro has lost about 15% of its value against the USD, as the graph below shows. Three explanations have been provided for that, namely: the anticipation that the ECB will start new dosages of quantitative easing; the stagnation in the EU, and recently the fears that the Greek elections on January 25th could produce an unfriendly government to the austerity programs imposed by the EU, the ECB, and the IMF (troika), which may force Greece to leave the Eurozone.
For those not following the details, here is in a nutshell how the latter can take place: The new government in Greece demands from the troika a renegotiation of the terms and conditions of the bailout package along with debt forgiveness. The troika refuses to do that, and the Greek government in turn refuses to continue with the austerity program. Over the course of the last four years, the Greek banks have limited liquidity due to the cash infusions by the ECB. However, the ECB has clearly stated that it will cut off the liquidity to the Greek banks if Greece is not within the parameters of the agreed- upon austerity measures. As the threat of the cutoff surfaces (and especially if it materializes), a run on Greek banks cannot be excluded. Of course, the cash is not there due to the over-lending activity of the banks in the past, which will lead to panic, capital controls, and the invention (which currently does not exist) of a mechanism to push Greece out of the Euro.
We know by now that if it were not for the US to persuade Germany not to do exactly that, the above scenario would have materialized since 2012. Of course, already we have a country that only nominally has the Euro as its currency (Cyprus). However, the reality is that it’s a different Euro given that capital controls still exist in Cyprus close to two years later. If Greece goes through the same route, the internal politics will not allow bail-ins (where depositors’ funds are confiscated to recapitalize the banks) and an exit from the Euro could be designed.
The illusion of the Brussels bureaucrats is that they have created a firewall, and thus in their estimates the potential unfolding events will leave the other Eurozone members untouched. Such thinking is truncated (like the way the convoluted Euro was designed and implemented) and we all know that truncated thinking not only produces biased results, but also dangerous outcomes.
Here are some reasons why such an expedition is dangerous:
First of all, by definition once a member country is out, the whole endeavor becomes reversible, which contradicts the assurances by the ECB and the EU that the Euro is irreversible.
Second, as the new Greek drama unfolds, questions about the fiscal and financial stability in other EU countries will surface. As a result, bond yields will start rising, financing will become more expensive for governments and the private sector, business deals will be jeopardized, while stocks will suffer.
Third, the impact of both of the above will be a further slowdown in the growth rate of the EU (which is already zero), which would lead to a recession and a downturn in business expectations and confidence.
Fourth, as recession hits and confidence declines, the illusion of an ECB reviving growth through monetary manipulations (a.k.a. QE) will become a boomerang because nobody would be willing to borrow in those depressed conditions and at rising debt levels.
Fifth, as business investments decline and the Euro loses ground against other major currencies, capital flights will take place which in turn will deprive the ability to finance various projects.
Sixth, as a consequence of the above, consumer spending will go into reverse, exacerbating deflationary fears and pushing the ECB into another round of ineffective and unorthodox measures whose outcome may be more dangerous than previous rounds.
Seventh, in the midst of these developments, massive government deficits will crown the schizophrenia, which dictates that money spending is the cure of economic ills. Cathartic voices calling for creative destruction by condemning the sclerotic and bureaucratic modus operandi of the EU will be cast into oblivion. Adopting flexible reforms that liberate the productive and dormant forces kept down due to the vested interests that enslave EU’s destination into a lethargic nightmare will be cast aside.
Eighth, as the results of the new unaffordable government deficits and debts are seen as dismal and with a population being on the edge and inpatient, the politics within the EU will become messy. Fanaticism and illiberal voices will lead people astray.
Ninth, even if nothing of what is described above takes place, it is still an illusion to think that the risks of contagion are minimal due to measures taken in the last three years. Once Greece is out of the Eurozone, the loans of the ECB to Greek banks – guaranteed by the Bundesbank – and the overall Target2 program (which runs in the hundreds of billions of Euros), will start unraveling the whole monetary mechanism of the EU.
Tenth, as defaults of Greek bonds held by the public sector (such as other EU countries, the ECB, the IMF) occur, the contagion will spread to other member countries ,which in coordination with the collapsing of the Target2 mechanism, will create a bonfire of illusionary vanities.
Now of course, if a combination of two or three of the above potentialities starts taking place, then a political deal may be cut in the form of a Paris Club agreement for debt forgiveness. Consequently, such a thing will force the hand of other countries to demand the same and will vindicate radical parties which in turn will lead to political instability in the EU.
As new parties become members of governing coalitions, simplistic measures will be adopted that do not address the structural deficiencies of a political system that is embedded with waste, inefficienct modes of production, and corrupt practices. Inability to change will be transformed into a change of inabilities.
My hope is that as I wrote on December 29th, http://stage.blacksummitfg.com/2818, the investors’ parachute will be working when the time comes.
Enjoy the ride!