Thursday, May 6, 2010

Why Decisive Action is Needed to Save the Euro

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

This morning, the euro has traded as low as 126.55 to the dollar. The currency has extremely strong support around the 125 level, so some bounce up from there should be expected. While some short-term relief is likely, in the longer term the survival of the euro is threatened until some significant changes are made in how the currency union is managed.

The current problems in Greece have exposed the flaws behind the euro. The currency was created with a set of rules that were meant to insure stability, but the eurozone seems incapable of enforcing its own standards. Because of this, the euro is losing credibility in the world markets. At this point, the EU has only two choices if it wants to regain an image of responsibility for its currency. It can either enforce its maximum 3% budget deficit to GDP limit or change the limit to something that can be accomplished and make sure all member countries stick to it. The Credit Crisis has made the first choice impossible, but the EU has yet to try to deal with this realistically. The second choice, while it would tend to lower the value of the euro, would allow it to keep functioning as a viable currency.

So far, the EU has chosen neither of these alternatives. Instead it has decided to take the bailout route. This is only a stopgap measure to deal with the problem and is not a workable solution in the long-term. It can be done for Greece, although it will be expensive, because Greece represents only 2% of the EU economy. It also could be implemented for Portugal and maybe even Ireland. At that point though the amount of bailout money being spent would be tremendous and would certainly create an inflationary strain on the entire eurozone. As the situation in Greece has shown, the cost of an actual bailout will be much larger than initial estimates. The funds for a proposed Greek bailout have already almost tripled from the first proposal and they will ultimately be much higher. The bailout solution has its limits though. Spain will be the breaking point. Italy is not even possible.

A good question is: Why are bailouts even being considered? Dollarization could easily have solved the problem - let Greece continue to use the euro, but remove it from the currency union (Greece would almost certainly have defaulted on its debt already if this had been done early on). The answer of course lies in who is really being bailed out. French and German banks together have funded the majority of external Greek government debt. They also have a decent chunk of Portuguese government debt. Just as was the case with the subprime crisis in the United States, the big banks are the ones being bailed out. Most large European banks were already bailed out is some way, shape, or form then as well. This would represent a second series of bailouts for them.

At some point, the EU has to make some tough decisions. This is something that governments throughout the world seem incapable of doing these days. Up to now, the governing body in Brussels has reacted like a deer caught in the headlights - frozen and incapable of action. Greece not only violated the EU's debt to GDP limits by a factor of four, but also lied to the EU about its numbers for many years. Instead of being punished for these serious infractions and being thrown out of the currency union, the EU and IMF have decided the best course is to reward Greece for its bad behavior with a bailout. The EU is sending the markets a clear message that their supposed standards behind the euro are meaningless. The market, not surprisingly, has sold down the euro in response.

As I said repeatedly during the Credit Crisis, there is no such thing as a single bailout. This will certainly be the case in the eurozone. If the EU wants to save its currency, it will have to take decisive action at some point. If it won't do so now, it will have to do so once it becomes obvious to them that the bailout approach is just too costly. Unfortunately for the rest of us, this can have a serious negative impact on world markets at any point in time. The Nikkei in Japan was down 3.3% last night and China's Shanghai composite was down 4.1% and they are not anywhere near Europe.

Disclosure: No position in euros.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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