Tuesday, 18 May 2010

The breakdown and breakup of Europe

John Mangun
Outside the Box
Business Mirror
http://www.businessmirror.com.ph/index.php?option=com_content&view=article&id=25314:the-breakdown-and-breakup-of-europe&catid=28:opinion&Itemid=64

The conception of the European Union (EU) happened in 1957 with the Treaties of Rome. The birth of the EU came with the formation of what is now known as the ‘Eurozone’ with 16 countries joining completely in a common currency on January 1, 2002. After a gestation period of more than 50 years, we may be witnessing the demise of both the euro and the Eurozone after less of decade of life.

More than $1 trillion is allocated to support the EU economic structure by, in effect, guaranteeing the debt of its economically weakest members, beginning with Greece. Two important conditions were a part of the series of agreements that formed the EU. The first was the member-states had to keep their financial affairs in order. Strict fiscal policy guidelines were established that both the “good” economies and the “bad” economies ignored. The second critical provision was that no member-state would be responsible for the debts of another. Because the first rule was ignored, the second rule had to be broken in trying to save the EU and the euro.

Guarantees of any sort are supposed to give credibility and inspire confidence. The economic ministers of Germany and France along with the US and the International Monetary Fund believed that their guarantee would do the job.

But like all guarantees backing a faulty product, this past week, many holders of the debt obligations of Greece and the other weak economies decided to take advantage of the EU guarantee. They sold their government debt and then immediately sold the euro that they received for these government bonds and went into the US dollar, Japanese yen, and gold.

As a result of this action, the euro went from 1.30 to the dollar to 1.23. The guarantee did not increase confidence because investors are so pessimistic about these economies defaulting on their debt or that the debt might be restructured forcing them to lose principle value.

Despite the $1 trillion being put on the table, no one wants most European government debt and no one wants the euro. There is talk that the euro will drop and trade one-to-one against the dollar. And if that happens, it will be the end of the European Union.

The inflationary effects of a devalued currency are unstoppable in this world where every developed nation is dependant on imports.

The developed world is being closed in on from all sides. It cannot keep its economic growth going without debt and more debt is impossible. It is printing money in massive quantities to give the illusion of economic growth but all that printing is inflationary. Currencies are being devalued as a desperate measure to pay off old debt as there is no real wealth left to pay these obligations.

And in Europe, the stronger economies like Germany will be brought down as they suffer because of the common euro currency.

At some point, perhaps before the end of the year if things continue as they are, countries such as Germany, France and others will be forced to abandon the euro to avoid going down with the sinking ship.

If the euro fails, then the US dollar will not be far behind.

Quoting one currency expert, “If you have the emergence of national European currencies as a result of the failure of the union, the mirror image strength of the dollar would instantaneously disappear.”

The euro and dollar are mirrors of each other. This means that selling the euro supports the value of the dollar. One goes up, the other goes down, creating a balance and equilibrium. Most dollar trading in the financial markets is through the US Dollar Index (USDX) which values the dollar against a basket of major currencies heavily weighted by the euro. Because the euro represents an economic system larger than that of the US dollar, the two currencies are said to mirror each other.

Quoting the currency expert again, “If the EU fails so does the USDX. With no mirror image to hold up the dollar artificially, the US dollar will fall faster than Greece’s credit.”

If the euro goes, so does this Dollar Index. If that happens, there is nothing to prevent a run against the dollar. Currently, if the Dollar Index goes too low, selling comes with profit taking, allowing the dollar to appreciate. If the dollar index disappears with the euro, then there is no counter force. If your favorite blue-chip stock goes way up, you sell, taking a profit and move into another blue chip that has not gone up. Or if that stock goes down, you sell out and move into another. But if there is only one stock, it could theoretically go up forever, or go down to zero.

After nearly a decade of the euro, there is no other currency to balance the dollar. Potentially, the Chinese renminbi could replace the euro in the world markets, but there is no way that the Chinese would ever allow their currency to be subject to pricing by the market and speculative forces.

If Europe goes back to individual national currencies, the weak ones will devalue to unheard of low prices causing even more economic and debt failures. The stronger ones like the deutschmark and the Swiss franc could be supported by their governments which would cause even more dollar problems.

Speculators would focus on the dollar because of the liquidity in the trading markets and the fact that it would be nearly impossible for the US to impose any kind of currency/capital controls like the Philippines did to protect the peso after Edsa 1. This is because there is almost as much US dollars held outside the US as there is within the US economic system.

This current European episode only accelerates the transfer of economic power and influence to the Chinese, Indians, and others in the developing world.

Buy the peso. Buy the PSE.



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