Both writers point readers to the FAQ from S&P on the downgrades in Europe on Friday. Both hone in on one particular section. I’ll repeat it:
We believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.
There is absolutely no way to achieve economic growth while pursuing fiscal austerity. It just doesn’t work like that. The only other possibility is for Italy and Spain to re-establish their legacy currencies. That is S&P's unwritten, but clear message.
Boom!
The point on legacy currencies made by S&P is actually an old one. Many have insisted that monetary union between north and south was a mistake. But for S&P to have put it on the table is very confrontational to existing EU thinking regarding the need for a breakup. European leaders have all along ignored the blogs and various MSM commentators. Their line has always been, “A breakup is unthinkable”. Not any longer.
I don’t expect “Merkozy” to change their stance on the single currency issue anytime soon. But others will. The message in the S&P FAQ will not be ignored. We’re going to see it in the MSM, and we’re going to hear about it from both the political and the financial sides of governments (and of course, the blogs).
The thought process of a resumption of legacy currencies won't start on Monday. Before this can be accepted as a viable option, things have to first get worse. Much worse. Liquidity has to dry up further. Bond spreads for Italy and Spain have to widen. Funding conditions for the banks have to get worse. Equities (especially bank stocks) have to be broadly declining. The economies of the region need to be in recession coupled with very high rates of unemployment. Declines would be most severe in Spain and Italy. Social disturbance would be on the rise.
Reading the S&P FAQ, you have to conclude that the conditions that would force a return of the legacy currencies will happen, and they will happen in the next twelve months.
There are some very substantial currency implications built into this line of reasoning. If you believe, as I do, that things have to get (much) worse before we see Pesetas and Liras again, then you might logically conclude that the Euro is first headed south against the crosses. EURUSD at 1.100 would not be out of the cards in this scenario.
But consider the end game for this. What's the value of a Euro if Spain, Italy, Ireland and Portugal were no longer part of the monetary union? That price starts at EURUSD 1.6000.
I look at this and wonder if the currency trade of the new millennium is taking shape.
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It is a commonplace that you can't raise taxes and cut social spending without putting the overall economy into a downward spiral.
ReplyDeleteAnd no doubt it is true enough.
But I wonder, what is the ratio of the private/public economy of the Euro nations compared to, say, the US?
If a vast swath of society is feeding at the public trough, then austerity is less threatening to that section of consumers because typically when a government "cuts", it does not cut unneeded workers. It will cut teachers or police or soldiers in order to prove that cuts are not in the general public's interest. Here in the US we've even had demonstrations of government workers demanding higher taxes, presumably in order to make their jobs more secure.
I have been looking at this and some other similar trades like Long Italian and Spanish stocks and short German if a breakup happened. But my largest problem is trying to figure out a timeframe. I know their problems are now and are likely to last for a long time but I wonder how long until the breakup. 1,2,3,..... years?
ReplyDeleteWhat type of time frame do you see?
Unless the Germans agree to subsidize the Portuguese a single currency can't work, and for countries that are evaluating leaving the Euro such as Greece, it's a choice of staying in , adopting austerity and having many years of no growth and pain or leaving the Euro, going back to the drachma, depreciating the currency and experiencing a few short years of high inflation. Seems like a few years of bad stuff and a path forward is better than many years of pain and no path forward.
ReplyDeleteDon't get me wrong: I like the idea, but if a 30-40% round trip is really the best currency trade we can look forward to, it hardly seems worth trying to stay in the game for another 998 years.
ReplyDeleteAnd if the Germans decide to leave the Euro, you get taken to the woodshed......
ReplyDeleteYup.
DeleteNo free lunch in FX...
what i don't get Bruce is leaders have stated in the past that the euro currency is their crown jewel, they're tired of centuries of wars...they've been striving for a union for sometime...the euro was supposed to bring them together, atleast from the politician/technocrat perspective...so for them to allow countries to breakaway? i find it paradoxical...
ReplyDeleteI think that's a good play, indeed.
ReplyDeleteThe Euro isn't going away, but some will likely have to leave it.
Europe is generally bloated with less than competent career politicians, bureaucrats, administrators and hangers on. It is largely (with few exceptions) bloated, outdated and metaphorically obese and out of shape.
The EU has absurdly 3 Presidents!! It's an "old boys" club and until these realities hit it and it starts to get trim, it ain't gonna win in the long run and that's the optimistic perspective.
There is a lot of hard work that needs to be done here and I just don't see the ability, or desire to get it done. And that's a relatively optimistic view.
Bruce - what do you suggest? A down and in option?
ReplyDelete> What's the value of a Euro if Spain, Italy, Ireland and
ReplyDelete> Portugal were [out]? That price starts at EURUSD 1.6000.
But Bruce, what would keep Germany afloat under such conditions? Its banks are just as broke as all others that took part in the global credit boom over the past 30 or so years, and its government will have wasted I don't know how many hundreds of billions trying to prop up the Euro, which will all, or most of it, be lost if the Euro's south jumps ship.
Also, the euro at 1.60 usd would pretty much imply a crisis of sorts having taken place in the global financial system, but it would also imply gold in euro's going deeply down the drain. Unless you have some even smarter thinking in the wings than your already extremely high average, I'm not sold on gold getting crushed at the next crisis in the financial system (as opposed to merely a stock market crisis). Instead, it will detonate and fly to the moon.
Oh, and remember a significant part of the Bundesbank's gold is stored at the NY Fed. Seems unlikely to me that in truly +extreme+ circumstances the German currency, be it euro or mark, cannot possibly rocket launch against the dollar unless the Germans own their gold lock, stock & bars at home.
Oops, take out in my last sentence...
DeleteMessing up here, sorry. Take out UNLIKELY in last sentence.
ReplyDelete1) Living within your means is not austerity
ReplyDelete2) Keynesian policy was supposed to run counter-cyclical - deficits during recessions, but pay it back during growth periods. Losers like Krugman just want to run deficits all the time, while jacking tuition 2-3x as fast as inflation. And the loser wants to default -- stick the next generation with his bills. FUCK Krugman. He should go back to the land of make believe in Princeton, he has no place in the real world
3) The CEO of Linde (German gas products conglomerate) said he thinks Germany needs to consider exiting the Euro... while more Bundesbank members are publicly voicing opposition to ECB money printing.
I think we need to send Krugman and Bernanke over to Greece and make them live their own policies instead of being parasites off honest people