A skyrocketing euro for a deep diving Europe

Although it is not the first time I write about why I think the actual exchange rate of the euro against other currencies is wrong (see here and here), the latest developments on the Eurozone's life well deserve a revision of the subject. A quick look at the Eurozone lets one see some not very encouraging facts. The Greek tragedy has been quieted down in the last days but is far from over. In fact almost everybody with eyes in the matter is expecting a default sooner rather than later. The only uncertainty seems to rest in knowing if it would be an orderly default, basically a giant debt restructuring effort (hopefully...), or a messy one.

On the opposite side of Europe we have Portugal, but it seems to be in the opposite side only geographically speaking, because its bonds have also been kicked out of investment grade and are now officially  'junk' grade like Greece's. This will make Portugal financing efforts (even) more difficult, which in turn could end with Portugal asking Europe for more money soon. And to complete the domino effect, this troubles are putting extra pressure into Italy's and Spain's not-exactly-buoyant finances.

Credit: Yahoo! Finance

But the euro simply does not care. As seen in the graph above, the euro is rising against the US Dollar, the British Pound and the Chinese Renminbi, and it is doing so with a specially notable rally in the actual week despite all the bad news surrounding the Eurozone. The european currency is spiking also against special cases like the Japanese Yen and the Swiss Franc, although this is a totally different matter. The Yen has its own set of playing rules because of the Fukushima incident, and the Swiss Franc had been overtly growing uncomfortable with its strength against the euro affecting their exports competitiveness. The case with China's Renminbi is a difficult one to analyze, but what happens with the Dollar and the Sterling Pound?

Recommended reading: The tragedy of the euro

Even though it is almost a year old, just yesterday I came across a book called "The tragedy of the euro" by professor Philipp Bagus from Universidad Rey Juan Carlos in Madrid. I have not had enough time to read it thoroughly, but what I saw in that short time span is more than enough for me to recommend it to everyone interested in knowing about the future (if any) of the European currency. You can find the full book here (PDF) thanks to the Mises Institute.

It is a story of good and noble ideas being badly applied or intentionally misunderstood. It is a story of how the fathers of what today is called the European Union tried to establish economic liberalism all across Europe, thinking of the possibilities, progress and growth an European-wide open marketplace could bring. But sadly, it is also a story of how some countries, specially France, managed to convert this great idea into a fully-fledged European super-state. A super-state with limiting regulations, the typical bureaucratic slowness and stiffness and inefficiency in general.

The book explains, with piercing clarity, the different motivations behind European countries to adopt a unified currency. Periferic countries like Greece, Ireland, Portugal, Spain and also France saw in the euro a great way to keep printing money and issuing debt (a necessary by-product of their deficit-prone economies). With an unified currency they would be able to hide the inflation caused by this objectionable tactics, as there would no longer be a Deutsche Mark to be compared against.

How did they convince Germany to be part of such an awful plan?

ECB raising interest rates. Damage control?

Take a quick look at the news an see how many times the expression 'raising tensions' appears on articles lately when talking about the situation in the Middle East. I am sure you do not have enough fingers to count them... Now take this same expression but exchange the word 'tensions' by 'interest rates' and see everybody panic and run for their lives. Although we have lived (and we are still living) one of history's longest period of low interest rates, people keep asking for more. Governments and enterprises around the world have grown so accustomed to debt issuing and uncontrolled spending thanks to cheap money that mentioning the slightest interest rate hike makes them shiver.

The key factors to justify a (slight) interest rates raise are all there though: we have growing core inflation, uncontrolled energy prices, excessive debt and severely depreciated currencies. On the other side we have a weak, mostly artificial recovery (already mentioned), that depends heavily on the availability of cheap money. Which side has a more important impact on the future status of the economy? It is clearly the first one, no hesitation. The Middle East turmoil is not coming to an end soon, and until it does the oil barrel price will keep rising, putting even more pressure on inflation control measures.

More inflation in the actual scenario we are facing would kill all recovery aspirations on the medium and long-term, even if it now seems detrimental for the short-term.

Do not get me wrong, as of now, a raise in interest rates will be hard to handle, specially for debt-burdened countries like Greece, Ireland or Portugal. It would be bad for Spain too even if its debt situation is marginally better, because all the semi-public savings banks (called 'Cajas de Ahorros') are now undergoing reforms to transform themselves into normal banks. A process that needs, and will need, a lot of funding and bond issuing on their part. For these troubled countries higher interest rates mean only one thing: more expensive financing, that is all they can think of when they hear these words.