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?

When rescue packages are not enough, a Greek tragedy in the making.

The astonishingly beautiful deep blue waters of the Aegean sea must be starting to boil as of now, with the economic situation in Greece heating up even further. Debt-to-GDP ratio has reached 143%, Credit Default Swaps are at 1371 basis points, S&P downgraded (once more) Greek debt to B rating from BB-, taking it only two steps about the C rating, which effectively erases one from financing and flags you as someone waiting to default. To make matters worse, often-violent demonstrations are stopping the country's already ailing economy day after day. I truly can understand the frustration the situation causes, but halting economic activity is clearly the worst thing to do in the actual situation...

Another rescue package, combined from both the European Union and the IMF (with or without Dominique Strauss-Kahn), seems to be in the way but its effectiveness is already in doubt. A recent poll shows almost everybody thinks this would be artificial life support for Greek debt. Sooner or later a default or a painful debt restructuring process seems to be coming. Not being a debt restructuring expert, just based in common sense I can only say: make it sooner rather than later.

Extending this situation is bad for everybody, it is bad for Greece's future, bad for Portugal and Ireland debt prices and bad for the whole euro area's stability. Stop being stuck in the actual situation, a situation that slowly built the hole where you are now. Just change everything! 

First thing, go out and make the people understand why spending cuts and privatizations are basic, unavoidable and necessary to have a future. You can not afford to have your people burning policemen, destroying everything that comes close and shutting down air transport... Tourism is a keystone in Greece's actual economy, so flying stones and burnt buses are not the best of promotions for the country. In fact any company thinking of investing in Greece as of now would be held back but the situation on the streets.

Germany's biggest enemy: a strong euro.

Neither the (now certified) fall of Portugal nor increased debt pressures on other european peripheric countries have been enough to tumble down the never-ending rise of the euro exchange rate against other significant currencies. This should be very worrying for the heart and engine of the eurozone, Germany. I am sure Germany is already worried about that, what I mean is they should be worried enough to do something about it. 

A net exporter like Germany should not allow its currency to be its Achilles heel. Ok, the currency is not really German, but they are its founding fathers and the main reason why it exists... With this in mind, it becomes very difficult to understand why they allow 'their idea' to make their international trades more expensive and complicated. In the actual economic situation, competitiveness and efficiency are key to keep selling and Germany can lose their edge because of this. It is survival of the fittest.
The competitiveness indicators based on consumer prices published by the ECB show this trend clearly, see charts below (where 100% equals the index value in 1999 ) with an obviously sharp decline coincidental with the rise of the euro.

Harmonised competitiveness indicator for Germany. Credit: Deutsche Bundesbank

A strong euro is obviously good for debt issuing, for general borrowing and for imports but it can really hurt the muscle of Europe. Maybe you could think of it as eating everyday at McDonalds (no bashing here, just an example): it is cheap, it is easy and convenient as you can find one almost everywhere and it gets you through the day. But in the long-term fats are bad for your figure and, more importantly, bad for your most important muscle, the heart. The European Central Bank (ECB) is damaging the heart of Europe.

And now Portugal... But hunters already looking for their next prey

Here comes the latest member (it is almost there) to join the euro-bailout club: Portugal. This is not breaking news, as everybody was expecting this to happen sooner or later. It is not frightening either, as Portuguese contribution to the whole European GDP is relatively low; it is lower than that of the Irish and clearly the eurozone did not break because of Ireland's (or Greece's) bailout. Belgium is mentioned too, but that would not pose a much bigger problem than Portugalm, but what IS frightening economists worldwide is the possibility of Spain or Italy being next.

Portugal 10-year Bond. Credit: Bloomberg

The pattern on European bailouts is becoming worryingly clear. One country's economy begins showing signs of slowing down and continues with its excessive debt issuing. Rating agencies notice (thus making the yields go up), international investors notice (and ask for bigger yields on said sovereign bond) and last but not least speculators notice and try to take advantage of the situation. The death spiral has begun and everybody knows the results... The same moment this happens, the whole financial world locks in to their next target; the most suitable candidates being now Spain and Italy. The first expression that comes to mind when mixing the word 'bailout' and the name of Spain is 'too big too fail'. The expression is already familiar for American people but European people have not suffered it yet. The falls of Greece and Ireland were manageable for the European rescue fund, but a crash in Spain, or Italy, would pose an enormous problem to the whole eurozone. But disregarding what the hunters (speculators) want, is really Spain in need of a bailout? 

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.

Tuning down inflation

Falling into deflation or stagflation has always been one of the greatest fear for politicians, economists and enterprises. A negative inflation rate theoretically means less money is available, in turn that means less credit and everybody knows what that means in a debt-dependent world like ours. Also deflation is correlated with lower prices, which people tend to associate with depressed economic growth. Whether one agrees with this affirmation or not, during last year's credit crunch it made some sense to be fearing deflation and its consequences,  thus no one worried about currency devaluation and general credit easiness to avoid it all costs.

Now, after the crunch is mostly forgotten and credit channels work again as normal, it begins to look like a flagrant excuse to keep interest rates at all-time lows and to support the worrying commodities rally. 

Strangely, some economists are still asking for a moderately higher inflation as a way to increase competitivity and as a way to cut salaries inadvertently (you cannot lower them without complaints, but you can make them effectively lower by increasing inflation) to boost employment. Everybody knows how to raise inflation, what is difficult is controlling its raise. Raising inflation when official levels are well under 4% would no be a problem by itself, the issue here is that official inflation levels are all wrong.

The euro, evolved. Europe's way out?

As we discussed in an earlier post, one of the possible solutions to the problems the single currency is causing to some eurozone members would be to split said currency into two different ones. The main purpose of this would be to better focus on the members' vastly different and diversified needs and demands. However this move would not be free of charge... 

Let's do a quick analysis of what this currency split would mean.