The Euro Exhibits Systemic Macro Weakness

The position of the European economic area, and particularly the currency union, grows more tenuous by the day. The European Commission is weak in leadership (more so than usual)) and suddenly struck by an uncharacteristic attack of economic liberalism, fiscal conservatism, and above all, noninterventionism. They are banking on the worst being over, a quick return to normalcy that will allow their high-end manufacturing exports to resume at scale; and disingenuously trying to blame the United States for the excesses for which European banks were every bit as responsible.

Denying their responsibility amounts to burying their heads in the sand and will merely exacerbates their own economic difficulties. Even the hardest of Germany's free-market CDU politicians will soon find it utterly impossible to maintain their stance as their economy and their domestic manufacturing operations collapse.

Millions of job losses loom on the horizon in Europe. These jobs are not particularly replaceable, as the workers themselves know. They are all too aware of the fate of the American Rust Belt cities when US manufacturing collapsed, and they will not suffer a similar collapse in Europe lightly. But it would be even worse for European manufacturing. There are no export markets currently. There is no vast new cheap labor pool coming online, as China did when the US was deindustrializing. They cannot import things cheaply to sell at first world prices and then talk of redirecting lost jobs into the construction of a "service economy"; there is no credit to finance it (much less long term credit), and no new slave labor to donate value to it. That emperor has now been conclusively shown to have no clothes. We cannot all live by cutting each others' hair.

This renders the European politicians' laissez faire approach untenable. Many Americans do not realize that the European left is far more socialist, far more vocal, and far closer to power than what we are accustomed to think of as the "left" in the United States. Obama may as well be another incarnation of Reagan by comparison. The largely unionized and politically powerful European workers don't really care in the end who is responsible; they want their jobs. If European manufacturing is allowed to collapse, it will be devastating, both for their economies and politically for those who allowed it to happen.

But Merkel and her free-market friends are politicians first and foremost. That means they are intensely aware of what that outcome would mean for their party and for their own careers. They will therefore eventually yield, after making the appropriate PR complaints. They may perhaps even have the nerve to consider burning the American-owned Saab and Opel to make a point and attempt to shift the blame to the United States.

But mass failures are not an option politically. The national governments of Europe will cede their fatuous airs of holding the moral high ground and intervene. The nominally right wing Sarkozy has already bailed out Renault and Citroën to the tune of €11 billion in a questionably legal move that flies in the face of European Union free competition. He is now pressuring various French manufacturers to keep their operations in France rather than relocate to areas of eastern Europe with much cheaper labor costs, in direct contradiction of various European Union open market agreements.

Merkel cannot be far behind, despite her pretense of economic-liberal ideology. Her grand coalition with the nominally socialist SPD will collapse and the CDU will be swept from power if German factories are allowed to shutter, and she knows it. Her actual choice is irrelevant; if she sticks to her ideological guns, the leftists will boot her from power and bestow even more government largesse upon German industry anyway.

When (not if) this begins to happen, it will lay bare long-festering internal tensions within the EU. It would be a political and diplomatic masterpiece indeed if the Eurocrats can manage to keep their nations' differences swept under the rug for much longer.

Spain and Ireland have long been calling for lower interest rates to mitigate the effects of their American-style property bubble collapses. France and Germany have allowed it only reluctantly and at a snail's pace. Now facing the pressing need to prop up their own export-driven manufacturing sectors, it is inevitable that the euro interest rate will converge to zero (though not as quickly as the Spanish and Irish have been demanding).

The newly added tensions from France's surge of protectionism, and Germany's inevitably following suit, will greatly exacerbate discord in EU governance generally, and ECB policy in particular. It will vastly increase the (nonetheless small) chance that someone will drop out of the currency union to be able to control interest rates and money supply independently. Silvio Berlusconi loves to blame the currency union for every domestic ill; he might take this excuse to win political points. Or the Spanish or Irish may decide that their national economies can't wait any longer for lower rates and an expanded money supply. If any member country drops, it will be disastrous for the euro's exchange rate.

Failing that extreme case, it is much more likely that one of the eastern European eurozone aspirants will abandon the stringently constrained fiscal policies required to accede to the euro. Many have directly pegged their currencies to the euro; all are prohibited from running large deficits of the kind many of their citizens now want to use to bail out their own economies. Though barely mentioned in the western media, civil unrest has sharply increased across eastern Europe in the past six months. Sometimes violent protesters from Latvia to Bulgaria are furious at what they see as the vast deception of capitalism foisted upon them. Their governments' abilities to respond to the economic crisis are hamstrung by the euro accession requirements; US-style deficit spending is simply not an option unless they drop their euro applications and unpeg from the euro. While this event would not be as disastrous for the euro as the withdrawal of a full member, it would certainly not be positive.

The IMF has been bailing out eastern Europe left and right. This trend seems set to expand. The Ukraine, Hungary, and Romania have already availed themselves of the IMF. Hungary is considering another round; as of this writing, Poland is said to be considering the IMF, too. This is more bad news for the euro.

Alternatively, Germany, France, Russia, the EU itself, or the IMF could engineer even more bailouts. Or the EU could simply relax accession requirements. All of these events would not be good for the euro relative to the world basket. While the outcome is unclear, what is clear is that the social and political reality on the ground will not allow the status quo to continue for much longer.

All of this points to a wise position being short the Euro. The other side of the trade is not so clear. The US dollar is little better off. Massive amounts of dollars have been created but not yet disgorged in the credit markets. When they finally start to flow, USD inflation will take hold in a big way — but we don't know when that will be. Given this uncertainty, the pure short Euro play would be against a large basket of other currencies and commodities, and none too much in US dollars - I would go so far as to net short the dollar, too. For the long side, combine Japanese yen, Swiss francs, and a commodity basket.

Disclosure: No stocks mentioned.

Comments

[franz:]

Best propaganda appeals to emotions rather than facts. When attempting to analyse a topic of 27 (widely diverse) countries, intellectual humility, is the best tool in your kit that you can possibly have. I do hope that your euro shorting strategy has some realisation hope in the time horizon, and also that you have another hedge against dollar implosion besides the tricky gold.

Apr 12 07:14 AM

[ArkansasAngie:]

If the dollar survives, the euro will. If the dollar implodes so also will the euro. And ... equally important, if the euro implodes so also will the dollar.

The problem with a growth based economic strategy is that it falls apart when there is no growth.

We used AIG bailout money to prop up European financial institutions (and a few of our own, of course).

So ... are you willing to bet that they aren't going to need additional funds.

Perhaps the better question might be are you willing to give it to them?

I'm reminded of the old IRS joke when the IRS agent tells the taxpayer -- "perhaps you'd feel better if you stop thinking of it as your money".

Apr 12 09:23 AM

[sunnsea:]

Most European factories owned by small and medium sized businesses, have a high degree of automation already built in, labor costs are actually not that much a problem. Since we in the U.S. think we have nothing to learn from them or anyone else, we never visit these factories. Human beings are used for quality control, continually developing new designs and marketing. Machine tools continue to be made and exported to China, even though has 30% tariffs on imports. America forgot long ago what a machine tool is.
Euroland will have its problems but in the end they will survive and grow and we will just bumble along unless we begin to relearn, rethink and retool for global demand not just domestic US demand which had been satisfied by moving everything to China. Our recent growth was ficticious made up largely of AIG derivative "products." That's why the average person in the US never felt a part of the "growth" that was supposedly occuring in the last 8 years..or may be even the last 30.

Apr 12 10:23 AM

[manya05:]

Agree with Sunnsea, the economic base of Europe is much deeper and wider than the US, they are much better positioned to weather the storm. Likewise, the euro may be in trouble, but it is the symbol of European union. I am confident no measure will be spared in order to keep it viable. The European Commission knows that if the Euro goes under, the cause of European Union will take a 50-year setback. Just as our administration will keep throwing money around to save the banks, the Europeans will do everything to save the Euro.....fear not.

Apr 12 12:03 PM

[bartenbach:]

The one great thing that the USA can do, and do very well, is create jobs - Europe has never shown this fantastic ability to quickly translate ideas into sellable products and services. Of course readily-available finance was a powerful fuel for such an engine and we will have to see how that pans out in the future. On Paul's general thrust, however, there can be no doubt that he is correct. The Euro "mentality" is a funny amalgam between a sort of Germanic "Arbeit macht Frei" way of thinking and the French desire to once again achieve glory. Many in the EU are in economic denial - also about their security, purchased as it was over many decades by US military spending and preparedness to go face-to-face with our enemies. The whole Euro thing is nothing more than an ego trip, pushed by an elite establishment who despise the ordinary voters. Quite just how the European Union weathers both the approaching economic storm and the demographic challenges presented by huge influxes of different cultures over the next few years is open to debate. There is too much pride -a dangerous amount of pride, certainly on the European side - tied up in this debate about the Euro. I for one welcome any Hedgie who takes a tilt at this particular windmill! Buy black tulips anyone?

Apr 12 01:47 PM

[Paul Legato:]

In the New York Times yesterday: the Spanish are beginning to see deflation. If deflation takes hold, they will be the first to break the union. Their talk is already heading in that direction.

www.nytimes.com/2009/0...

Even if they don't actually break it, this is not a good sign for the Euro.

I certainly wouldn't touch gold - too manipulated. The USD suffers from weird problems as the reserve currency and the "flight to safety" factor - despite the massive money-printing, recall that Treasury yields were *negative* at the peak of the crisis, and still close to zero. I do not think a Euro tank necessarily implies a USD tank (though the USD might also tank for unrelated or not-directly-related reasons.)

Like I said, the other side of the trade is not clear. I don't know what will hold value well, but I am pretty sure the Euro is going to bleed it. I'd go with some kind of diversified commodity basket and maybe a few incredibly well-researched equities with amazingly solid fundamentals.

Cheers.

Apr 21 04:25 PM