The Euro Crisis Is Structural

by: Shareholders Unite

It's not over 'till it's over, as the saying goes. The present president of the European Central Bank (ECB) Mario Draghi argued that the worst of the Euro crisis is over. Apparently so confident does he feel that he could turn to other concerns, like the one traditionally engaging the ECB, inflation. Draghi argued:

Should the inflation outlook deteriorate, we will immediately take preventative action

But he's not worried:

If one allows for the oil price and the recent tax increases of lots of governments, we have been stable at 1.5 percent (inflation) for months

Although it's somewhat unique to have an ECB president not being worried about inflation (after all, that's their main job description), it is undoubtedly a good thing. Should the ECB start to worry about inflation in earnest, they could tighten policy which really wouldn't help the Euro crisis.

It's not a surprise that, when the Euro zone is marred in a recession and some parts fare considerably worse, inflation isn't rearing its head. But there are other encouraging signs. The two long-term liquidity infusions by the ECB (LTRO), three year 1% loans to the banking system) have held the fort, for now.

Also, the ECB hasn't felt the need to intervene in peripheral bond markets for quite a while, as rates have gone down on Italian reforms and the LTRO program itself. But is the Euro crisis over, or even past its peak? Well, not necessarily. Here is Draghi's predecessor, Jean-Claude Trichet:

No one should think that "because of the forthcomingness (of central banks), there is no crisis," Jean Claude Trichet told a conference in Washington on Saturday. That should be a "collective, collegial message from the central banks."

Much more negative is Willem Buiter, head economist of Citybank (and one of our former professors, if you must know).

It (the long-term refinancing operation) really hasn't solved the problem, and for Europe the worst is still to come. There will be a further restructuring of Greece and Portugal, Ireland is at risk, and Spain has been deteriorating spectacularly in the recent past in terms of its public finances.

Spain indeed seems the next fault line. Buiter in particular is worried about Spain:

Spain has never been so close to default and Greece, Ireland and Portugal may need further bailouts, Citigroup Inc. chief economist Willem Buiter said.

And he's hardly alone. High up the list of potential collateral damage is Italy, which is why Mario Monti, its reforming technocrat Prime Minister, is also worried about Spain, no surprise there. The problem is that due to a renewed recession, the budget deficit isn't even close to meeting targets and the public debt/GDP ratio is rising fast as a result.

Austerity and the Euro
Austerity is doing a lot of damage to the peripheral economies. Those that are saying (and even putting it in formal economic models) that under the present circumstances of deeply depressed economies with near zero interest rates, austerity does more harm than good, even in the limited terms of public finances, look to have a point.

However, in the context of the Euro, there isn't a ready alternative (apart from leaving the Euro altogether). Peripheral countries (apart from Ireland) have lost much competitiveness in the previous decade, largely the result of mismanaging large capital inflows that were the result of them joining the Euro in the first place.

Whatever the cause, the loss of competitiveness is real and within the context of the Euro zone, it's very difficult to address. Countries used to be able to devalue their way out of these kind of problems, or at least having their central banks embark on expansionary monetary policy.

Well, what about the ECB, isn't the ECB embarking on rather unprecedented monetary expansion? Well, yes, and it helps, but not nearly enough. One has to understand that the periphery is not only mired in a deep recession (or, as in the case of Greece, an 1930s style depression), money is also leaving these countries at alarming rates.

One of the central problems with the Euro zone is that neither investors nor depositors need to stay in their home country. They can invest, at zero currency risks (and zero transaction cost), using the same currency, in Germany. Or put their bank deposits in a German bank. And this they are doing in substantial numbers.

The money supply in much of the periphery is actually falling, despite what the ECB is doing. See for instance the monetary figures from Italy:

The upshot
The Euro periphery is mired in a situation in which, in order to reduce wages and prices and restore competitiveness, austerity is necessary but this only increases public debt burdens and the ECB embarks on unprecedented expansionary policies but can't prevent money supplies from shrinking in the periphery.

Our only hope is that the bigger firewall (apparently Germany's Bundeskansler Merkel has given up her resistance against having the two Euro zone rescue funds, the EFSF and the ESM, exist side by side) and structural reform improving European competitiveness and economic dynamism will save the day.

Otherwise things look bleak indeed. The Euro crisis hasn't gone, it's still smoldering and could catch fire at any moment.

We think that the slightest sign of trouble could easily ignite a broad market sell-off in the Euro and European stocks. For the Euro, an alternative to investing directly in the forex markets is Euro based currency exchange traded funds (ETF).

One could short those that are long on the Euro, like CurrencyShares Euro Trust (NYSEARCA:FXE), WisdomTree Dreyfus Euro (NYSEARCA:EU), iPath EUR/USD Exchange Rate ETN (NYSEARCA:ERO), or be bold and short leveraged long Euro ETF's like: Ultra Euro ProShares (NYSEARCA:ULE), or Market Vectors Double Long Euro ETN (NYSEARCA:URR).

Perhaps simpler is just to invest in short Euro ETFs like Market Vectors Double Short Euro ETN (NYSEARCA:DRR) or UltraShort Euro ProShares (NYSEARCA:EUO).

For specific Euro zone country ETF's, here is a list of some:

  • iShares Italy ETF (NYSEARCA:EWI)
  • iShares Spain ETF (NYSEARCA:EWP)
  • iShares Ireland ETF (NYSEARCA:EIRL)
  • iShares Belgium ETF (NYSEARCA:EWK)
  • iShares Austria ETF (NYSEARCA:EWO)
  • iShares Netherlands ETF (NYSEARCA:EWN)
  • iShares France ETF (NYSEARCA:EWQ)
  • iShares Sweden ETF (NYSEARCA:EWD)
  • iShares German ETF (NYSEARCA:EWG)

There is more information on these ETF's here (top holdings, etc.). An alternative is to go long in stocks of countries that are sound and not a member of the Euro zone, like Norway. For instance through the Global X Norway ETF (NYSEARCA:NORW).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.