Many believe that, when and if a nation like Spain withdraws from the eurozone, it will be left with an unbearable debt burden. The claim is that the new currency, such as peseta or lira, would fall dramatically in relation to the euro. Since all existing debt is denominated in euros, the argument continues, it would cost a fortune to pay it off.
The argument only makes sense in the context of a tiny country like Greece. The withdrawal of Greece would leave the rest of the eurozone intact. If a large nation, like Spain, Italy or France, or a combination of smaller nations such as Greece, Portugal, and Ireland, were to withdraw, the entire eurozone would collapse. Remember, the euro is an irredeemable fiat currency. It is backed by debt. Confidence is maintained by the creditworthiness of debt (ie: sovereign bonds) held by the central bank (the ECB).
If a large part of the zone withdraws, the value of all the bonds, issued by that part, would drop dramatically. The value of other bonds, issued by other parts of the zone, also in debt trouble, would also drop precipitously. Not even Germany would be entirely safe. Its bonds are also denominated in euros. If the eurozone were broken, Germany could denominate debt held by its own citizens and banks into new marks. But, no one knows whether that policy would extend to citizens of other euro nations.
The credibility of the ECB could not survive the exit of a large EMU nation or a group of smaller nations. Hundreds of billions of dollars worth of repo loans, made to European commercial banks by the ECB, are outstanding. In the wake of losses caused by a breakup, commercial banks would be unable to redeem the bonds they posted as collateral. Its base assets, which are sovereign bonds from its various members, would also take a trillion euro + hit to their value. The ECB would be holding mostly illiquid assets, leaving it insolvent. Which northern European state would recapitalize it? Finland? The Netherlands? Germany? Remember, the entire concept of a pan-European currency would already be dead.
The value of an irredeemable fiat currency is supported by confidence. People assign a high value to confidence, because it is what supports the notion that others will accept title to pieces of paper or electronic units, in exchange for real goods and services. The ECB could theoretically print an unlimited number of new euros, but that would accomplish nothing. When confidence is lost, a fiat currency becomes worthless.
In other words, if a major nation or a group of smaller nations exit the euro, the currency union falls apart. It is as simple as that. The euro depreciates to the value of a Confederate dollar after the Civil War -- absolute zero. A new peseta or lira might also lose value, after initial introduction, against currencies that retain confidence, such as (most likely) the U.S. dollar and others. But, against the euro, the peseta or lira would appreciate to infinity. The value of collapsed fiat currency is the amount offered by the surviving nations, and no more. The value of the euro would end up being whatever Spain, Italy and/or any other sovereign offered in exchange for existing euros.
The de facto effect of an end to the eurozone is that European debt will be involuntarily "forgiven." By setting the exchange value by which the old currency could be converted to the new currency, each European sovereigns would be in a position to pay whatever it wanted to pay on legacy debt. The biggest losers will be current holders of savings accounts and bonds issued in or by weak euro nations. Foreign holders of German, Dutch, and Finnish savings accounts and/or bonds could also lose big, if all such holdings are not converted into new marks, guilders and krona. Theoretically, for example, Germany could choose to denominate all foreign-held bonds into the currency of its holder's home nation, resulting in German debt instruments redeemable only in pesetas or lira.
The biggest holders of euro debt are European banks. Large internationally oriented American banks, like JP Morgan Chase (JPM), Goldman Sachs (GS), Morgan Stanley (MS) and Citigroup (C) may also hold euro denominated debt and/or credit default swap (CDS) liabilities. CDS will be triggered by an end to the eurozone, causing heavy losses. Various smaller institutions may have speculated long on European debt, and they will pay a heavy price. For example, George Soros' hedge fund (now private) is widely known to have purchased Italian debt. His losses, if any, will be private. Stakeholders will lose in publicly owned corporations, and limited partnerships (hedge funds).
If the eurozone implodes, most banks and insurers in Europe, and many in America and Asia, could end up insolvent. Many may need to be nationalized, with a myriad of deposits and obligations re-denominated into successor currencies. After bankruptcy, the divisions of many banks and other financial institutions may end up being sold into the hands of new management. Shareholders of afflicted financial institutions will be wiped out.
There is little stomach for the type of bailouts we saw in 2008/2009. National finances are now so shaky that it is nearly impossible to repeat the actions of the past. Thankfully, for shareholders, Europe is not likely to collapse right now. There will be a window period for them to sell their shares, and convert their assets into hard currency. Remember, it is far easier to kick the "can" down the road than to deal with it.
By the end of June, in the opinion of this author, the ECB is going to print nearly endless reams of funny-money euros, with the belated blessing of Germany and others. This will not happen, however, until after the Greek elections. The shock of the victory of an anti-bailout government and the prospect that Greece will be cut-off from ECB funding, will tank markets. Bank stocks will collapse. But, there will soon be an announcement, from the Federal Reserve, of more quantitative easing. The nations of Europe will agree to granting ESFS a banking charter. The end result will be the biggest money printing extravaganza in the history of mankind. Bank stocks and markets in general will soar, carried upward by a flood of liquidity.
Dissolution of the eurozone is inevitable, but months of artificially soaring markets, stoked with funny money, printed jointly by central bankers around the world, may provide near-ideal conditions in which to dump stocks. Buying and then selling bank stocks is a strategy that could be highly profitable, but extraordinarily risky. Germany and others may remain steadfast. If my guess is wrong, they could refuse to allow unlimited printing, and, then, we will see an immediate dissolution of the eurozone.
It is better, therefore, not to attempt to trade bank stocks, but to make sure you just don't own them. A eurozone collapse is now a question of "when?" not "if" anymore. Correctly timing the buying and selling could be difficult if not impossible. Several big international banks could fail, nearly overnight, and, if your timing is off, you may get wiped out entirely.
In the short run, precious metals, including gold GLD, IAU, SGOL, PHYS and silver PSLV, could follow a pattern, similar to bank stocks. However, metal prices have already declined, due to heavy selling of "paper gold" by banks seeking to raise cash. Manipulators have already capitalized on that. Fewer weak hands are left. It now costs real gold, in the physical market, to keep prices declining. Physical buyers in China were carting precious metals away, at prices just slightly below where they are now. So, prices could soar even as an initial response. In the longer run, once the euro ends, and even before that, when more money is printed in an attempt to "save" it, prices will rise far above current levels.
In the long run, shifts in investment demand for some precious metals, like silver and platinum, are very likely. Demand may now be heavily influenced by industrial events, but this is not a permanent state of affairs. Investors with a fresh memory of the havoc that fiat currencies and associated debt cause, will seek out more stable hard currencies, and gold, silver and platinum are all viable substitutes for fiat currency. Once investment demand far exceeds industrial demand, prices will respond more and more like gold. They will all rise with the yellow metal and, given more favorable prices right now, the likelihood is that they will rise considerably further and faster.
The U.S. dollar, UK pound and Japanese yen may be in vogue at the moment, but they will all lose their allure. The problems that afflict Europe, also afflict America, Britain and Japan. These nations are heavily in debt, have central banks that specialize in blowing big bubbles and subsequent busts, and have little chance of paying down their debts any time soon.
Discussion of competing currencies brings us to another issue. Fiscal union provides no answer to the eurozone's problems. This was explained in more detail in last week's commentary. The American Federal Reserve is the product of a fiscal union, yet it blew an immense bubble in Arizona, Nevada, and Florida, because it imposed uniform interest rates suitable for New York City, upon those fast growing dynamic states. The Fed-grown bubble is as bad or worse as the bubble blown by the ECB in Spain. Lack of fiscal union merely makes it more difficult to privatize profits while socializing losses.
Europe can take two paths. In the end, however, both paths lead to the same destination. First, it could continue to impose austerity as it has done in the recent past. This will result in the immediate dissolution of the eurozone. Second, it can print huge numbers of euros to buy sovereign debt directly, or indirectly through proxy banks. The money printing option is one chosen by the U.S. Federal Reserve. Quantitative easing, however, is a theoretical violation of the ECB charter. But, it be done covertly, by repeated longer term refinancing operations (LTROs), or, more efficiently, by giving a bank charter to the ESFS.
I think it is almost certain that the second path will be chosen. The ESFS will buy an unlimited number of sovereign bonds. Those bonds will be handed to the ECB and turned into cash that cash will be used to buy yet more bonds, which, in turn, will be converted to cash to buy more bonds, and so on and so forth, until all existing sovereign debt is monetized. The problem is that inflation will go out of control. But, the end will be delayed, with more of the losses shifted from the financial class, to the population as a whole. The eurozone will eventually end anyway.
There is really only one question. Will the euro end, three weeks from now, in a big bust, or in a delayed inflationary holocaust? The answer will come within the next few weeks and/or months. After we get the answer, the now-40 year old irredeemable U.S. Federal Reserve Note version of the U.S. dollar will move front and center.