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  • Different Smart Opinions On The Eurozone And What History Should Predict 0 comments
    Jun 11, 2012 10:37 PM

    To say a lot of ink has been spilled on the topic of the euro is just a slight understatement. Here I record some of what I have found to be the more interesting commentary, followed by my bet at the end.

    First, let us define the problems, which Paul Donovan at UBS puts this neatly:

    The current Euro situation is demonstrating the three flaws of the construction of the monetary union. First, Greece's problems would be lessened if there were a fiscal union or fiscal confederation. This is why all functioning monetary unions are accompanied by fiscal unions. Second, Spain's problems help explain why a monetary union needs a single banking regulator and lender of last resort (with infinite resources). Finally, the general tone demonstrates the folly of total policy inflexibility (monetary, exchange rate AND fiscal inflexibility). Source: UBS daily roundups - The Euro's three flaws - 8 May 2012.

    Now to some possible solutions, The Economist points out the two available paths:

    What will become of the European Union? One road leads to the full break-up of the euro, with all its economic and political repercussions. The other involves an unprecedented transfer of wealth across Europe's borders and, in return, a corresponding surrender of sovereignty. Separate or superstate: those seem to be the alternatives now.

    The Economist's plan:

    That is why our rescue seeks to limit both the burden-sharing and the concession of sovereignty. Rather than building a federal system, it fills in two holes in the single currency's original design. The first is financial: the euro zone needs a region-wide system of bank supervision, recapitalisation, deposit insurance and regulation. The second is fiscal: euro-zone governments will be able to manage-and reduce-their fiscal burdens only with a limited mutualisation of debt. But in both cases the answer is not to transfer everything to the EU level.

    Niall Ferguson and Nouriel Roubini agree somewhat and write in the FT:

    Germans must understand that bank recapitalisation, European deposit insurance and debt mutualisation are not optional; they are essential to avoid an irreversible disintegration of Europe's monetary union. If they are still not convinced, they must understand that the costs of a eurozone break-up would be astronomically high - for themselves as much as anyone.

    Andrew Roberts, in an earlier FT opinion piece, has a quite different view and makes a very good point about the ECSC:

    So when was it that the Brussels empire over-reached, and became more concerned about its own expansion and glory, its own ambitions for hegemony, than about the daily economic wellbeing of its citizens? Was it when Greece was admitted in 1981, a country whose basic economic make-up had nothing in common with the original six as conjoined by the Treaty of Rome in March 1957? Those countries - West Germany, France, Belgium, Luxembourg, the Netherlands and Italy - at least had a natural synergy since they had formed the European Coal and Steel Community six years earlier, whose "higher authority" had supranational powers.

    Roberts' solution:

    Germany and France should, therefore, in as orderly and honourable a way as they can, return to the safety and the rationality of the original Treaty of Rome, reinstitute the "six", and keep the euro only for those countries that deserve membership on the logical grounds of genuine economic synergy. These are utterly removed from the commission's hubristic fetish of global hegemony.

    John Mauldin's SA article is also definitely worth reading, as it talks not only about Europe, but also touches on Japan (which surely is another ticking debt time-bomb). On Europe, a slightly hedged but very fair answer:

    I get asked all the time if the euro will break up. The honest answer is, we really don't know. I think the economically rational thing to do in the very long term is for some countries to figure out how to leave the euro, but that is more a political question than an economic one. And if you can tell me what politicians and voters will do in a political crisis and deepening recession, then your crystal ball is less foggy than mine.

    I think it is 50-50. The drive to hold the euro together will go head to head with national self-interest. Right now, it depends on whom you ask as to what answer you get. But I do not think we will be asking the question much longer. Soon enough, we will know.

    So then, so far we have a couple of plans to try to more or less save the majority of the eurozone, a plea for a reduced eurozone akin to the original common market, and a fair point that politicians and voters will act in unpredictable ways.

    I have a lot of respect for all of the above points and their respective authors, but what can we know from history? To be specific, I mean what have been the outcomes of past examples of fixed exchange rates/single currencies?

    Well for this, I turn to a research note from about a year ago, that I keep coming back to time and time again. I think these few sentences provide a great road map from history which puts the odds tremendously against the euro surviving. I quote Dylan Grice at Societe Generale:

    We're all aware of the eurozone's fiscal issues, but the conventional wisdom remains that the euro will survive because … (take your pick) there's too much political capital invested in it … it's in no one's interest for it to break … it would be too difficult for anyone to leave … policymakers won't allow it to fail. Yet events are the enemy of conventional wisdom. Such reasoning relates to the specifics of the eurozone's plight today. Let's think about the 'base rate' here. The Gold Standard, the Gold Exchange Standard, the Latin Monetary Union, the East African Currency Board, Bretton Woods, the Asian economies' dollar pegs, the Austro-Hungarian krone, the Soviet ruble, the Yugoslav dinar and of course, the original European Exchange Rate Mechanism (ERM) are all examples of fixed exchange rates/single currencies which traumatically buckled under political strains.

    Off the top of my head I make that ten fixed exchange rate systems/currency unions that have failed in the past hundred years or so. In fact, how many such currency unions/fixed exchange rates have succeeded? Switzerland and Hong Kong's dollar peg (at a stretch) are the only two I can think of. The 'base rate' of successful currency unions is therefore low. Source: Societe Generale Cross Asset Research - Popular Delusions - 22 June 2011

    My bet then is that eventually the euro will be totally history. It might take ten years or more, but as each domino tumbles, there will be initial periods where the fallout from the European policy errors will be painful but soon after creative destruction will work its magic. It appears Greece will be the first to go, so my logic follows that from the eurozone, Greece will also be the first to recover. One recent example to follow is Iceland. After a hefty currency devaluation in 2008 the main Icelandic stock index is up around 50% over the last three years.

    In the case of the euro then, it's worth remembering Mark Twain's quote, "The past does not repeat itself, but it rhymes."

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

    Themes: economy
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