Wednesday, January 07, 2015

Euro Drop Brings Woe to Europe

The euro's precipitous decline reflects more than financial market nervousness over Greece's political stability.  Persistent structural weaknesses in much of Europe's constituents feed the euro's fragility.

The European Central Bank (ECB) watches the euro's unfolding crisis with alarm.  Its most recent reforms allow it to act more decisively in setting monetary policy, much like the US's Federal Reserve.  It can now move swiftly to unleash quantitative easing that can flood the Continent with new credit that supports the euro's nominal value.  The deluge remains a simple-minded central banking solution to a complex problem that only the liquidation of bankrupt debtors has ever solved.

The national economies of Spain, Greece, Italy, and even France continue to suffer from severe competitive deficiencies.  All are saddled with high taxes and complex regulations that make their economies less competitive.  Their exports would suffer without Germany's willingness to allow its creditworthiness to support their profligate borrowing.  That profligacy partly drives the ECB's plan to buy European sovereign debt.  It also leads to a vicious feedback cycle of debt-driven sovereign spending, credit-enhanced consumer spending, and currency inflation that will demand still more quantitative easing.

European banks have unfortunately started down the road of paying negative interest rates on deposits.  Charging depositors for the privilege of holding savings in cash accounts feeds the euro's deflationary trend by slowly taking the most liquid form of money out of circulation.  Deflation gets a bad rap from central bankers, but the eurozone's high level of indebtedness means a deflationary spiral makes it harder for private-sector debtors to pay their bondholders.  The ECB knows that European corporations can't afford to be sanguine about deflation, hence the increasingly loud financial sector chatter for a more inflationary monetary policy.

The European unity experiment is under more stress now than at any time in its history.  Lithuania's entry into the currency union is in no way a counterbalance to Greece's potential exit; the difference is measured in hundreds of billions of euro-denominated debt that could instantly evaporate.  The ECB would be well advised to delay its planned QE past this month's Greek elections.  It would otherwise swallow worthless Greek bonds whole.

Full disclosure:  Long put against FXE.