Tuesday, 8 November 2011

The €uro Has Failed

Capitalism is a truly wonderful system. Across Europe, it is now forcing political leaders to accept reality. The markets continue to punish Greece, Portugal and Ireland for their debts, and now they are punishing Italy. The single currency project has failed utterly. Sovereign nations are not sovereign if they cannot control their own currencies. They are reduced to the status of corporate bodies. And corporate bodies can become insolvent and go bankrupt.

I was talking to a leading fund manager on Thursday. He told me the following:

'Italian 10-year bond yields have passed 6%. No nation has ever come back from 6% without needing some form of assistance. If they reach 7%, that's normally the point at which you call in the IMF. And if that happens to Italy, we are screwed. Italy is the 3rd largest bond market in the world - it's worth €1.3trillion. Nobody - not even Germany - has that kind of money. If that happens, Italy will default on it's debt - causing massive write-downs across the global banking industry. It will simply mean the complete collapse of the financial system as we know it.'

We may be utterly fucked.

Italian 10-year bond yields are now 6.7% and climbing. Yet even now, there is a way out of this mess. In fact, there are two.

Scenario 1 - United States of Europe
The Eurozone countries agree to form a permanent fiscal (and implicitly political) union, which amounts to Germany agreeing to massive transfers of wealth to the peripheral economies in perpetuii. Even then, the might of the German economy will still not be enough. With the condition that Italy is in, the ECB would have to also slash interest rates embark on an immediate campaign of Quantitative Easing (money-printing) to cover the debts that even Germany can't pay off. The entire USE would have to de-value and suffer inflation to make themselves more competitive to grow their way out of recession.

The problem with this is Germany. The Germans seem loathe to work until they're nearly 70 so the Greeks can retire at 68. Furthermore, Germany is fundamentally opposed to the idea of printing money. The last time a German nation undertook such an exercise was the Weimar Republic. And we all know how well that ended. The markets would prefer this option, but it seems unlikely.

Scenario 2 - Breakup of the Eurozone
Quite simply, the countries which are struggling - Greece, Ireland, Portugal, Italy - maybe Spain as well - leave the Eurozone and adopt their own currencies. First, these currencies would be fixed at 1:1 with the €uro, at least until they'd managed to get new hard currency into circulation. This would take about a month. This would be followed by a smooth but pretty rapid de-coupling from the €uro, pegging at 90%, then 80% and so on until their currency was freely floating. This would be accompanied by reductions in interest rates and expansive QE programmes.

In all seriousness, we're probably looking at a combination of the two - some peripheral economies will probably leave, and France and Germany will probably cleave together. One thing is becoming increasingly clear, however - the markets will not tolerate inaction. Something has to be done, and quickly - otherwise the Masters of Europe risk falling over a cliff, and taking the global financial system with them.