Yesterday I described three fatal flaws in the Eurozone; today we look at three more structural reasons the zone and its common currency the euro are doomed.
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Reason #1:: The Imbalance between Exporting and Importing Nations
An intrinsic source of instability is the imbalance between export powerhouse Germany, which generates huge trade surpluses, and its trading partners in the EU that run large trade and budget deficits— Portugal, Italy, Ireland, Greece, and Spain.
Those outside of Europe may be surprised to learn that Germany’s exports are roughly equal to that of China ($1.2 trillion) even though Germany’s population of 82 million is a mere 6% of China’s 1.3 billion. (Germany and China are the world’s top exporter nations, while the U.S. trails as a distant third.)
Germany’s emphasis on exports places it in the so-called mercantilist camp, which depends on exports for their growth and profits. Since the inception of the euro, Germany’s exports rose an astonishing 65% from 2000 to 2008 while its domestic demand was near zero. Without strong export growth, Germany’s economy would have been at a standstill. The Netherlands, which reaped a $33 billion trade surplus from a population of only 16 million residents, is another example of a Eurozone country which runs substantial trade surpluses.
The “consumer” countries, on the other hand, run large current account (trade) deficits and large government deficits. Italy, for instance, has a $55 billion trade deficit and a budget deficit of about $110 billion. Total public debt is a whopping 115.2% of GDP.
Spain, with about half the population of Germany, has a $69 billion annual trade deficit and a staggering $151 billion budget deficit; fully 23% of the government’s budget is borrowed.
Though German wages are generous, the German government, industry and labor unions kept a lid on production costs even as exports leaped. As a result, the cost of labor per unit of output—the wages required to produce a widget—rose a mere 5.8% in Germany in the 2000-2009 period, while equivalent costs in Ireland, Greece, Spain, and Italy rose by roughly 30%.
The consequences of these asymmetries in productivity, debt, and deficit spending within the Eurozone are subtle. In effect, the euro gave mercantilist, efficient Germany a structural competitive advantage by locking the importing nations into a currency, making German goods cheaper than domestically produced goods.
Put another way, by holding down production costs and becoming more efficient than their Eurozone neighbors, Germany engineered a de facto devaluation of its own products within the Eurozone at the expense of its importing neighbors.
Reason #2: The Euro Removed the Mechanism of Currency Devaluation
The euro had another deceptively pernicious consequence. The overall strength of the currency enabled debtor nations to rapidly expand their borrowing at low rates of interest. In effect, the euro masked the internal weaknesses of debtor nations running unsustainable deficits and those whose economies had become precariously dependent on the bubble in housing (Ireland and Spain) for growth and taxes.
Prior to the advent of the euro, when overconsumption and over-borrowing began hindering an importing, “consumer” economy, the imbalance was corrected by an adjustment in the value of each nation’s currency. This currency devaluation would restore the supply-demand and credit/debt balances between mercantilist and consumer nations.
For instance, the Greek drachma would fall in value versus the German mark, effectively raising the cost of German goods to Greeks, who would then buy less German products. The trade deficit would shrink, and lenders would demand higher rates for Greek government bonds, effectively pressuring the government to reduce its borrowing and deficit spending.
But now, with all 17 nations locked into a single currency, devaluing currencies to enable a new equilibrium is impossible. As a result, Germany is faced with the unenviable task of bailing out its “customer nations.” Meanwhile, the residents of Greece, Italy, Spain, Portugal, and Ireland are faced with the unenviable task of cutting government benefits to realign their budgets with the productivity of their underlying national economies.
Germany helped enable the over-borrowing of its profligate neighbors by buying their government bonds; according to BusinessWeek, German banks are on the hook for almost $250 billion in the troubled Eurozone nations’ bonds.
This has pushed Germany into a double-bind. If Germany lets its weaker neighbors default on their sovereign debt, German banks will fail, but if Germany becomes the “lender of last resort,” then the German taxpayers end up footing the bailout bill.
If public and private debt in the troubled nations keeps rising at current rates, it’s possible that even mighty Germany may be unable (or unwilling) to fund an essentially endless bailout. That would create pressure within both Germany and the debtor nations to jettison the single currency as a good idea (in theory), but an ultimately unworkable one in a 17-nation bloc as diverse as the Eurozone.
Reason #3: Crushing Private and Public Debts
Banks around the world have a major challenge in the next few years: trillions of dollars in debt must be “rolled over” or refinanced. Globally, banks owe about $5 trillion to bondholders and other creditors that will come due by 2012, according to the Bank for International Settlements (BIS).
But European lenders have a substantial share of that burden: About half of the liabilities—some $2.6 trillion–are in Europe.
The BIS has several fundamental concerns about this stupendous Eurozone debt load. One is that banks desperate for refinancing will compete with governments such as those in Greece and Spain, which must also roll over gigantic sums in the global bond market. Competition for bondholders’ favors will result in higher credit costs for business and consumers, with predictable consequences: Higher borrowing costs lead to reduced economic activity.
The BIS’s second great concern is the gargantuan sums that have been promised to citizens in Eurozone social welfare programs. As Europe’s working-age population shrinks and the number of its retirees rises, the ability of governments to pay the benefits and service the huge debts that have been accumulated is in question.
The choices facing governments with rising social welfare costs and debt costs are bleak. Either cut benefits or raise taxes on a dwindling base of workers–or both.
The bottom line: The flaws in the structure of the European Union and euro cannot be resolved by face-saving compromises and additional bailouts.
Since the devolution of the Eurozone and the euro is baked in, as investors we need to think through the consequences of a probably messy restructuring of the EU and the euro. In Part II of this report: Positioning Yourself for the Devolution of the Euro, we delve into the most probable series of outcomes for the euro and how investors can position themselves to protect and possibly increase the purchasing power of their capital vs. this troubled currency.
Click here to access Part II of this report (free executive summary, enrollment required for full access).
Charles Hugh Smith – Of Two Minds