Do you hear that ripping, tearing sound? It is the duct tape of the eurozone being pulled apart at the seams.
Last week, first-quarter growth rates came in for the various euro-area economies. France and Germany, two “core” countries, were impressively strong. Both surpassed growth estimates. Germany in particular is a growth powerhouse.
The periphery countries, however, are in a world of hurt. (No surprise there.) Deep and painful recessions are on deck for Greece, Ireland and Portugal.
This harsh reality has led to riots in the periphery countries (Greece in particular). Angry citizens know the “austerity measures” forced upon their struggling nations are at the behest of far-off masters, not the local government. More infuriating still, they know these measures are designed to protect the banks.
You can shear a sheep many times, as the old saying goes, but you can only skin him once. Taxpayers — the “little people” of Greece, Ireland, Portugal and the like — are being flayed alive in service to a corrupt system.
And the huge disparity in growth rates is making the problem much worse.
The challenge is that a country’s monetary policy is supposed to reflect economic conditions. When growth is strong and inflation risk is high, you raise interest rates and attempt to cool things off a bit. When growth is slow and painful recession looms, you keep rates low and try to avoid harsh measures.
But now the “core” and “periphery” countries are going in dramatically different directions. This makes the “one size fits all” monetary policy of the eurozone an impossible boondoggle.
It makes zero sense for two countries as disparate as Germany and Greece to share the same interest rate. The very idea is ludicrous. (We have expressed this opinion many times before in these pages.)
The Economist had a good metaphor some time back: The eurozone is like an airplane that is half high-tech and half balsa wood. Germany supplies the precision jet engine. Greece and Portugal are the balsa wood. A plane like that can very easily be shorn apart by turbulence.
That is where things stand now, and it is part of the reason the euro tanked last week (falling sharply on Friday as this piece is being written).
As Der Spiegel writes,
Out of consideration for Europe’s most troubled economies, the ECB cannot raise the base lending rate nearly as much as would be necessary to contain price pressures in boom countries like Germany. If it did, their borrowing costs would rise even further, choking off what feeble growth the southern European countries are experiencing.
If Germany keeps roaring along at its current pace, inflationary pressures will threaten to undo the economy. This possibility will be less tolerated in the land of Weimar than it is in China. But heavy-handed hikes could mean pushing Greece and Portugal into deep recession… or depression.
And the situation only gets more complicated from there…
Some say the answer is to stop tiptoeing around the real issue: The need for the struggling periphery countries to restructure their debts.
Stop pretending that Greece has a hope in Hades of paying off its nearly half-trillion-dollar mountain of debt, this wisdom says. Let the creditors take haircuts. Let the workout process begin and bondholders face the consequences.
There is a reason, though, why white-faced politicians talk as if this option does not exist. Says Christine Lagarde, Finance Minister of France, in respect to Greek debts: “What I rule out is restructuring. There is no question about it.”
And why would France be so dead set against Greek default? Because French and German banks are loaded to the gills with the sovereign debt of periphery countries.
It’s the subprime debt crisis all over again — but this time on a sovereign scale. Greece is like a desperately underwater homeowner with a negative amortization mortgage and a garnished paycheck. France and Germany own the banks sitting on a huge pile of toxic mortgage derivatives that will blow up if Greece and Portugal, the underwater homeowners, dare to default.
What is happening, bit by bit, is a forced exchange where private holders of periphery country debt are being bailed out by taxpayers. The stupid banks, which have gotten themselves into serious hot water once again, are receiving a stealth rescue from the eurozone political system.
Lee Buchheit, a New York-based lawyer who helped negotiate Uruguay’s restructuring in 2003, recently wrote the following on Greece:
If the sword of a debt restructuring must eventually fall in order to render Greece’s debt stock manageable, that sword will fall principally on the neck of the official sector lenders… The original creditors will have swapped place in the tumbrel with official lenders quite literally in the shadow of the guillotine.”
So how do you fix this mess?
Ultimately, the answer is probably still default. In a Bloomberg global poll, 85% of investors surveyed said they expected Greece to go under, with the same likely fate for Portugal and Ireland too.
This would be the fairest thing for the citizens of these countries. The alternative is for the periphery country “man in the street” to trudge along with a huge millstone around his neck for decades to come — a millstone fashioned and placed there by the banks.
Still, though, Europe’s politicians are afraid to even whisper of default because of contagion risk.
As French Finance Minister Lagarde says, “You can’t stroke an elephant just a little bit.” If the reality sinks in that Greece is going under, investors will immediately quantify their worst-case scenario projections of Portugal and Ireland doing the same thing. A brushfire of fear could then ignite an even bigger horror show possibility: Forced default from a major country like Spain.
Under the wrong circumstances, all of this could unfold with a rapidity and ferocity to match the aftermath of the Lehman Brothers bankruptcy in fall 2008. And it remains unclear how such an endgame might be successfully avoided.
In the medium term, this crisis reality is very bullish for the dollar. That is why yours truly has been warning of a U.S. dollar resurgence, and why we took action in Macro Trader in recent weeks regarding bullish USD and bearish commodity-related positions.
As we have said before, it’s “look out below” for commodities right now. One painful way to solve Europe’s “divergent growth” problem would be a sharp slowdown in the global economy as risk assets face a massive unwinding, dollar permabears get caught in a vicious short squeeze, and commodity prices fall through the floor.
When too many people expect one thing to happen, it is often another thing that happens. A dramatic shift back toward crisis awareness in the eurozone could bring about such a reversal of fortune now.
Questions, thoughts, comments? How would you solve Europe’s problems? Are you taking defensive action in your own portfolio from a potential dollar surge? Comments and questions welcomed: firstname.lastname@example.org.