The euro

Beware of falling masonry

The crisis in the euro area is turning into a panic and dragging the zone into recession. The risk that the currency disintegrates within weeks is alarmingly high

Nov 26th 2011
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FIRST Greece; then Ireland and Portugal; then Italy and Spain. Month by month, the crisis in the euro area has crept from the vulnerable periphery of the currency zone towards its core, helped by denial, misdiagnosis and procrastination by the euro-zone’s policymakers. Recently Belgian and French government bonds have been in the financial markets’ bad books. Investors are even sniffy about German bonds: an auction of ten-year Bunds on November 23rd shifted only €3.6 billion-worth ($4.8 billion) of the €6 billion-worth on offer..

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Worse, there are signs that the euro zone’s economy is heading for recession, if it is not there already. Industrial orders in the euro zone fell by 6.4% in September, the steepest decline since the dark days of December 2008. A closely watched index of euro-zone sentiment, based on surveys of purchasing managers in manufacturing and services, is also signalling contraction, with a reading of 47.2: anything below 50 suggests activity is shrinking. The European Commission’s index of consumer confidence fell in November for the fifth month in a row.

The German government can probably shrug off a failed auction: it likes to price its bonds as richly as it can, and occasionally cannot sell all it would like, even in untroubled times. Still, the timing is awful, and other governments are not so lucky: the contrast between Germany’s borrowing costs and those of other euro-zone sovereigns is stark (see chart 1). European banks are dumping the bonds of the least creditworthy, and other assets, in an attempt to conserve capital and improve cashflow as a full-blown funding crisis looms. Governments are promising ever more severe budget cuts in the hope of pacifying bond markets. The direct result of these scrambles is a credit crunch and a squeeze on aggregate demand that is forcing Europe into recession. Add the indirect effects on the confidence of consumers and businesses, and the downturn will be deep.

A recipe for recession

Consider the three ingredients for recession: a credit crunch, tighter fiscal policy and a dearth of confidence. In aggregate, European banks’ loans exceed their deposits, so they rely on wholesale funds—short-term bills, longer-term bonds or loans from other banks—to bridge the gap. But investors are becoming warier of lending to banks that have euro-zone bonds on their books and that can no longer rely on the backing of governments with borrowing troubles of their own. Long-term bond issues have become scarce and American money-market funds, hitherto buyers of short-term bank bills, are running scared.
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Banks are frantically shedding assets both to raise cash and to ration their capital in order to meet European Union minimum capital-adequacy targets by next June. The early victims of this deleveraging are borrowers in emerging markets. The euro zone’s eastern neighbours may be hit particularly hard: the Turkish lira, for instance, has come under pressure in the past week, a hint that money is flowing out. The repatriation of funds by euro-zone banks might explain why the euro has been remarkably stable against the dollar in recent weeks, despite the zone’s internal convulsions. But businesses and householders at home will also soon be hurt by scarcer credit and rising interest rates, as the banks’ higher funding costs are passed on.
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Governments are cutting back too. The precise impact of next year’s belt-tightening is tricky to gauge. France’s budget plans are close to being agreed on; further cuts are likely but will be delayed until after the elections in spring. Italy has yet to vote through a much-revised package of cuts. Spain’s incoming government has promised further spending cuts, especially in regional outlays, in order to meet deficit targets agreed with Brussels.
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Even so, it seems plain that fiscal tightening will weaken growth. Take the plans that countries presented to the European Commission and add what has been advertised since, and the squeeze across the euro area comes to around 1.25% of GDP next year, reckons Laurence Boone, chief European economist at Bank of America. That alone is enough, says Ms Boone, to chop around a percentage point off GDP growth in 2012.
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Germany will be the least affected of the zone’s four biggest economies, followed by France. Spain and Italy will be hurt most.

The euro zone’s businesses and consumers will be drawn into the downward spiral of confidence. In the autumn of 2008 companies learned that credit lines could not be relied on when banks were fighting for survival.
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Then banks are short of liquidity, firms have to watch their own cashflow closely. That implies leaner stocks and reductions in discretionary spending, such as capital projects or advertising campaigns.

September’s sharp decline in industrial orders is an early sign that companies are cutting back. Andreas Willi, head of capital-goods research at JPMorgan, notes that SKF, a Swedish firm that is the world’s largest maker of ball bearings and a bellwether of industrial demand, gave analysts a cautious assessment of its future revenues in mid-October. That guidance suggests a further softening of investment demand. Consumers are also likely to defer big purchases as long as the crisis is unresolved and credit is scarce.
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A drop in demand for capital equipment, durable consumer goods and cars will strike at the euro zone’s industrial heartland, including Germany. Ms Boone reckons GDP will fall by around 0.5% in Germany next year and by the same amount in the whole zone. In September the IMF forecast that the zone’s GDP would grow by 1.1% in 2012 but estimated that if European banks were deleveraging quickly (as they are now), the economy could shrink by around 2%.
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Breaking point
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A downturn of such severity will hugely increase the pressures within the zone. Investors will be even less willing to finance banks, as more garden-variety loans to businesses and householders turn bad. As unemployment rises, tax receipts will go down and welfare payments up, making it harder for governments to rein in their deficits and hit the targets they have set, and causing bond markets to question their solvency more pointedly still.
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In such circumstances, the chances of a policy error or broader panic increase sharply. The calculations of bond investors, bank depositors and politicians are prone to sudden change. Hopes that the fracture of the euro zone might be averted by far-sighted policymakers could give way to a belief that it is inevitable. Such beliefs, once they take hold, are likely to be self-fulfilling.
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How? The drying-up of funding for sovereigns and for banks is a threat to the integrity of the euro, because of the stark divide between debtor and creditor countries within the zone. As late as March 2010, Jean-Claude Trichet, then head of the ECB, boasted that simply belonging to the euro area automatically ensured balance-of-payments financing. It doesn’t look that way now.
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During the credit boom, cheap capital flowed into Greece, Ireland, Portugal and Spain to finance trade deficits and housing booms. As a result, the net foreign liabilitieswhat businesses, householders and government owe to foreigners, less the foreign assets they own—of all four are close to 100% of GDP. (By comparison, America’s net foreign liabilities are 17% of GDP.) Much of their debt is being financed by local bank borrowing or bonds sold to investors in creditor countries, such as Germany. Ireland is unusual in that a large chunk of what it owes is in the form of equity (all those American-owned factories and offices) and so does not need to be refinanced.

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With a few exceptions, the benchmark cost of credit in each euro-zone country is related to the balance of its international debts. Germany, which is owed more than it owes, still has low bond yields; Greece, which is heavily in debt to foreigners, has a high cost of borrowing (see chart 2). Portugal, Greece and (to a lesser extent) Spain still have big current-account deficits, and so are still adding to their already high foreign liabilities. Refinancing these is becoming harder and putting strain on local banks and credit availability.
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The higher the cost of funding becomes, the more money flows out to foreigners to service these debts. This is why the issue of national solvency goes beyond what governments owe. The euro zone is showing the symptoms of an internal balance-of-payments crisis, with self-fulfilling runs on countries, because at bottom that is the nature of its troubles. And such crises put extraordinary pressure on exchange-rate pegs, no matter how permanent policymakers claim them to be.
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One of the initial attractions of euro membership for peripheral countriesaccess to cheap fundsno longer applies. If a messy default is forced upon a euro-zone country, it might be tempted to reinvent its own currency. Indeed, it may have little option.
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That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social unrest, high borrowing costs and banking chaos seem likely either way.
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The prospect that one country might break its ties to the euro, voluntarily or not, would cause widespread bank runs in other weak economies. Depositors would rush to get their savings out of the country to pre-empt a forced conversion to a new, weaker currency. Governments would have to impose limits on bank withdrawals or close banks temporarily.
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Capital controls and even travel restrictions would be needed to stanch the bleeding of money from the economy. Such restrictions would slow the circulation of money around the economy, deepening the recession.
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External sources of credit would dry up because foreign investors, banks and companies would fear that their money would be trapped. A government cut off from capital-market funding would need to find other ways of bridging the gap between tax receipts and public spending. It might meet part of its obligations, including public-sector wages, by issuing small-denomination IOUs that could in turn be used to buy goods and pay bills.
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When cash is scarce, such scrip is readily accepted by tradesmen. In August 2001 the Argentine province of Buenos Aires issued $90m of small bills, known as patacones, to employees as part of their pay. The bills were soon circulating freely: McDonalds even offered a “Patacombomenu in exchange for a $5 pata c ón. Argentina broke its supposedly irrevocable currency peg to the dollar a few months later.
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Scrip of this kind becomes, in effect, a proto-currency. In a stricken euro-zone country, it would change hands at a discount to the remaining euros in circulation, foreshadowing the devaluation to come. To pre-empt further capital outflows, a government would have to pass a law swiftly to say all financial dealings would henceforth be carried out in a new currency, at a one-for-one exchange rate with the euro. The new currency would then float” (ie, sink) to a lower level against the abandoned euro. The size of that devaluation would be the extent of the country’s effective default against its creditors.
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Market gurus and other students of misaligned stock, bond or home prices often say that although it is easy to spot an asset-price bubble, it is impossible to know the event that finally pricks it. In much the same way, the likeliest trigger for a disintegration of the euro is unknowable. But there are plenty of candidates. One is a failed bond auction that forces a country into default and sends a shock wave through the European banking system. Italy has €33 billion of debt coming due in the final week of January and a further €48 billion in the last week of February (see chart 3). Since bond investors are turning their noses up even at offerings from thrifty Germany, the odds against Italy’s being able to raise the money it needs early next year are uncomfortably short.
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Another danger is a disagreement between Greece and its trio of rescuers (the EU, the IMF and the ECB) over the conditions of its bail-out. The risk of a mishap will be greater after the Greek elections in February if the country’s political mood sours yet further. Perhaps the spark will come from another source: the bankruptcy of a bank; fresh trouble in Portugal; or a chain of events that starts with France losing its AAA rating and ends with runs on banks across Europe. The exposure of French banks to Italy and to other countries that have been in bond traders’ sights for longer implies that contagion would quickly spread to the euro’s core (see chart 4). Widespread defaults in the periphery would wipe out a big chunk of Germany’s wealth and begin a chain of bank failures that could turn recession into depression.
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The few left in the euro (Germany and perhaps a few other creditor countries) would be at a competitive disadvantage to the new cheaper currencies on their doorstep. As well as imposing capital controls, countries might retreat towards autarky, by raising retaliatory tariffs. The survival of the European single market and of the EU itself would then be under threat.
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Such a disaster can still be averted. The ECB might launch a programme of bond-buying on the pretext that a deep recession in the euro area threatens deflation. If done on the scale that the Bank of England has undertaken, it could restore stability to Europe’s panicky bond markets. If bond purchases were made in proportion to the size of each euro member’s economy, that might go some way to overcoming German misgivings that the central bank was being used to provide favourable financing to profligate countries.
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Such action by the ECB is an essential short-term palliative. But any lasting stability for the euro must lie with governments, particularly in the degree to which they are willing to give up fiscal sovereignty in return for pooling liabilities. Germany stands firmly at one extreme of this debate.
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Its chancellor, Angela Merkel, wants big changes to force probity (and wants the EU summit on December 9th to focus on such rule changes), but has opposed the idea of jointly guaranteedEurobonds”. German officials have argued that any open-ended commitment to joint liabilities would encourage errant governments to profligacy, violate Germany’s constitution and raise its borrowing costs. Even now, the head of the Bundesbank, Jens Weidmann, appears to believe that the imposition of fiscal rigour will be enough to restore calm to Europe’s bond markets.
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Hanging together
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Others think that circumstances demand speedier concentration on ways to pool liabilities. On November 23rd the European Commission laid out three approaches for issuing Eurobonds, two of which imply mutual guarantees.

.Another new proposal is intriguingthanks, in part, to its provenance. Germany’s Council of Economic Experts recently proposed a “European Redemption Pact”. This scheme would place the debt, in excess of 60% of GDP, of all euro-zone governments not already in IMF rescue plans into a jointly guaranteed fund that would be paid off over 25 years.
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Modelled in part on the federal government’s assumption of the debt of America’s states begun by Alexander Hamilton in 1790, the fund would provide joint liability for these debts under strict conditions. These would require euro-zone countries to introduce debt brakes into their constitutions, like the one Germany and Spain already have; give priority to paying off the mutualised bonds; set aside a specific tax revenue to do so; and pledge foreign-exchange reserves as collateral.
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At its peak, the redemption pact would be huge: the joint liability would amount to €2.3 trillion. But it would technically be temporary. For all these safeguards, Germany’s government has so far poured cold water on the idea. But time is running out. And the scale of the impending catastrophe demands radical answers.


Italy can save itself and the euro

Martin Feldstein

November 30, 2011


The euro currency may soon collapse even though there is no fundamental reason for it to fail. Everything depends on Italy, because financial markets now fear that it may be insolvent. If the Italian government has to continue paying a seven or even eight per cent interest rate to finance its debt, the country’s total debt will grow faster than its annual output and therefore faster than its ability to service that debt. If investors expect that to persist, they will stop lending to Italy. At that point, it will be forced to leave the euro. And if it does, the value of the “new lira” will reduce the price of Italian goods in general and Italian exports in particular. The resulting competitive pressure could then force France to leave the euro as well, bringing the monetary union to an end.
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But this need not happen. Italy can save both its own economic sovereignty and the euro if it acts decisively and quickly to convince the financial markets that it will balance its budget and increase its rate of economic growth so that the ratio of its public debt to its gross domestic product will decline in a steady and predictable way. If markets have confidence in that, Italy’s interest rate could decline to the four per cent that it paid before the crisis began.
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Italy is in a good position to achieve this. It already has a “primary budget surplus”, with tax revenues exceeding total non-interest government outlays. It can eliminate its small overall budget deficit if it cuts spending and raises revenue by a total of just three per cent of its GDP – an amount not impossible to find in a public budget that now equals 50 per cent of GDP.
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The country also has a positive growth rate of about one per cent per year. If reforms to strengthen incentives and reduce regulatory impediments raise that growth rate to two per cent, that together with a long-term balanced budget would cause Italy’s public debt to decline from today’s 120 per cent of GDP to about 65 per cent over the next 15 years. That is similar to what happened in the US after the second world war when a combination of a balanced budgets, 2.3 per cent growth and 3.3 per cent inflation brought the debt to GDP ratio from 109 per cent in 1946 to 46 per cent in 1960.)
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Italy’s situation is totally different from Greece’s. The latter has a budget deficit of nine per cent of GDP and its real GDP is declining at seven per cent, driving its debt from 150 per cent of GDP today to 170 per cent after just one year. The over-valued exchange rate results in a current account deficit of ten per cent of its GDP. Greece would be better off if it abandons the euro, devalues its new currency, and defaults on its debt.
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A decision by Athens to leave the euro and default could cause a run on the euro and on Italian debt in particular. That’s why it is so important for Italy to stress that its conditions are totally different from those in Greece, and that its new policies will soon produce budget balance and a declining ratio of debt to GDP.
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Italy can do all of this itself. It does not need assistance from Frankfurt, Brussels, or Washington. The proposed policies for help from the European Central Bank, the European Commission, and the International Monetary Fund would ultimately weaken Italy and undermine its economic independence.
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There are strong voices, including the French government, calling for the ECB to buy the sovereign debt of Italy and other countries in order to keep the level of their interest rates within about 200 basis points of the rate on German bonds and therefore low enough to avoid an automatic rise in their debt to GDP ratios. But this would violate the “no bail-out provision of the Maastricht treaty, put Germany at risk if any countries are eventually forced to default, cause an explosive inflationary supply of euros, and remove any market feedback about whether Italy and other governments have done enough to control future deficits.

In exchange for supporting the debt of these countries, the ECB or the EC would have to be able to veto national budget decisions. Italy, like Greece today, would become an economic vassal of Germany.
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After the clear failure to expand the European Financial Stability Facility from €400bn euros to the thousands of billions needed to backstop borrowing by Italy and Spain, the EC recently proposed an alternative policy of creating stability bonds. Every EMU country would be able to issue these ‘eurobonds’ that would be guaranteed by all 17 eurozone members. This would only be feasible if the national budgets were subject to control by the EC, which would be dominated by Germany as the primary guarantor of the new bonds.
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The IMF in turn has suggested that it create a fund that would lend to troubled eurozone members and perhaps be used to put a cap on their interest rates. This fund would be financed by loans from the ECB, thus deftly circumventing the Maastricht treaty’s rules against bail-outs and against buying new bonds issued by member governments. Under this plan, some combination of the IMF and the EC would have to control the budgets of the borrowing nations.

Any of these proposed programmes would create new conflicts within Europe as borrower governments are forced to relinquish their ability to set their own national tax and spending policies.

Moreover, what would start as EC limits on fiscal irresponsibility could evolve into limits designed to prevent trade advantages. Ireland’s low corporate tax rate would be an obvious target for its eurozone competitors. The riots and political upheavals in Greece are a symptom of what would happen more generally if the Brussels bureaucracy and the German Chancellor came to dominate national economic policies.

Fortunately, none of this is necessary if Italy now acts forcefully to create budget and growth conditions that imply sustainable debt outcomes. But impatience and scepticism in financial markets may cause a deeper financial crisis before Italy has time to prove itself.
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The writer is professor of economics at Harvard University and former chairman of the Council of Economic Advisers and president Ronald Reagan’s chief economic adviser.


The Currency War Big Picture Analysis for Gold, Silver & Stocks

November 30th, 2011 at 8:57 pm



I think you will admit that we are in the middle of one major crazy financial mess. The part that makes things really crazy is that it’s not just in the United States anymore but rather serious global problem which if not handled properly could change the way we live our lives going forward or possibly even spark some type of war, hopefully things don’t get that crazy. But I do know one thing. Fear is the most powerful force on the planet and people do some crazy things when they are backed into a corner.
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Anyways, on a more positive tone today China decided to help provide more liquidity for the financial system along with the central banks. This news triggered a monster rally in overnight trading making the market gap up sharply at the opening bell. This news did hit the US dollar index hard sending it sharply lower but the question remainsWill today’s news be a one week hiccup in the market?” If Euroland starts printing money it will likely send the dollar higher and stocks lower for 6- 12 months.
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Just today I was joking with Kerry Lutz of the Financial Survivor Network about how each country should just give each other country a second chance. Wipe the debt clean and start over knowing this time around exactly how each country truly operates at a financial level allowing everyone to avoid a repeat of this BS. Some countries will get off way better than others because they would get so much dept wiped clean but isn’t it better than years of problems and possibly wars over food, gold, guns, oil and Canadian water? – EH
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All joking aside, let’s take a look at the weekly long term charts.
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Dollar Index Showing Possible Massive Rally If Euro Starts Printing Money:

I’m sure my off the cuff options/thoughts will cause a stir but I am fine with that. Everyone I talk to is thinking the dollar is about to fall off a cliff while I think it’s very possible that it does just the opposite. Either way I will be looking to benefit from which ever move unfolds.
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Weekly Gold Chart:



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Weekly Silver Chart:

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Weekly SP500 Chart:

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Long Term Thoughts:

I would first like to say that tonight’s report is out of my norm. Generally I do not focus on the big picture negative stuff and I like to avoid it for a few reasons. One, it’s just downright depressing to talk and think about. And Second I don’t want to be labelled as one of thoseThe Sky Is Falling kinds of guys.
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So, that being said I think these charts above show a situation what is very possible to happen in the coming 6-12 months. Keep in mind that my focus is on short term time frames as it allows me to avoid and actually profit from major market moves while providing enough information for my followers to learn technical analysis and trade management. And the obvious idea of not looking too far into the future with a negative outlook.

With headline risk changing the market direction on a weekly basis, this negative outlook could easily change in a couple months. I will recap on the big picture as things unfold in January/February.

Talk to you soon,
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Chris Vermeulen