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Europe’s Turn Again

by John Rubino on March 10, 2011 · 16 comments

Europe has been pretty quiet lately. But apparently that was an illusion. The Eurozone’s slide down the slippery slope continues, but because the current stage involves colorless bureaucrats debating the terms of debt swaps rather than street riots and air strikes, it has been overshadowed by the chaos in the Middle East.

That’s about to change, as the flaws in the design of the common currency system really start to bite. As Telegraph’s Ambrose Evans-Pritchard reports:

EU paralysis drives fresh bond rout

Portugal edged closer to the brink yesterday, having to pay almost 6pc to raise two-year debt. The yield on 10-year bonds briefly surged to 7.8pc after the Chinese rating agency Dagong downgraded the country’s debt to BBB+.

“These levels of interest rates are not sustainable over time,” said Carlos Costa Pina, secretary of the Portuguese Treasury, blaming the latest upset on the lack of a coherent EU debt strategy rather any failing by Portugal to deliver on austerity.

Mr Costa Pina rebuffed calls by leading economists in Portugal for an EU-IMF bail-out rather than drawing out the agony. “It is not justified. Portugal doesn’t need external help, it needs urgent measures by the EU to restore market confidence.”

David Owen from Jefferies Fixed Income said last week’s shock move by the ECB to pre-announce rate rises had tightened credit and effectively doomed the country. “The ECB by its actions has made it inevitable that Portugal will need a bail-out. There are parallels with the actions of the Bundesbank during the ERM crisis in 1992,” he said.

Mr Owen said the ECB is playing brinkmanship with EU leaders, pressuring them to come up with a grand solution to the debt crisis at summits this month. It is a dangerous game. “Spain is not yet safe. It has €2.5 trillion of combined household and company debt. That is an awful lot,” he said

There is no sign yet that Germany, Holland, and Finland will agree to expand the remit of the bail-out fund (EFSF), letting it buy the bonds of debtor states pre-emptively, or lend to these countries so that they can buy back their own debt in a “soft-restructuring”.

If anything, the mood is hardening in Germany. The regional Länder have begun to demand a say over any EFSF deal. Hesse’s justice minister Jörg-Uwe Hahn said he “categorically rejects” all moves to an EU ‘Transferunion’, debt pool, or fiscal fusion.

The three blocs of Chancellor Angela Merkel’s Bundestag coalition have written a paper instructing her to resist any concessions on a debt union. She has little leeway anyway since the long-awaited ruling of Germany’s constitutional court on the legality of the EU rescue machinery hangs like a Sword of Damocles.

“The EU will do too little, too late: the markets will dictate the solution,” said Louis Gargour from LNG Capital, speaking at a Euromoney bond forum. He said Greece is already in the grip of an unstoppable debt spiral, spending 14.3pc of tax revenue on interest costs. He expects 50pc ‘haircuts’ on the debt, perhaps along the lines of the Brady Plan following Latin America’s debt crisis.

The Greek crisis is going to from bad to worse. Ten-year yields spiked to 12.78pc yesterday and unemployment jumped sharply to 14.8pc in December, a reminder that the social trauma of austerity has yet to hit.

Greece is undergoing the harshest fiscal squeeze ever tried by a modern Western economy, yet public debt will end above 150pc of GDP by 2013 even if it complies with EU-IMF terms. “We should default and return to the Drachma to punish foreign loan sharks who have bled us dry,” said Avriani, a paper linked to the ruling PASOK party.

There was similar anger in Ireland yesterday where Socialist MP Joe Higgins denounced “the poisonous cocktail of austerity concocted by the witchdoctors in Brussels and in Frankfurt”.

Premier Enda Kenny said Ireland was at “the darkest hour before the dawn.” He has so far played down talk of a clash with Germany over the terms if Ireland’s bail-out, but Irish politics may force him to default on senior bank debt if the EU refuses to yield.

George Magnus from UBS said EU leaders are living in a “parallel universe”, unable see that the festering EU debt crisis cannot be resolved without going to the root cause and recapitalising the banks.

Peripheral EMU will remain trapped in deep slump without debt forgiveness but the EU cannot do this until lenders are strong enough to absorb the losses. “The sequencing of this has to start with the banks, otherwise there will be fears of another Lehman. The EU and IMF are in denial about everything we have learned over history.”

“The US banks raised $200bn of common equity in six weeks and that proved to be a turning point. If the EU does that, the crisis goes away,” he said.

Olli Rehn, the EU economics commissioner, has been pleading for a policy shift to lessen the burden on debt-stricken states, including a cut in the punitive interest cost imposed on Ireland.

However, EU leaders have the final say on the terms of the rescue machinery, and they are answering to their own angry electorates. The eurozone remains a collection of sovereign states. That is the nub of the matter.


Some thoughts:

It looks like the Eurozone made a huge mistake in not kicking Greece out of the system the minute it failed to meet the zone’s debt and deficit targets. This would have established that the rules matter. If a country wants the benefits of a strong common currency, it has to manage its finances responsibly. In the same way that expelling a disruptive student from a classroom changes the behavior of the remaining kids, the other PIIGS countries would have immediately begun making the hard cultural and financial choices necessary to live in a (relatively) sound money world.

But by bailing out Greece, Europe instead sent the message that soaring government spending and double-digit deficits will be rewarded with massive loans. This allowed the other weak economies (Ireland being the notable, admirable exception) to put off the hard adjustments — which soured German voters on further bailouts, making help on an effective scale a tough, if not impossible sale.

Now, with inflation rising, the European Central Bank has been forced to promise to raise interest rates, which traps the PIIGS countries between two destructive forces: rising interest rates (prospective from the ECB and immediate in the bond markets) and the inability of German leadership to deliver a trillion-euro bailout.

The result is a feedback loop of deteriorating finances leading to credit downgrades leading to higher bond yields leading to further deteriorating finances, until at some point everything falls apart.

We may not be far from that point, when the bond markets demand unmanageably high rates on new Portuguese or Spanish bonds, one or both threaten to default, and German voters call their bluff. What happens then is anybody’s guess.


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  • Too Big to Jail

    The ECB will buy PIIGS bonds with printed money.

    They & the Fed, have done it before, so they’ll do it again.

    Unless I missed something, they’ll print until the Euro is toilet paper.

    Bet the house on it.

  • Agent P

    Too Big to Jail –

    Indeed, when the consequences (primarily, social unrest) are weighed against the begrudging task of re-liquifying neighboring economic deadbeats, the Hobson’s choice becomes all the easier. Especially when the Eurozone has a front-row, center section view of the social unrest maelstrom going on just south of the Mediterranean.

  • Lowell L Morse

    Looks like the “Tower of Babal” will fail again.

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  • James Woroble Jr

    New global reserve currency. The ‘SPLATY’

    Analogous to two pilots of a destroyed aircraft, plummeting to the ground, passing a single chute back and forth to convince everyone below, all is well — oblivious to having passed a point in altitude where neither will have the time required to put it on.


  • paper is poverty

    I think it was Greece that made the huge mistake in not leaving the Eurozone a year ago. It seems to me they would benefit from a much weaker currency and growth in domestic production and exports. But instead they’ve played along with the IMF, impoverishing their people in order to buy time for an international financial system which is doomed anyway. Ireland did something similar in rushing to put in place bank guarantees / bailouts, then imposing harsh austerity on its public. “Screw the people, save the banks” is the motto. Perhaps the analogy to schoolchildren is apt, since these countries are behaving like timid children instead of like sovereign nations who have every right to wield their own monetary policy. The Euro was always a bad idea, bound to create not less strife among European nations but more strife, as the compromise in economic policies winds up being right for no nation, but wrong for all.

    Anyway, there is no possible scenario in which Greece and Ireland (and others) do not default. The only question is whether it’s going to take austerity, poverty, civil unrest, and political revolution before the repudiation comes. Best to get it over with now while there might (might) still be some sort of capital left in the country, and before production has been shut down by austerity. The EU can’t forgive debts until the banking system is stronger? Screw the banking system; it’s not up to them.

  • Black Water

    To Lowell L Morse ; The Tower of Babel will come after the complete crash of the financial system. The “elite” try’s to gain “Order by creating chaos”, this is all planned…and the only thing for the ECB as well as The Fed is to postpone a global economic death now and delay it for maybe one or two years (we ‘re already in this mess for almost 3 years, so …..) …RIP

  • Bruce C.

    I agree with paper is poverty, et al.

    Here are some more thoughts:

    The truest sentence in the whole piece is: “The EU will do too little, too late: the markets will dictate the solution.” Politicians are cellularly incapable of acting (vs just talking and hand wringing) before a crisis, which I believe is occurring in the US as well. Ironically, though, a market “solution” is probably better than anything the politicians/bureaucrats could come up with.

    The least true sentence in this article is: “The US banks raised $200bn of common equity in six weeks and that proved to be a turning point. If the EU does that, the crisis goes away,” Amazingly, they just don’t get it. The PIIGs are creating more debt by the day despite the already unsustainable austerity programs and policies. For example, as the article states, “Greece is undergoing the harshest fiscal squeeze ever tried by a modern Western economy, yet public debt will end above 150pc of GDP by 2013 even if it complies with EU-IMF terms.”

    Perhaps only those not so emotionally and intellectually invested in the fate of the euro can face the fact that outright defaults by all of the PIIGs are inevitable (OR, that they will be monetized by the ECB, which will crash the euro in that way. Pick your poison.)

    For those of you who may be wondering why the inflation-deflation debate still rages despite all the evidence of price inflation throughout the global economy, consider the fact that the global “debt bubble” still hasn’t yet burst. It could have back in 2008, but the Fed and the US Congress didn’t let it go. It was stopped before it really got started and every effort is being expended by all the CBs to keep it inflated. That is why we currently see price inflation. However, it cannot be sustained indefinitely. Even the coveted “economic growth” solution won’t do it. Just like Greece, the whole world is beyond the point of no return in terms of uncontrollable debt creation. The US budget deficit is a case in point, never mind Japan. Either direct or indirect (i.e., currency value implosion) default is the only possibility now. It is just a question of when.

    In the meantime, I suspect the dollar index will bounce back up for a while, for several reasons. Their is more “bearishness” against the dollar now than in 2009, Japan needs to desperately lower the yen now, and the euro is about to take a bath as Europe capitulates. Ironically, if Treasury rates drop from here you can forget about any serious progress on the US spending cuts. They’ll use that as a sign that such things can wait until after the 2012 election. Incredible. Not that it would matter in the long run, I’m afraid, but if there is any country that could possibly pull back from the brink it’s the US, but not at the rate things are going politically.

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  • Speedy Gonzales

    We gangs gonna git you white peeps!

  • Brad Thrasher

    It certainly would appear that supply is about to significantly exceed demand Bill Gross has reduced PTTAX fund holdings of U.S. Treasuries to zero. Jim Jubak reports at Smart Money that the Federal Reserve QE2 ends in June. Who will step in to buy 70% of Treasuries when/if the Fed really does sit silent at the auctions?

    The Japanese will be selling assets and issuing even more debt to rebuild as they dig out from the triple hit they are still taking. The quake, the tsunami’s and the reactor meltdowns. There are no words.

    The Europeans are about to discover this isn’t a seller’s market. The supply of debt instruments is increasing as the demand for debt is decreasing.

    Anyone with thoughts as to how we might profit from the obvious?

    • Bruce C.

      Hi Thrash.

      The most obvious speculative theme concerns interest rates, that they should be going up to entice investors to lend (i.e., buy bonds), so it might seem obvious to just buy leveraged inverse ETFs like TBT and TMV, which short the 20+ and 30-year Treasuries, respectively.

      However, I don’t know if it’s as simple as that, but it may be. I say this because in the midst of all the debt issuance there is also a lot of debt destruction – the old inflation-deflation paradox. Thus net-net there may not be as much debt growth as you seem to think. Another way to say it is that the transference of private debt to public debt is still going on. When the proceeds of Treasury sales are used to benefit the banks and corporations – which is what government spending amounts to – then its a form of stealth taxation/wealth transference.

      Just look at today’s market behavior (March 15). Insurance and re-insurance companies, along with hedge funds, are selling “assets” to raise cash to backstop Japan, and that cash is used to buy bonds. So stocks are dropping and Treasuries are rising, thus Treasury rates are dropping. (Bill Gross missed an opportunity to sell Pimco’s on a rally, but that’s the way it goes.) Despite all the incredibly inane claptrap about the Japan rebuild being a boon, it is actually another deflationary step down. When the reconstruction dust settles Japan will simply be essentially back to the way it was on March 10 or so but the global financial system will have more debt. Net-net it’s a loss, though some groups will benefit on a relative basis.

      That said, there are far more people predicting higher interest rates ahead than not (like Bill Gross, Jim Sinclair, Jim Richards, and Porter Stansberry). There are also the ongoing currency devaluations by the central banks, and the rising interest rates in the developing countries, and the “obvious” end to the 30 year long bull market in Treasuries. On the other hand, if you look down in the trenches where I live, people are running out of money/income in droves. I posted an apartment on Craig’s list on March 7 at a rent rate that was 20% lower than any other unit in the complex and got one response. I checked Craig’s list this morning and there are now – just a week later – about 15 others at rates lower than mine. I think everyone collectively yet privately are freaking out.

      It’s a weird dilemma. The only way to get people to borrow is to make it cheap enough (i.e., lower interest rates) but the only way to get people to lend is to make it profitable enough (i.e., raise interest rates.) So who is going to win that battle? Will the equilibrium point be higher or lower than where we are now? I don’t know yet.

      Smiley face.

  • Brad Thrasher

    Hey Bruce C.,

    Certainly have second hand on the ground confirmation of your Florida? rental experience. Here in SoCal a relative (young couple) just announced moving from a 2bd 1 bth $1350 per mth condo 30 miles east of L.A. into a 3bd 1 & 3/4’s bth 50 miles east and 4000 feet above L.A for $750 per month. Net gain cash in pocket $600 per month plus a bdrm and 3/4 bth. Not much need for air conditioning up on the mountain which should offset filling gas tank a time or two per month.

    You are so right about the paper money boys I mean bond markets. Could be simple or could be like the hot girl who says yes and before you know it she changed her mind and you’re left holding the bill, er bond :)

    Type : then ) no space between the colon and end bracket = smiley face.

    All the best,

  • Niklaus101

    “The EU can’t forgive debts until the banking system is stronger? Screw the banking system; it’s not up to them.”

    Well said

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