A great editor once told me that big stories don’t break, they ooze. The demise of the Euro – the common currency used by 17 of the 27 countries in the European Union – is just such a story. And each time it oozes, U.S. stock markets drop. The collapse of the Euro, one way or another, is now inevitable, in my view. When it happens, banks around the world will be shaken and stock markets will plummet. Smart investors should be braced for this — and also prepared to take advantage of bargains created by any selloff.
This past week, a new spate of rumors of a Greek default made the rounds. And the top German official at the European Central Bank resigned unexpectedly. As a result, the Dow ended last week down more than 600 points from its level eight days earlier, when Greece’s situation looked momentarily better.
Academics, journalists and even government officials have proposed a variety of schemes to save the Euro – new European financial institutions, Eurobonds backed by all the countries collectively and even a United States of Europe. But it’s clear that any such scheme to save the Euro will find little political support today. The breakup will probably be extremely painful. But the alternatives would be even more unpalatable.
To understand why, one has to look at why European countries went into the Euro in the first place. Put aside professions of solidarity and high-minded blather about Europe whole and free. The Euro came into existence because it helped to meet a variety of needs for a variety of countries. Yes, a common currency made trade easier and eliminated some unnecessary transaction costs. And yes, it was part of an admirable trend toward interdependence, co-operation and freedom of movement in Europe. But mostly, it was a way to solve practical problems.
Countries such as Portugal, Ireland and Greece, for example, got to borrow large amounts of money at low interest rates to finance development. France got to preserve its highly centralized system by foisting bureaucracy on its economic rivals.
Germany might seem to be the good European in this whole affair, having given up its stable Deutsche Mark for the sake of continental unity and then paying a disproportionate share of the costs whenever things go wrong. But it too was primarily motivated by economic logic. Germany and a few other Northern European countries, such as the Netherlands, are hugely successful exporters. For them, keeping unemployment rates low requires steady export sales – and that’s very difficult if their currencies appreciate. (Indeed, just this past week, Switzerland had to put a ceiling on the value of the Swiss franc because Swiss products were becoming too expensive for foreigners.)
Germany’s clever solution was to tie itself to weaker economies through the Euro, which prevented the currency from appreciating too much. In effect, Germany was subsidizing Italian, Spanish and Greek consumers so that they could buy expensive German products, thereby preventing layoffs at German manufacturing firms. This made great sense as long as the cost of propping up weaker economies wasn’t too big. But now, Germany is facing the prospect of huge, open-ended payouts that will greatly exceed the economic benefits.
Meanwhile, other Eurozone countries also may feel that the Euro has gone from a blessing to a burden, but for different reasons. Greece and Italy are being asked to make horrific spending cuts. France and Germany have even suggested that all 17 Eurozone countries should adopt a balanced-budget amendment – a notion sometimes described as insane or fanatical in this country when proposed by the Tea Party.
The fact is, neither the strong nor the weak benefit anymore from a common currency. But as the old song goes, breaking up is hard to do. As I see it, there are four possible ways this can play out, one far more likely than the others.
- The current policy just continues. This will happen in the short run, of course, but simply can’t be sustained for long. When debt reaches a certain size, it essentially becomes impossible to repay. Greece has probably reached that point already, and Spain and Italy may be heading there. Germany is baulking at ongoing bailouts, and at some point wouldn’t be able to finance them even if it were willing.
- A unified European financial system is created. Unification is the only real long-term solution that would enable the Eurozone to hold together. But it would mean that countries such as Greece, Italy and Spain would have to take orders in financial matters from Germany. And ultimately it would require that countries such as France submerge their national identities in a European superstate. Germany was willing to pay almost without limit to incorporate East Germany after reunification. But local loyalties in Europe are still stronger than any common continental identity. I rate this outcome as highly unlikely.
- The strong countries expel Greece and other weak countries from the Eurozone. This is the most likely scenario, I’m afraid. In it, the stronger Eurozone countries bail out the weaker ones grudgingly, calling for brutal spending cuts, until resistance on one side or the other forces a default. At that point, the defaulters would probably be expelled from the Eurozone. Such an outcome would present several problems. The defaulter would have lousy credit – and therefore high borrowing costs – for a decade. And since the defaulter’s debts would still be denominated in Euros, there would be little relief. The rich European countries would bear much of the financial burden, either by paying the costs of a restructuring or by bailing out banks all over Europe that hold the debt. As unattractive as the results would be, this remains the most likely scenario, because it requires the least leadership. Indeed, Germany is already discreetly preparing for it.
- Germany and a few other strong countries secede from the Eurozone. This outcome isn’t particularly likely, but it would almost certainly be the best solution for everyone. Germany, the Netherlands and a couple of other financially strong exporters could unilaterally leave the Eurozone and set up their own new currency. The existing Euro would immediately depreciate against this currency, as well as against the dollar, the British pound and the yen. A cheaper Euro would make the countries remaining in the Eurozone more competitive and reduce the real value of their national debts, offering almost instant economic relief. Ambrose Evans-Pritchard outlined this solution lucidly almost two years ago, yet it has still not been openly discussed by European politicians. The reason, I suspect: The idea of a financially dominant Germany surrounded by satellites strikes many as historically disturbing. In a more subtle version of this strategy, Poland, Slovakia and the Czech Republic could also be included to hold down the appreciation of the new currency. If Germany is going to be responsible for bailing out anyone, it should be countries that provide cheap subcontracting for Germany industry. Just don’t call the new currency zone the Deutsches Reich.
Note that only a unified European financial system could postpone a Euro crisis indefinitely – and it is the least likely solution. All of the other outcomes would lead to major defaults by someone, and costs that are likely to be borne by the banks, whose shares would drop even if they are eventually bailed out.
For speculators, there is an opportunity to play the collapse. One could, for instance, sell short bank stocks. But for most individual investors, there is little to do on the way down besides conserving cash (and building a larger cash reserve if possible).
The investment opportunities will consist of buying after some sort of default or other crisis. It’s quite likely that something dramatic will go wrong, and when it does, you’ll know it. If U.S. stocks tank – remember that the Dow got down to 7000 briefly during the 2009 selloff – there will be lots of things to consider buying. Among them: Chevron and Exxon, if the price of oil falls further on fears of a global recession.
The investments that I am watching most closely are exchange-traded funds (ETFs) that hold preferred shares, largely the issues of U.S. banks. These preferreds pay very high yields, currently averaging more than 7%. And unlike the common stocks of banks, they are not especially sensitive to corporate profits. As long as the bank is not at risk of failing and continues to pay its preferred dividends, earnings shortfalls don’t matter all that much. In 2009, fears about the global banking system knocked down ETFs such as iShares S&P U.S. Preferred Stock (PFF) and PowerShares Financial Preferred (PGF) far below today’s prices. If anything close to that happens again, those ETFs could yield 9%, 10% or even more, at which point they would look like compelling buys indeed.