In the report, we repeatedly say that any of the four could go at any stage and trying to guess which could be the first to go is folly - but that does not stop us and when the report was written we had a slight hankering for it being the Euro. Recent events have, of course, now changed all that. We are certain it will be the Euro. The ECB (and by implication Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain) is living on borrowed time. The French smoke and mirrors re-fi plan (AKA when is a default not a default? When you can kick the can down the road!) contains more holes than a large wedge of French Gruyere - cf www.guardian.co.uk/world/2010/aug/16/swiss-win-the-gruyere-cheese-war.
These were so obvious that it made us realize that even EU finance ministers could not insult our intelligence so brazenly.
Do not be surprised if the EU decides that the GIPSIs must leave the single currency and re-introduce Drachma, Punts, Escudos, Pesetas and Lire - but with a difference. These meaningless second tier currencies could well be artificially pegged to the single currency meaning that the GIPSI banking system would be cut adrift and their new currencies would be traded more on street corner black markets than Manhattan’s money markets.
Having previously focused on the problems facing debt-ravaged Japan, which by simple metrics is the most indebted of the Four Horsemen of the Economic Apocalypse, it is time to look at how the wedding between the Euro family and the GIPSI nations (Greece, Ireland, Portugal, Spain and Italy) is bringing about increased economic chaos in, arguably, what is the most complex of our horsemen, the Euro zone.
The Euro zone’s fundamental flaw was the co-mingling of debt of lower risk nations such as Germany and France in the same credit risk pool as the GIPSIs. This disaster in the making is now entering the final sequence.
How were nations with such disparate risk profiles able to obtain similar credit ratings and interest costs on debt?
The answer lies in the determination of the European Central Bank, on behalf of the EU, to manipulate criteria that even the weaker economies could eventually achieve. However, it still required creative accounting, unfathomable derivative contracts and the financial engineering capabilities of Wall Street’s sharpest minds before 17 members managed to gain entry into the monetary union club, thereby enjoying years of collective cheap funding. The periphery nations boomed as their lower cost bases and higher growth rates were combined with access to previously unimagined amounts of cheap credit.
In the cold light of day it does seem inconceivable that Greece, having spent around half of the last 200 years in default, was granted a credit rating comparable to Germany. However, once the credit ratings agencies swallowed the deception that the Euro zone was broadly homogenous, investors, including banks, followed. The GIPSIs are Europe’s version of sub-prime, overwhelmed with debt they are unlikely to ever be able to repay. Greek borrowing costs, which had been running at well over 25 percent per year, virtually converged with German debt costs at well below 5 percent. Membership of the Euro for countries that had previously had difficulties raising capital and whose price of capital had reflected this was like giving membership of a candy shop to children with a sweet tooth.
The whole plan of the Euro was another example of the effects of the tidal wave of global liquidity that flooded markets in the 1980s and 1990s, flowing into the most immediately rewarding (and generally riskiest) asset classes. Asset bubbles grew and grew until 2008… when they started to burst.
To be continued…