Euro Falls to Lowest
in Two Years as
Breakup Seems Imminent

Euro currency

May 17, 2010 - The euro fell to its lowest level since the collapse of Lehman Brothers Holdings Inc. (September 15, 2008) on concerns that the 16-nation currency may be headed for disintegration.

The shared currency fell for a fourth week versus the dollar and a third week versus the yen, the longest losing streaks since February, as German Chancellor Angela Merkel said that Europe is in a “very, very serious situation” despite a rescue package for the region’s most indebted nations.

“We went through a massive liquidation trade in Europe and risk-taking positions were wiped out across the board,” said Sebastien Galy, a currency strategist at BN Paribas SA in New York. “The markets are trying to figure out what the consequences are for growth. There are massive uncertainties and that will keep the downward pressure on the euro.”

The euro fell 3.1 percent to $1.2358 this week, from $1.2755 on May 7. It traded as low as $1.2354 on May 13, the weakest since October 2008. The common currency dropped 2.1 percent to 114.38 yen, from 116.81 last week. The dollar traded at 92.47 yen after gaining 1 percent last week, the first weekly gain since the five days ended April 23.

Thursday, of last week, Jean-Claude Trichet, president of the European Central Bank, said three times "Non! Non! Non!" when asked in a press conference if the ECB would consider buying Greek bonds. His exclamation was accompanied by a forceful lecture on the need for eurozone countries to get their fiscal houses in order. Trichet was remonstrating about the need for the ECB to remain independent, and was rather definite about it. Then on Sunday he said, in effect, "Mais oui! Bring me your Greek bonds and we will buy them." What happened in just three days?

Basically, the leaders of Europe did not like the look of the alternative which in the end forced an agreement which involved almost $1 trillion in a rescue package.

"French President Nicolas Sarkozy threatened to pull out of the euro unless German Chancellor Angela Merkel agreed to back the European Union bailout plan at a summit last week in Brussels, El Pais newspaper said.

If at this point, given how it's falling, Europe isn't capable of making a united response, then there is no point to the euro,' the newspaper quoted the French President as saying.

Maybe the euro zone can be reformed so that similar crises do not happen again. This probably means entrenching the European Central Bank's ability to intervene in government debt as a long-term solution to Europe's mounting fiscal problems. It will also mean establishing German-designed European institutions capable of monitoring national budgets and punishing profligate spenders in the future.

There are so many implications of this latest action it is hard to know where to begin.

There seems to be a need to buy time but will this be enough to save the euro and the euro zone?

It appears to be more of a panic-driven response to market panic.

1. European governments have committed €500bn (€440bn in loan guarantees to eurozone members in difficulties, and a €60bn increase in a balance of payments facility).

2. The International Monetary Fund will, it appears, put up an additional €250bn ($320bn, £215bn).

3. The European Central Bank has, to the chagrin of Axel Weber, president of the Bundesbank, decided to purchase the bonds of members under attack.

4. The US Federal Reserve has reopened swap lines, to provide foreign banks with access to dollar funding. This is a panic-driven response to market panic.

There is enough in this fund to purchase all the expected debt of Greece, Portugal, and Spain for three years. The money could actually last a lot longer, as Spain might not need to tap the fund for some time.

But it is not just the PIIGS (Portugal, Ireland, Italy, Greece, Spain) countries that are out of compliance in Europe.

Look at the following chart from Der Spiegel. Note that France has a budget deficit of over 8%. There are going to have to be austerity measures enacted all over Europe.

Euro zone budget and deficits-may 17, 2010

Notice that Ireland has the largest deficit, at 14.7%. This is in spite of (or more aptly, because of) the enactment of severe austerity measures, far beyond what Greece, Portugal, and Spain have contemplated.

These austerity measures are not growth plans. They are not designed to help countries grow their way out of the problem. There is no reason to think that if Greece enacts the measures that have been proposed, that what happened to Ireland will not happen to them. It almost certainly will.

It is not just the PIIGS but all of Europe will have to make cuts. And in the short term that is going to be a drag on growth and a headwind for the euro.

The reality is that the coming austerity measures are going to reduce the ability of the PIIGS to buy products from outside their countries. Germany's surplus will thereby suffer.

At the end of the day, Greece will just have more debt. Perhaps Spain and Portugal can work through their problems, but that will be very difficult and will involve considerable economic pain. Italy can succeed if it decides to.

This new program simply buys time to try and figure things out. It is Germany saying, "Ok, I give you 3-4 years. But don't come back asking for more."

All this does is bridge to the middle of the decade, when the truly massive health and pension promises made all over Europe must be dealt with. Europe cannot impose more taxes to climb out of their debt situation as they already have tax rates that are high and growth-inhibiting. The entitlement problems in many countries are more onerous, and their working populations are not growing.

This is just the beginning of their woes. They have a long way to go and a short time to get there. I have my doubts that the European Union in its current form will exist in 5-7 years.

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