Saturday, June 25, 2011

The eurozone is shuddering

The risk of a catastrophic financial accident is as high as it was in 2008. Eurozone bank risk spreads are rising as investors take flight, while the yield on one month Treasury bills is now below zero. Even though the troika (EU/IMF/ECB) is moving forward with Greece’s bailout, investors are seeking cover anyway. Thus Greece doesn’t have to default for there to be a eurozone financial crisis.

If Spain, Portugal and Eire (governments and banks) lose market access, they will have to reschedule (default) because the troika doesn’t have enough money to rescue them all, along with Greece.

This scenario would be more like the cascading worldwide defaults of 1931 than 2008. One would have to imagine that the wealth destruction in such a scenario would be unprecedented.

Can such a scenario be contained to the Eurozone, or could contagion spread to other developed markets? I can’t see how other European banks won’t be affected to some extent, but they benefit from borrowing in domestic currency, which their central banks can print. I would not expect that non-European banks and governments would be affected, because they all borrow in their own domestic currencies.

Such a scenario would pose an unprecedented challenge to the ECB, which would have to make some very hard choices in order to maintain financial stability (i.e., taking on trilllons of exposure to eurozone banks, presumably with government guarantees of questionable value).

None of this would be happening were it not for the incredibly stupid idea of a monetary union of a hodgepodge of economies based on a geographic concept. The lesson learned during 1931-33 will now have to be relearned: only domestically issued fiat money can prevent deflation and defaults. No country should ever adopt a foreign currency as its own: If you can’t print it, don’t borrow in it. (And no central bank in the world can print gold, so forget about that “solution”.)

The breakup of the eurozone is such a black swan that its ultimate ramifications fall into the Rumsfeldian “unknown unknowns”. I’d have to say long-term bullish, but short term frightening.

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