Is it the Euro or the Yugo?

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The highly-touted European currency, the Euro, is performing more like the ill-fated Yugoslavian car maker, the hapless Yugo.  And, there is a pretty good analogy between the problems inherent in the fractious group of countries that make up the European Union and the fractious group of countries that made up the now-defunct country of Yugoslavia, where the Yugo was born.  You know the regions I'm thinking of–Bosnia, Serbia, Montenegro etc. Once the veneer of nationality was swept away, Yugoslavia quickly descended into a hellish nightmare of civil war and racial hatred.

Maybe I'm overstating things a bit, but the events in Greece over the past few weeks do not suggest a peaceful outcome is nigh as riots, strikes and social strife rock the country.

David Callaway, Editor-in chief, at MarketWatch, recently wrote a lengthy piece on the history of the Euro and what is going on.  He believes the Euro can and should be saved, but only if the European Community goes to extraordinary lengths to do so [emphasis added].

Malignant market forces set sights on Europe (MarketWatch, May 6, 2010, David Callaway)

…A cover story in Business Week magazine, perhaps 15 years ago before the euro was adopted, envisioned how it would collapse. As Greece was not seen as an eventual member then, the story imagined the crisis would start in Italy, and almost exactly as it has played out in Greece, with poor budget management leading to economic punishment from Europe, leading to rioting in the streets.

The story was shrugged off by the winners of the euro debate at the time, who with the momentum of historic change behind them claimed it was scare-mongering by a reckless financial media. Once instated, the euro could not collapse without economic chaos if member states tried to revive their former currencies, they argued. Now the markets are looking at the very real possibility of that happening.

There is still time to save the project, and indeed, it should be saved. But it will take an extraordinary effort not just by Jean Claude Trichet at the ECB, and the IMF, but by the leaders of the major European nations, Germany, France, and yes, the non-euro U.K., once it votes on a new government this week.

…The euro can be saved. But Europe's leaders will need to trash their playbook and roll out a much more ambitious and expensive plan — one that will call for an unprecedented degree of cooperation and sacrifice among each other and their nations. And they need to realize that at the moment, nobody is betting that can happen.

The reason the financial markets are skeptical about the Euro is that Europe's leaders have already given the crisis their best shot.  They united briefly on this nearly $1 trillion bailout, but that is almost certainly about as far as they can go.  In fact, the bailout is already causing severe political problems for Germany's leadership.

Unfortunately, as New York Times columnist and Nobel prize-winning economist, Paul Krugman wrote at the end of a column about the Greek crisis, the bailout won't be enough to do the trick [emphasis added]:

…The good news here is that for the first time in this crisis, European policy makers have gotten ahead of the curve, acting more strongly than almost anyone expected. That's a shock, and it has awed the markets. But I still don't think it's nearly enough.

The problem Krguman refers to is solvency, not just liquidity.  That is, Greece has a budget deficit north of 13% of GDP and there is little likelihood that the political and social will exists to cut that back in a meaningful way.  Government debt amounts to 125% or more of GDP.  Deficits and debt of that magnitude are well beyond what that economy can manage.  In other words, Greece is broke.

Earlier in the column referenced above, Krugman spelled out what has to happen if Greece is get become solvent [emphasis added:

…What the country must do, regardless of how it's accomplished, is achieve relative deflation — reduce its costs and prices compared with Germany and France, regaining competitiveness. With German inflation low, this means an extended period of deflation, with high costs in employment and output. It also means fiscal difficulties, requiring spending cuts and tax increases that deepen the slump…

The prescription for regaining fiscal health as outlined above above would probably work, but it would also trigger negative consequences including lower economic growth and social unrest.  Truly, a no win situation.  And, I sincerely doubt if the political will exists in Greece or the EU to take the steps outlined by Krugman.

The currency markets have looked at the Euro and, at least for now, the trend is down as this MarketWatch report indicates:

The euro slumped Friday to the lowest level against the dollar since October 2008, as worries about financial stability on the Continent and the political will to enact unpopular deficit-reduction measures led traders to dump the shared currency. The euro's decline was sparked by a report, since denied, that France's president had threatened to pull his nation out of the euro zone.

…The shared currency touched an intraday low of $1.2357, its weakest level since at least October 2008…

…"The euro is in a no-win situation at this point," said strategists at Brown Brothers Harriman. "There is also concern that the much tighter fiscal stance in the euro-zone periphery will have significant negative impact on the growth outlook, with potential serious negative social consequences."…

So, where does that leave the Euro.  Is it:

• The Euro, the vaunted currency that is poised to supplant the U.S. dollar as the world's reserve currency
• The Yugo, a failing currency whose time has come and is now going?

I believe we will see some countries leaving the common currency as they become increasingly unable to manage their own economies under the Euro straitjacket.  Candidates for this would be Greece, Italy, Spain, Portugal and Ireland.  It also has become unlikely the United Kingdom will agree to give up the British Pound to go with the Euro.  What will be left are stronger countries such as Germany and France and perhaps a few more.  At that point, there will not be much reason to keep the battered Euro going.

Though it will take a long time, I believe the Euro is really the Yugo and it is doomed to a similar fate.

http://blogs.marketwatch.com/fundmastery/2010/05/15/is-it-the-euro-or-the-yugo/