I suggested in last week’s article (Dead Dollar Sketch), that the end of the US dollar hegemony as the global reserve currency has ended. It is only out of habit (meaning a complete lack of either competence or imagination or both) rather than economic rationale that Asian central bankers continue to hold US dollars and indeed even talk about the currency when describing reserves.
In the same article, I dismissed out of hand the notion that the euro could possibly replace the US dollar as the world’s reserve currency. On second thoughts though, it is clear to me that a cursory dismissal of the notion may be misconstrued as an exercise in the authors’ prejudiced view of the world. Quite to the contrary, the idea certainly has been evaluated at some length across the markets and its adjunct professions with a unanimous conclusion on the lack of suitable merit for the candidacy.
It is fair to say that two main sources of objection are the European Central Bank (ECB) and the political system of Europe. On the former, while the ECB has been unique in its focus on inflation at the expense of economic stimuli, its actions belie its words – in effect, it can be proved that the primary source of inflation that may confront Europe in the next few months is the one created by the ECB itself. Things are worse on the political front. Be it the tax pursuits of Germany and Britain, political imbroglio of Spain and Italy or the circular logic loop of French reforms, there is no reason for hope across the Old continent.
First, look at the ECB. By refusing to cut interest rates in the wake of substantial decline in both investment and consumption across Europe, ECB president Jean-Claude Trichet has raised a banner of sorts for a return to the simple past of inflation targeting that served as the primary purpose of a central bank.
This course of action has led him to be one of the most unpopular central bankers in the world, particularly in his own backyard. Not a week goes by when a French politician of some hue or other doesn’t take a potshot at the venerable president for failing to do enough for the European economy. Much the same venom is delivered on Trichet from other quarters including Germany and Italy. Everyone likes an underdog, and all the political attacks make Trichet the poster-boy of monetary economists, assuming they still have space on their walls after posters of Alan Greenspan and Ben Bernanke.
This adulation, though understandable, is also completely illogical because the ECB is the body that has unleashed the very forces of inflation that Europe will have to confront in coming months. This has been done through the enhanced liquidity facilities made available for European banks since last summer.
It is no secret across the banking world since the time that the first rumors of a UK bank being in trouble surfaced that the ECB has been quite generous in providing cheap liquidity access for banks. Over the course of the last one-third of 2007, the facilities were expanded to include all kinds of dud collateral.
When the US Fed last week made an announcement that it would expand its Term Auction Facility (TAF), the idea was greeted with sardonic smiles across the boardrooms of European banks. After all, the Fed had only made operational in March what the ECB had been doing since last summer.
How it operates is quite simple. Banks gather all the collateral on their books that cannot be sold into the wider market and provide it to the ECB against which, following some minor valuation adjustments, the central bank provides immediate liquidity. This has proven quite useful in the current climate of poor liquidity in various market instruments.
Thus, we have found out that European banks have continued to issue billions of euros-worth of residential mortgage backed securities (RMBS) that are never sold to any investor. After securing the rating, the securities, which are simply paper representing actual mortgages in the books of various banks, are pledged as collateral to the ECB and liquidity lines are drawn.
In turn, this borrowing from the ECB is used to support the uneconomic overseas operations of European banks, ie their investments in US subprime collateral, poorly constructed collateralized debt obligations (CDOs) and the like. By not being forced to sell such assets, European banks continue to pretend that they have taken fewer losses than their US counterparts when the truth is the exact opposite.
German banks are in hot water and have been so since last summer. Indeed, many industry observers believe that all of the fabled Landesbanks are bankrupt if they adopted mark-to-market valuation on the US collateral as well as other problem assets, including European leveraged loans currently on their books.
French banks, in addition to the problems of low-quality collateral being held by their banking books also have large mutual fund operations where exactly the same investments are made. And just in case they had too few challenges on the balance sheet front, their risk management has also shown up as a key weakness (see The Rogue and the Pogue, Asia Times Online, January 26, 2008) in the form of rogue traders. Some risk managers working in American banks have taken the surreal step of performing secondary audits on the positions of all their “French” trading desks, ie the ones where risk is taken by anyone with a Francophone accent.
Italian banks dodged the bullet because their central bankers refused to allow them to buy CDOs. However Spanish banks have not been as lucky – while they avoided the headlines concerning structured investment vehicles and the like, they do have very substantial overexposures to poor-quality mortgages both in the US and Spain itself – the latter boasted the same type of price boom that was witnessed in the Hispanic parts of the US such as California.
Thus, European banks were forced neither to sell down the problem assets nor change their behavior. Many European banks still operate as if there was no year called 2007, and it has always been business as usual. In this respect, they are more dangerous than American banks because the latter have realized their failings and are at least swiftly moving to counter the declines, while the former are still engaged in the same kind of “bubble inducing” behavior.
That is the reason there will be inflation in Europe. Despite all the evidence of a global economic slowdown, European companies are still going around purchasing uneconomic assets and making stupid investments, financed by their banks. Even with sky-high costs of manufacturing in Europe, instead of trying to move production offshore the companies are turning to increased investments at home, in the vain hope of a better tomorrow that will never arrive.
In turn, banks are able to finance these hare-brained schemes because of the blank check provided by the ECB. It is therefore no surprise to me that Trichet worries so much about inflation, because he knows himself that it is at the very liquidity window of the ECB that it is being created to spread like Ebola across the European economy.
With the central bank unable to help provide monetary easing that could ease their own interest costs this year, European governments are left confronting the stark math of falling revenues, rising expenses and obdurately high coupon payments on their burgeoning debt load. In this situation, it is but natural that some quarters would be tempted to go for politically expedient targets.
Although it is not part of the euro, the experience of Great Britain may prove telling for the rest of Europe. Public spending rose for every one of the past 12 years or so, in effect wiping out the fiscal benefits of the sustained economic boom over the period. At the end of the boom, the UK government has been left holding various worthless pieces of paper, including most tellingly its ownership of Northern Rock (see Rocking the land of Poppins, Asia Times Online, September 22, 2007).
In order to fight this decline, the government has unveiled sweeping tax increases on its expatriate population, ie the very people who moved into the UK over the past few years and ushered in the services-led boom that has helped to damp down the costs of a sustained manufacturing decline since the Thatcher reforms of the ’80s. The moves are immensely unpopular, which, combined with the current carnage in financial markets, would mean that thousands of banking professionals stationed in London and other cities may choose to leave the country.
Much the same threatens to happen in other jurisdictions such as Germany. The recent flap over the tax haven of Liechtenstein adds to the ongoing problems that European governments have with other such areas such as Monaco and the Isle of Man. Even as the biggest tax haven of all, Switzerland, now cooperates on such matters with European governments, other locales may be forced to fall into the European mold of taxation.
This leaves the plutocrats in a quandary. Their business interests are located across the Old continent, but the math simply doesn’t work when they have to pay short-term taxes on essential long-term investments and strategies. This means that more of them – such as the Russian oligarchs – will choose to fall at the feet of the Kremlin and move back to Moscow. Others not of Russian origin will have to make similar arrangements and most likely away from Europe to favor other destinations such as Dubai and Singapore. Indeed the latter is quickly evolving into a 24/5 financial center, attracting all hues of private banks and hedge funds into its fold. The rest of the market, the so-called “real money”, will not be far away.
The main reason that European governments are preoccupied with taxes is that structural reform efforts have fallen flat. Reformists such as Angela Merkel and Nicholas Sarkozy have instead turned to accept gradual steps led by compromise between the various interest groups. This in turn leaves Europe without much ability to combat the US slowdown by staging a dramatic recovery on its own terms.
If the euro were to be acceptable to global central banks as the new reserve currency, it should bring with it a promise of superior performance against what is being replaced. The US dollar certainly offered all that and more when it pushed the pound sterling away in the years following World War II and certainly by the mid-60s.
In contrast, while the euro has been moving higher against the US dollar, much of this can be explained by the behavior of its own banks. The financial system of Europe is broken even more than that of the United States while its political system chases its own tail. Neither of this can help the case of the euro. If anything, the opposite is true – anyone buying the euro is doing so merely to avoid the recent problems of the US economy. When the problems of Europe come to the fore, the mad rush to the exit will leave the region and its currency unmasked as the frauds that they are.