Will Europe impose exchange controls to head off disaster?

The die is now cast. As the euro brushes $1.50 against the dollar, it is already too late to stop the eurozone hurtling into a full-fledged economic and political crisis. We now have to start asking whether the EU itself will survive in its current form.

It takes eighteen months or so for the full effects of currency changes to feed through, so the damage will snowball late next year and beyond into 2009. Although "damage" is a relative term.

As Airbus chief Thomas Enders warned in a speech to the Hamburg workers last night, Europe's champion plane-maker - the symbol of European unification, in the words or ex-French president Jacques Chirac -- is now facing a "life-threatening" crisis.

Mr Enders said the company's business model is "no longer viable", and "massive losses" are on the horizon. So much for all those currency hedges that analysts like to cite. Have they ever tried to buy a currency hedge? They would discover how expensive these instruments are. Hedges cannot protect a company with $220bn in delivery contracts priced in dollars, when the euro/sterling cost-base is leaping into the stratosphere.

The sudden rocketing in sovereign bond spreads this week between core German Bunds and Club Med debt - Italian, French, Spanish, Portuguese, Greek, as well as Irish, Belgian and Slovenian - is a clear sign that markets are starting to price in a break-up risk for the single currency, however remote. Italian spreads have risen beyond the danger point of 40 basis points. This is less than the 100bp or so seen in Quebec (viz Ontario debt) when it looked as if the separatists might prevail. But it is dangerous nevertheless.

Moreover, these bond spreads are telling us that liquidity is drying up and that monetary policy is now too tight for the eurozone, as it is across much of the developed world. Two-year bond yields are collapsing in the US, Britain, and the Anglo-Saxon states, a signal that markets are now discounting possible recession. The whole central banking fraternity seems behind the curve, spooked by residual (lagging) inflation - and prisoners of a defective economic model (Neoclassical/New Keynesian synthesis). This is how the 1930 recession metastasized, although one doubts that Ben Bernanke will allow Part II to unfold this time. He has spent half his life studying the blunders of the Fed in 1930-1932.

One thing is sure, President Nicolas Sarkozy will not let Airbus go bankrupt, nor see decimation of the French industrial core, without an almighty fight against those countries deemed to be engaging in a beggar-thy-neighbour strategy of currency devaluation - benign neglect in Washington, less benign in Beijing.

He will have allies soon enough, once the housing bubbles collapse in Spain and across the Med. Mr Zapatero will not be in power for long in Madrid. Mr Prodi is on borrowed time in Rome. A new political order will soon take hold in much of Europe, bringing in a new wave of prickly national populists.

So, how will they fight? Will Mr Sarkozy and his allies resort to 1970s-style exchange controls to stem the rise of the euro?

They certainly have the power to do so. Four years ago a little-known cellule at the European Commission wrote a report - on prompting from Paris - exploring the legal basis for measures to stabilize the currency.

After combing through the EU treaties and court judgments, it concluded that Brussels may impose "quantitative restrictions" on capital inflows.

"Should extremely disturbing capital movements endanger the operation of economic and monetary union, Article 59 EC provides for the possibility to adopt restrictive measures for a period not exceeding six months," it says.

It would be renewable each six months, so the policy would in fact become permanent.

Any decision would be taken by EU finance ministers under qualified majority voting. Britain would have no veto, even though the effects of such a move on the City of London would be catastrophic - and trigger the certain withdrawal of Britain from the EU (and good riddance, some might say in Paris).

This "disturbing" capital movement is occurring right now. Portfolio inflows into the eurozone reached a record EUR46.2bn in September. China, Asian wealth funds, Petrodollar sheikdoms, and now even Nigeria, have all joined a stampede into euros, utterly disregarding the underlying reality that Europe is in no better shape the United States itself. It is in worse shape, though this is disguised by the cycle. It is much worse in terms of economic dynamism and demographics.

Confidence has cratered in Germany, and the Netherlands, not to mention Belgium - which has not had a government for 165 days, and is now sliding towards disintegration. Since Belgium is a metaphor for the EU - an arranged marriage of squabbling tribes, speaking different languages, who do not love each other, and never did - this in itself amounts to a tremor for the EU system.

EU industrial orders fell 1.6pc in September. Spanish, French, South Italian, and Irish house prices are already all falling.

Spreads on the iTraxx financial index of 25 European bank and insurance bonds have jumped to a fresh record, worse than during the depths of the August crunch. The iTraxx Crossover of low-grade corporates is back to crisis levels above 400.

The European Covered Bond Council suspended trading in covered bonds this week because the spike in spreads had become disorderly, and three-month Euribor rates have gone through the roof again, and that is the rate that sets Spanish and Irish mortgages. Bond issuance in Europe is frozen.

France is in the grip of a national strike costing EUR2bn a day. The railways are paralyzed. The country's 5.2m public workers are staging walk-outs.

Is this a currency bloc that should be now be deemed the ultimate safe-haven, the repository of trust in a dangerous economic world? This hodge-podge of disputatious clans, lacking a central Treasury, government, debt union, and guiding philosophy - let alone the sacred solidarity of a nation?

Returning to the Commission cellule, it said that: "Among the actions that can be undertaken when a member state experiences serious balance of payments difficulties, Articles 119 and 120 EC provide for the possibility to reintroduce 'quantitative protective measures' against third countries."

The measures are of course exchange controls. This is the nuclear option, but Europe's politicians could equally invoke Article 104 of the Maastricht Treaty giving politicians the power to set fixed exchange rates (by unanimous vote) or a dirty float for the euro (by majority).

The document is annexed to the Commission's 2003 EU Economic Review. Nobody paid any attention at the time, just as the Commission had hoped - at least that is what one of the authors told me. This is the EU's Monnet Method, one silent fait accompli after another.

French President Nicolas Sarkozy certainly seems inclined to go this route. He has again invoked his ideas for "Community Preference" - ie, a closed trade bloc - in a speech this month to the European Parliament. Contrary to claims, he is not letting go of his mercantilist plans.

The ECB may or may not intervene in the currency markets to cap the euro. But this is a red herring. Europe's retort - if and when it comes - will be far more political, and far more dramatic. We are at one of History's "inflexion points".

One recalls the months leading up to the collapse of the Gold Standard in 1931. That was triggered first by Credit Anstalt in Austria and then by a British naval mutiny in Scotland.

Any bets on what will trigger the collapse of Bretton Woods II? I wager that it will be a decision by the Gulf states to break their dollar pegs, leading to a temporary surge of euro purchases. That will tip Mr Sarkozy over the edge.

In my opnion an interesting article, even very interesting. However, before we start dancing for joy that the EU is falling down, one should note that Sarkozy actually (at least partly) has beaten the unions and the strike appears to be crumbling. Also, the last few days the spread between the Italian and German 10-year bonds have declined (slightly and still at more than 35 basis points, but still...) and that the French will not if they can avoid it start a full attack on the ECB until the reform treaty has been agreed to by all the national parliaments (or by referenda) which will probably not happen before the spring 2009.

But even with these caveats the article paints a bleak picture of the future of the eurozone (the EU countries that use the euro).

The real news in A E-P's piece is the part about the fact that the various treaties make it possible to impose currency regulations.

Interesting ScaniaBoy, normally a currency can be issued in mass through a easing of credit terms, why aren’t the Europeans doing that to weaken a too strong currency?

That and my goodness the “fix” is in, politicians care very little for what the people have to say, they will end up ratifying that EU document come hell or collapse if they feel like it is needed.

'He will have allies soon enough, once the housing bubbles collapse in Spain and across the Med. Mr Zapatero will not be in power for long in Madrid. Mr Prodi is on borrowed time in Rome. A new political order will soon take hold in much of Europe, bringing in a new wave of prickly national populists."

Good news here and the article has left out the fact the strike in France has all but collapsed and the unions handed a historic defeat.

A couple intriguing points (among many more in the article):

...these bond spreads are telling us that liquidity is drying up and that monetary policy is now too tight for the eurozone, as it is across much of the developed world...The whole central banking fraternity seems behind the curve, spooked by residual (lagging) inflation - and prisoners of a defective economic model (Neoclassical/New Keynesian synthesis). This is how the 1930 recession metastasized...

(That's certainly food for thought, even if it does run counter to my personal views.)

The real news in A E-P's piece is the part about the fact that the various treaties make it possible to impose currency regulations.

I am not sure what "currency regulations" means. Does this mean that each country can have a different policy for the Euro?

Evans-Pritchard wrote a book called “Blood In the Streets”, about twenty years ago. He’s kind of a scare monger, but maybe he will get one right.

I understood the idea of the EU.
And the Euro.
I never thought the Euro first befor the EU was a good thing.
It kind of seemed like a currency fait accompli, shoved down the Europeans political throats.

I’m a litte suspicious of elites in general, and specially European ones vs. their own populations, regardless of the goals. The ends do not justify the means.

Also, China has really ripped up the old ways of measuring things. I don’t know how much older pre-China, pre-Soviet collapse world economics can guide us.

We are moving into a intellect world. Europe is well prepared.

I’m not a big Harry Truman fan, but he said that, “If you see ten problems coming down the road at you, don’t worry, eight will go off the road before they get to you.”

I think that is the case here.

why aren’t the Europeans doing that to weaken a too strong currency?

The German hyper-inflation of the 1920's which led to the rise of the Third Reich is a very strong feeling in the German psyche.

You will rarely hear Germans complaining of a strong Euro (effectively the German Mark) which is rooted in the strength of the northern teutonic German financial discipline.

This inflation “angst” is still deeply rooted in the mind of the German. In fact the Germans, Dutch, Austrians and Finns will all try to keep inflation as controlled as possible.

Because we in America have lost that sense of financial discipline, the Arabs are starting to sell their petrodollars and buy US assets.

If each country could have it’s own regulations for the Euro, how does that differ from each country having their own currency, like they had before the Euro?

Yes, exactly why I asked the question. I don't know what an international currency is good for if each country treats it like a national one. So I am asking for clarification. Perhaps I don't understand what the term "currency regulations" means.

To answer your question, they'll end up just about like they were in late 1991, after our ol' buddy ''Char'' Kohl announced reunification and the currency merger with the former East Germany at 1-to-1. In short, they'll be in a brand-new shiny impossible currency arrangement a la the old ERM.

This would be the opportunity of a lifetime for currency traders, yr hmbl srvnt included. The trick is to figure out the net effect on Eurocurrency. Likely wa-a-a-ay negative, I should think.

One other thing, E-P's comments about the difficulty of hedging a few billion are nonsense, plain and simple. The volume daily in forex is in the multi-trillions (dollar-equivalent). A few billion of hedges here and there could be handled very easily by any of the major Interbank players. What's happened is that Airbus is, effectively, managed by committee, and they can't get their thumbs out.

You doubtless recall the old ''definition'' of a committee: the only known form of life with 12 bellies and no brain. Fits Airbus' management perfectly.

Sorry, the article is hyperventilating nonsense.

The EU economy, no great shakes to start with to be sure, is not going to roll over and die because the Euro is strong. The EU central bank can cut their IRs anytime it likes. All currencies are losing value compared to commodities (gold, oil, etc), the Euro just isn't falling as fast as some others. IRs are too low worldwide, everybody is trying to manage their economy exclusively by printing more, while credit standards remain unsound, savings rates abysmal, geopolitical policies completely irresponsible, etc. All will just end in another bout of stagflation, until people get serious again. China and the other BRICs will be the gainers, the old world (EU and US) the losers.

''Currency regulations'' or ''currency controls'' are very easy to understand. They are an attempt by government(s) to forcibly change the mindset of a markey or markets. As John Galt put it: ''How will your gun make me change my mind, Mr. Thompson?''

They have a very sordid and very unsuccessful history. The most recent attempt was ERM, which crashed and burned in August-September 1992. Prior to that, there was the post-Bretton Woods arrangement (what E-P references as a ''dirty float''), wherein there was simple chaos in forex for 2-3 years after Nixon closed the gold window.

Prior to that, there was the Sterling Bloc in the post-WW II era, whereby the UK attempted to control both Sterling flows and gold flows. It ended when (finally) some boffin figured out that it was impoverishing the nation quite steadily.

Think of government managing the Postal Service (cough), and multiply by 10,000. That's what we'll see if these losers go the route of currency controls.

I can't wait -- we nasty old forex traders will make a megaboatload on this deal.

You will rarely hear Germans complaining of a strong Euro (effectively the German Mark) which is rooted in the strength of the northern teutonic German financial discipline.

That's correct. And with a regained higher productivity, the Germans can stand a higher valued euro than the Italians, the Spanish or the French can.

The German hyperinflation of the 1920's which led to the rise of the Third Reich is a very strong feeling in the German psyche.

I'm sorry to be picky, but this canard does not get more correct because it is repeated time and time again. The Nazis gained power on the back of the 1929 crash and the deflationary policy of the politicians at the time. Mass unemployment, not hyperinflation was the reason Hitler came to power.

Also, I'm sure most Germans who had lived through the inflation in the 20s never forgot it, but by the time the new West Germany and its strong D-Mark came to be so many tragedies had come to pass that the 20s inflation was in all likelihood relegated to distant memory. What was much more resent was the Lucky Strike economy in the vanquished Germany, and the hyperinflation that made cigarettes more valuable than the currency. Although, that is very seldom talked about this was the situation that the new minister of finance Ludwig Erhardt never wanted to see repeated.

Aren’t they worried about inflation? And is this precisely why they have not cut rates? Why else would they leave themselves at such a competitive disadvantage vs the US? Look what’s happening in Canada now with the loonies value vs the dollar a + 60% or more. Their economy has shed jobs rapidly over the past 18-24 months and at an accelerating pace.

Canada won’t do the obvious and lower rates either for fear inflation will be worse then what they face now. Europe is in the same boat.

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