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.

Thanks for some sterling comments.

I certainly agree on the Airbus and hedging, although that is certainly not my profession.

I have no idea about the EurIBOR (is what??), but note my comment on the Italian and German 10-year bonds. The spread took off the same day Prodi managed to get his budget through the Italian parliament (cause and effect unclear at best :-) ) and continued upwards, but the last few days it has stabilized and started to decline.

So, I think A E-P makes some very interesting points (especially for you currency traders!) but he may hyperventilate a little too much.

My only concern is that the #1 scumbag in trading on the World Monetary System, George Soros will take advantage of this some way and hurt one of our allies or the US itself. he has shown himself in the past to be capable of some foul play to enhance his position before. That is how he made his billions of $$ to begin with.

You make some good points, but you don’t seem to appreciate the large difference between the Club Med and the economies of northern Europe, nor the political game between the French and the Germans on who is going to control the European central bank (ECB).

Historically, those kind of problems have scuppered more than one currency union. One would be very unwise to to discount a major rift in the eurozone.

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.

Reparations imposed by non-German politicians initially resulted in deflation. In response, German politicians generated hyperinflation.

EurIBOR (European Inter-Bank Offer Rate) is a 3-month interest-rate strip, not dissimilar in nature from the Eurodollar rate (pls note that Eurodollar is the 90-day interest rate earned by dollars held abroad, and has nothing to do with Eurocurrency, aka 'the Euro'.)

Not surprised at all (though I don't follow these mkts) to see the spreads between Italian debt and German debt widening. Frankly, I should have thought that this should have occurred long since, Euro or not. The ''single currency'' doesn't -- hell's bells it can't -- mask out consequences of traditional Italian fiscal policy, which has been generally insane, worse even than the Regress' fiscal policies by an order of magnitude or more.

Prodi being a dyed-in-the-wool Marxist doesn't help matters any, either, and certainly not confidence in Italian debt. Sheesh.

The Euro is heading towards $ 1.75 next year. That may help stimulate the U.S. economy but will certainly upset people working for factories in France, Germany, Italy, Ireland, Spain and Portugal to name a few. What do we manufacture here in the U.S. today?

14,833 U.S. Companies have been taken over by foreign corporations since 1978.

In the meantime . . .

The Finance Industry in California is Laying Off Hundreds Right Now

By next year the number of unemployed mortgage clerks, realtors, bankers, construction workers, investment advisers, automobile finance clears will number in the thousands. As many as 20% of Californians were working at least part time as realtors. Another 5% - 10% were using their real estate license to work in mortgage lending. All those high paying jobs will be gone for at least ten years.

Food service workers hardly make $ 10/ hr. Unless they are working for a great family owned corporation like 'In-n-Out Burger.' The problem with finding employment in the food service industry is that you MUST speak fluent Spanish. "No Gringos Allowed!" Fast food restaurants have Mexican employees who taunt Anglo customers openly.

Have fun looking for work in California.

Reparations imposed by non-German politicians initially resulted in deflation. In response, German politicians generated hyperinflation.

Yes, that and the French occupation of the Ruhr area in 1923. However, in November 1923 a currency reform was undertaken and inflation ceased. That was in 1923/24. The nazis did not gain in the elections until 1930 (after the Wall Street Crash) when they increased their number of seats from 12 (2.4%) to 107 (18.5%). By that time the unemployment rate was more than 15%. In the next general election in 1932 they further increased their tally to 230, when almost a third of the German workforce was unemployed.

Not surprised at all (though I don't follow these mkts) to see the spreads between Italian debt and German debt widening. Frankly, I should have thought that this should have occurred long since, Euro or not. The ''single currency'' doesn't -- hell's bells it can't -- mask out consequences of traditional Italian fiscal policy, which has been generally insane, worse even than the Regress' fiscal policies by an order of magnitude or more.

Prodi being a dyed-in-the-wool Marxist doesn't help matters any, either, and certainly not confidence in Italian debt. Sheesh.

True, true, true, but one of the ideas with the euro was that it would shield the irresponsible from their irresponsible actions. Yes, there were many in Germany and elsewhere who argued for a small euro, which would definitely have excluded Italy. However, by the time the euro was formed it was only Luxembourg that would have been able to pass the Maastricht criteria and therefore entry into the euro became a political and not an economic decision. Italy as one of the founding nations could not be kept out.

And next year Cyprus and Malta will take on the euro as their currency (!!)

"French will not if they can avoid it start a full attack on the ECB "

The ECB is Germany. France can complain all it wants. Germany does not see it the same way.

Sarkozy can use his problems to institute more and quicker reforms.

yitbos

The ECB is Germany. France can complain all it wants. Germany does not see it the same way.

The ECB was created as a pan-EU Bundesbank. However, all through the 80s and 90s there was a cold war between France and Germany who was going to control the bank, and whether the bank would run according to German or French policies. (See The Rotten Heart of Europe by Bernard Connolly.)

Unnoticed by almost every political commentator Mrs Merkel has allowed France to steal at least one base with the new "Reform Treaty".

First free market economy was dumped as one of the EUs main goals. Then the French managed to include the ECB as a full EU institution (§9 in the new treaty). That means that it will no longer be an independent bank, but basically run by the politicians. However, as long as no one makes any fuss about this things will carry on as before - in my opinion until the treaty has been ratified. Then the French will start to act, and the German's will have a much weaker legal position to defend their view of the bank.

We are witnessing a bank robbery in slow motion.

"it will no longer be an independent bank, but basically run by the politicians."

True and put better than I. But, Germany and its economy has the "political" clout.

If worse comes to worst, the Euro remains stealth capitalism. If the EU thinks it can alter the facts of capitalism, there are many who will be happy to pick up the economic pieces from the wreckage.

yitbos

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 overall EU economy won't die, but that won't much matter to the Italians, the Spaniards, the Greeks and the Portuguese (referred to by the author as Club Med).

The northern countries will weather a downturn, but the southern group (France can be included) are in very bad shape and this is why he speculates about the future of the currency itself.

The EU is a "country" in name only. The idea that its members could unite and reconcile their individual economies and governing styles was an extremely utopian and, I think, unworkable idea.

The Germans control the central bank. It will pursue a policy that maintains the strength of the Euro, just like the Germans maintained the strength of the Mark throughout the history of Bretton Woods. They will still inflate and the Euro will lose value relative to commodities, over time. But not as fast as western monopoly money, let alone southern confetti.

And no, this will not harm anyone, it will help them maintain some of the highest living standards in the world. The rest of their economic practices will not, but their currency will remain better run than ours, because less wedded to inflationist nonsense. Their labor markets, on the other hand, will remain seized, their welfare states and especially treatment of public employees ludicrous, and their immigration and population policies a long slow suicide. Europe will be a well appointed museum, as it has been for some time now.

It isn't unworkable, it is working just fine. The southern economies can work harder, or they can be poorer. Same reality they have always lived in. Letting pols print lots of confetti to toss around to supporters didn't change anything for southern Europe for the last 6 decades, and it wouldn't change anything now, either. They are better off with a money actually worth something, and they know it.

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.

I thought that when the Euro was implemented, the Germans called it the "teuro" (expensive).

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