Little has been written about the instability of the Euro, but it’s a very real threat to investors worldwide, as well as to the global economy. Swings in global asset markets have been increasingly driven by developments in Europe. This is something new: in the past, Europe was one of the most stable parts of the global economy, and its typically minor economic fluctuations would have little bearing on US equity markets.
Now, Europe's economic and political developments will be a persistent source of shocks for global financial markets.
As an investor, you need a roadmap. This book is that roadmap.
The Fall of the Euro describes the Eurozone’s unstable equilibrium and explains why a breakup of the Eurozone is still a possibility.
Nomura's global head of currency strategy and one of the world's top experts on the Euro, Jens Nordvig gives us a detailed and fascinating explanation of this precarious situation, providing the information, insight, and authoritative analysis you need to make the wisest investment decisions possible.
A riveting analysis of one of the most important currencies in the worldcertainly the most unstable of the major currenciesThe Fall of the Euro covers:
- The history of the Euroand how it differs from other global currencies
- The problematic origins of the Eurowhich is grounded more in politics than economics
- How politics will affect the next crisis in the Eurozoneand what we can do about it
- What-if scenarios of Eurozone breakup possibilitieswith insights that will surprise you
The original version of the Euro was not resilient enough to survive a major crisis. European policymakers are attempting to construct a new version of the currency, but its specific form remains highly uncertain. Will it be a hard currency? Will it be a soft currency? Or will it break up?
If the path ahead involves a disorderly breakup of the Eurozone, the instability to come will be much more intense than what we have seen to date.
Go beyond the rhetoric of the politicians and the journalists who write about them and get a financial expert's assessment of the real issues at hand. Jens Nordvig explains the state of the Euro's present position in the global economy with levels of objectivity and expertise you will find nowhere else.
The Fall of the Euro gives you the critical information you need to prepare your investments before the next crisis in the Eurozonewhich is, in Nordvig's view, inevitable.
Praise for The Fall of the Euro
"Nordvig brings a keen insight into markets and economics that he ably combines with a brisk, no-nonsense narrative. This is essential reading for market players, investors, and prognosticators of the future of the eurozone." Richard Clarida, C. Lowell Harriss Professor of Economics and International Affairs, Columbia University; Global Strategic Advisor, Pimco
"Jens Nordvig's book artfully combines a master economist's framework, a seasoned market participant's advice, an historian's far-reaching perspective, and a
European citizen’s passionate case for an open discussion of the way forward for the world's largest economic bloc." Scott Bessent, Chief Investment Officer, Soros Fund Management LLC
"Jens Nordvig was one of the first to analyze the economic, legal, and political consequences of the euro splitting asunder. Whether or not you share his pessimism about the future of the euro project, Nordvig's guide to the crisis is a compelling and essential read." Gavyn Davies, Chairman of Fulcrum Asset Management LLP,
former Goldman Sachs Chief Economist
"In this bold, highly readable book, Jens Nordvig beautifully highlights the tensions between the politics and the economics that are at the heart of the euro crisis. A must read for anyone who cares about the future of Europe." Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance, University of Chicago Booth School of Business
"I learned much from The Fall of the Euro and I thoroughly recommend it." Simon Wolfson, CEO of Next plc and sponsor of the Wolfson Economics Prize
"Needs to be read by all those demanding brave policy from Europe's timid elite." Tom Keene, Editor at Large, Bloomberg Television & Radio; Host of Bloomberg Surveillance
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THE FALL OF THE EURO
Reinventing the Eurozone and the Future of Global Investing
By JENS NORDVIG
McGraw-Hill EducationCopyright © 2014 Jens Nordvig
All rights reserved.
The Premature Celebration
A great deal of mystery surrounds the concepts of money and currency. What constitutes money? How can a piece of paper be worth anything? What is the value of one currency relative to another?
Money derives its value from the common belief that people can always convert it into goods and services at will. It is the universal acceptance of the idea that money can be exchanged for something else at some time in the future that gives it value. Government actions underpin this acceptance. Certain laws, such as those that allow people to use money to pay taxes, help define the role of money in our society. Meanwhile, government control of the supply of money helps to ensure trust in the value of the currency. As a society, we have entered into this social contract.
Each country has its version of money. In the United States, money is called dollars. In the eurozone, it is euros. In Japan, it is yen. In each case, the currency has value because it can be used to facilitate transactions (buying and selling of goods) and to store wealth for the future.
THE PURPOSE OF A CURRENCY
But currencies serve a purpose beyond providing the ability to buy a carton of milk, sell a house, and accumulate savings conveniently. Governments that have control of their own currency have a powerful tool at their disposal. Having an independent currency allows a country to tailor its monetary and exchange rate policy to meet the specific needs of the economy. For this reason, currencies are often symbols of national power. During the nineteenth century, for example, at the peak of the British Empire, the pound sterling was the dominant international currency.
The relative values of currencies are determined in foreign exchange markets. For most major currencies today, market forces are allowed to determine exchange rates. The supply of and demand for a currency will dictate its price in accordance with economic and political developments at home and abroad. But the success of a currency cannot be judged from its nominal strength or weakness alone.
A currency's success should ultimately be evaluated based on its ability to deliver on the core objectives of the country's citizens. In many countries, this isn't limited to economic prosperity, but also includes basic values such as democracy, equal opportunity, and political stability.
The euro was created with such fundamental values in mind. Therefore, it should follow naturally that judgment on the euro's success should not be based solely on its value against the dollar, or against any other currency. Rather, the euro's success should be based on the currency's ability to deliver prosperity for all European citizens and its ability to reinforce the most treasured European values.
PREMATURE EURO CELEBRATIONS
The euro turned 10 years old on January 1, 2009. European officials used the occasion to celebrate their achievements. Past and present leaders—the people who had created the idea of the euro and watched it come into being—gathered at a high-profile conference in Brussels, Belgium. The European Union even launched a public website to celebrate the euro. The 10-year birthday website showcased the euro's success through a series of easy-to-understand (albeit fictional) stories from the various countries using the currency. A family from Greece was happy because of low interest rates on its mortgage. A line manager from Finland was happy because of strong growth and new business opportunities.
On the front page of the website, the top economic official of the European Union, Joaquin Almunia, captured the positive spirit of the moment in relation to the euro:
Ten years on, it is a historic achievement of which all Europeans can be proud. Not only is such a currency union unprecedented in history; we can declare it a resounding success. Within the space of a decade it has clearly become the second most important currency in the world; it has brought economic stability; it has promoted economic and financial integration, and generated trade and growth among its members; and its framework for sound and sustainable public finances helps ensure that future generations can continue to benefit from the social systems that Europe is justly famous for.
At the time, the European currency was still viewed as a pillar of strength, a strong common anchor during a time of global financial turmoil. In previous crises, individual European currencies had fluctuated wildly, buffeted by global shocks or homegrown tensions. This time, the euro had been strong and relatively stable. The initial catalysts for the global financial crisis were concentrated in the United States, and the euro had actually gained versus the U.S. dollar in the early part of the crisis.
BACK TO REALITY
Just four years later, the reality is very different. Some eurozone countries are chugging along just fine; Germany is the best example. But others, like Greece, Spain, and Italy, have plummeted into unprecedentedly long and deep recessions.
In Greece, teachers are seeing their students doubled over with hunger pains during class. Like scenes straight out of Dickens, some children are even pawing through trash cans to try to find food or begging their classmates for scraps. In a story in the New York Times highlighting this issue, one of the teachers said, "Not in my wildest dreams would I ever expect to see the situation we are in. We have reached a point where children in Greece are coming to school hungry. Today, families have difficulties not only of employment, but of survival."
In Spain, more than 26 percent of the labor force is unemployed, up from less than 10 percent before the crisis. Meanwhile, youth unemployment has skyrocketed to more than 50 percent. People cannot pay their mortgages, are losing their homes, and have nowhere to turn. In February 2013, four people in one week committed suicide after being evicted from their properties throughout Spain.
In Italy, small businesses—in aggregate the biggest employer in the country—are struggling to pay their bills and are closing. According to the Italian business association Confindustria, the number of bankruptcies has doubled since 2007, and with credit conditions still worsening, there is no relief in sight. In May 2013, even the pope chimed in on Twitter: "My thoughts turn to all who are unemployed, often as a result of a self-centered mindset bent on profit at any cost." You know that the economic hardship is significant when the pope enters the debate.
Meanwhile, Europeans elsewhere, especially the more prosperous ones in the north, are getting tired of the woes of the poorer countries. They are growing weary of funding bailouts for struggling banks and sovereigns in the south. They have turned the screws on places like Spain and Greece by demanding severe government spending cuts and structural reform with the aim of bringing budgets into balance. But this is affecting funding for basic social services, including public hospitals in Greece. This exacerbates the situation for people in poorer countries at the worst possible time.
Recently, demonstrators took over a square in Madrid, shouting, "To fight is the only way!," according to a report on CNN. During demonstrations this year in Greece, Cyprus, and Spain, depictions of Angela Merkel dressed in a Nazi uniform have been shown. Both sides are fuming. The Germans are paying the bills, but they are getting blamed for the hardship. The common currency was supposed to bring Europe together. But in reality it is a source of disturbing political tension.
THE EURO'S CONGENITAL FLAWS
To the creators of the euro, their achievement looked strong and successful just a few years ago. But the euro's underlying flaws have now been exposed. Since the euro's 10-year birthday, the global financial crisis has morphed into a euro-specific crisis. The euro's flaws have been made evident through repeated waves of financial market turbulence and a trend of underlying economic deterioration.
The euro crisis started in Greece. The country was vulnerable after years of excessive government spending, and it underwent its own credit crunch when investors pulled back in late 2009. Then housing markets collapsed in areas that were previously booming, and Ireland and Spain descended into severe recessions. The largest eurozone banks teetered, not only in Ireland and Spain, but also in France and Italy. Individual European financial markets started to drift apart, reversing the trend of financial market integration that had existed for the previous 10 years. Finally, for the first time since World War II, a developed European country defaulted on its debt. Greece restructured its government bonds in March 2012.
Now, public finances in places such as Portugal and Spain look close to unsustainable. The anchor provided by the common currency has become dislodged, and confidence in European institutions and policy making has eroded. Today, few would agree with the statement that the euro has been a resounding success.
The euro was born out of a political desire for European integration. It was a noble idea, but it lacked a sound and resilient underlying structure. Countries that adopted the euro would be united through the common currency and a common monetary policy set by the European Central Bank (ECB). Each individual country that was part of the eurozone surrendered its ability to make its own monetary decisions, even in a time of crisis. Unified monetary policy implied that tools that could help save an individual economy during periods of severe stress were no longer available to the individual countries. Meanwhile, there was no centralized fiscal policy to provide an offset. Unlike the United States, the European currency union had no backing from a common federal government that was able to transfer funds between weak and strong regions. What's more, no European institution had any real ability to control an individual country's budget or spending habits. The monetary union was handcuffed in the event of a catastrophe.
These fundamental flaws have caused severe economic and financial stress in the eurozone since 2010. Over the last four years, major swings in global asset markets—across currencies, fixed income securities, and equities—have been driven by European events, a clear departure from patterns in recent history. In the past, Europe was one of the most stable parts of the global economy, and its typically minor economic fluctuations would have little bearing on U.S. equity markets, for example.
TRYING TO REINVENT THE EURO
Recognizing the incompleteness of the infrastructure supporting the euro, senior European officials eventually put forward a blueprint for a so-called genuine economic and monetary union of the eurozone countries. This change in thinking came about in the summer of 2012. The new vision for the euro involves closer coordination of public-sector budgets and common supervision of the region's banks. Some officials also hope to eventually put in place a common financing instrument, so-called eurobonds. This is a long-term vision.
But there are serious obstacles to moving toward a more mature monetary union.
First, short-term problems need immediate responses that a long-term vision won't provide. Large eurozone countries such as Spain and Italy are currently facing high public-sector borrowing costs and negative growth, which threaten to make their debt burdens unsustainable.
Second, although the eurozone now has more ECB support, European treaties were written to categorically preclude central bank financing of public-sector deficits. While, astoundingly, many deals have been able to circumvent this seemingly clear legal directive, the ECB has been forced to attach at least some conditions and caveats to its interventions. For example, in order to get access to ECB support in the future, the Spanish government would have to submit to unpopular budget restrictions and supervision from the ECB. The lack of unconditional backstop from the ECB leaves public finance in an uneasy vacuum of uncertainty while policy makers struggle to make progress on the longer-term integration process.
Third, the political reality is that voters across the eurozone have lost their appetite for further European integration. Even if European leaders are willing to sign up, European citizens are skeptical that they can make good on their promises. Future elections and referenda may present significant and decisive setbacks to the integration process, and this uncertainty may feed into a growing sense of pessimism in the shorter term.
THE EVOLVING EURO CRISIS
The complexity of the euro crisis is derived from several main elements. The euro is an incomplete monetary union, incapable of dealing with shocks in specific eurozone countries. It has a conservative central bank that is unwilling to provide unconditional support for individual countries. And, perhaps most important now, European countries have diverging political views and cultural backgrounds, and European policies are rapidly losing credibility. A severe decline in public trust in European institutions across the entire eurozone makes significant further integration extremely challenging.
To put it bluntly, the eurozone cannot survive without further fundamental reform, and if further integration is not feasible, some form of breakup is inevitable.
In the early part of the euro crisis, any mention of a breakup of the eurozone was regarded as speculative paranoia in European policy circles. But new political realities in Greece and Cyprus have opened up a space for such conversations. European policy makers have finally admitted that some types of exit from the eurozone are a possibility. You could even argue that a form of breakup has already taken place when severe capital controls were imposed on Cyprus in 2013, limiting the movement of money into and out of the country. President Nicos Anastasiades of Cyprus admitted the same in an interview with the New York Times on July 9, 2013. "Actually, we are already out of the eurozone", he said.
At the same time, policy makers are still trying to pretend that other forms of breakup—such as those involving the departure of Spain, Italy, or even Germany from the euro—remain inconceivable. But this position may change over time too.
THE POLITICS OF THE FUTURE EURO
Still, European policy makers have invested immense amounts of time and energy, not to mention political capital, in the euro project, and they are not about to give up easily. They are pursuing gradual further integration to save the common currency, and they may even have gained confidence from a degree of financial market stabilization since the last intense crisis wave in the summer of 2012.
To be viable in the long run, Europe's currency union needs to be underpinned by more closely integrated economies. Member countries need to move toward fiscal and political union; and the ECB needs to assume direct responsibility for protecting the currency by assuming an explicit role as the lender of last resort.
Just a few years ago, European policy makers were celebrating the euro as a "resounding success," and markets were assuming minimal government default risk across the entire eurozone. But the euro is failing to deliver on the core objectives of European citizens. Markets are no longer collapsing, but confidence in European institutions is. Weak growth and years of broken policy promises are combining to create unprecedented euroskepticism, both in peripheral countries and in the very core of the eurozone.
EUROPE'S NEXT CRISIS IS POLITICAL
This book will provide a new framework through which readers can understand the key indicators that are of longer-term importance for the future of Europe and global financial markets. Investors should learn the danger of premature celebrations and position themselves for a new investment environment in which political risk in Europe plays a potentially dominant role.
Excerpted from THE FALL OF THE EURO by JENS NORDVIG. Copyright © 2014 Jens Nordvig. Excerpted by permission of McGraw-Hill Education.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
Part I The Euro: The Early Years 1
Chapter 1 The Premature Celebration 3
Chapter 2 The Birth of the Euro: A Grand Political Bargain 13
Chapter 3 The Euro's Honeymoon Years 33
Chapter 4 The Euro Crisis: Waves of Escalating Tension 49
Part II European Integration: The Difficult Path 73
Chapter 5 The Big Choice: More or Less Integration? 75
Chapter 6 The Revenge of Realpolitik Europe's Dilemma 83
Chapter 7 An Involuntary Gold Standard: The Economics of Inflexibility 99
Chapter 8 Where's the Growth?: The Cost of Deflation 109
Chapter 9 Europe's Political Fragility: The Seeds of the Next Crisis 123
Part III The Mechanics and Implications of Breakup 141
Chapter 10 When a Currency Splinters 143
Chapter 11 The Devil's Guide to a Eurozone Breakup 153
Chapter 12 What's the Worst-Case Scenario? 163
Chapter 13 Who Should Stay and Who Should Go?: The Economics of Exit 175
Part IV The Future Euro: Investment Implications 191
Chapter 14 Europe at the Center: Europe's Effect on Global Financial Markets 193
Chapter 15 A Road Map for the Future Euro 203
Data Appendix: The Breakdown of Eurozone Debts 227