Where’s the euro heading? You don’t want to know!
But for the sake of your finances you probably should take a few moments to consider it. When you think about it, it’s kind of obvious.
On Monday, I introduced you to the idea of purchasing power parity (PPP). We used the Big Mac Index to help see if currencies look over/undervalued. PPP is an incredibly useful concept. It shows how nominal currency values convert into real wealth from country to country.
Not only is it useful when considering currency valuations, we can also use it to shine a bright light over the European debacle. We can use PPP to prove the single currency is a fundamentally flawed concept, why it’ll probably come undone and, most importantly, what it means for you.
A roomful of politicians wrecked Europe
The beauty of floating currencies is they establish healthy international trade. In my own business, I import fantastic oils for the beauty industry from Latin America. In return, we (as a nation) sell them a few Jaguars and Land Rovers and a few other choice goods. The national currency expresses each country’s relative purchasing power and keeps the entire system in balance.
But of course by establishing a single currency, the eurozone wrecked PPP within the eurozone. Currency values can’t express the PPP differences between countries. Now everyone shares the same prices. Full stop.
And yet the deluded politicians argued that the single currency would foster trade – supposedly by removing currency risk. All it’s actually done is create massive distortions. Sure there’s been plenty of trade, but it’s been in all the wrong stuff.
When Audis are too cheap and olives are too dear
Before entering the euro, the values of the escudo, peseta, lira and drachma were massaged to fit in to the exchange rate mechanism (ERM). The markets kind of assumed these countries would be dragged up to northern European prosperity levels, which I guess to some extent they were (temporarily). It was normal for a currency to strengthen before joining the euro.
But it’s now pretty much received wisdom that the peripheries went into the euro at an unsustainably high level.
That led to a fantastic boom in the periphery. Suddenly these countries were rich. Their purchasing power was higher. They could afford all sorts of things they couldn’t before. Porsches, Beemers, Mercs and Audis rolled off German production lines and headed south. As for oranges and olives coming the other way, well it didn’t quite happen. They weren’t as cheap as they used to be! And so trade imbalances started to grow.
Now, the fact that the southerners got a good deal on purchases is one thing, but where did they get the money to finance them? It was, of course, the richer northern states that financed it all.
It worked like ‘vendor finance’ does in business – where the guys making the stuff effectively loan you the money to buy it.
At first it was the commercial banks providing the loans. Now it’s the central banks. Today the Bundesbank is saddled with about €500 billion worth of loans to other European central banks.
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That money will never be repaid
So the peripheries are going to have to pay back some debt. But here’s the thing: they can’t.
That’s because PPP can’t play its vital role. The euro straitjacket won’t allow them to export their way out of trouble. Nobody wants their stuff at these inflated prices. And that includes us Brits – have you noticed how wine sales, for instance, have migrated towards non-euro countries?
In fact, many of the southern industries have shut down as they’re no longer economical. Olives, wine grapes and oranges rot, because they’re too expensive to harvest.
Unemployment is rising. Tax-take is down and benefits are up.
And it gets worse... the artificially high exchange rate makes the loans too dear to repay. And of course the markets know it. That’s why they’re pumping up the interest rates on loans to the peripheries.
The point is, currency unions don’t work – why? Because you lose the fantastic benefits of PPP. Far from helping trade, it warps it.
That’s why austerity can’t fix the problem. And while the politicians wilfully ignore their predicament, the markets can see exactly what’s going on. Sure, the authorities can step in and meddle – a ban on short selling, or maybe even buying investments themselves. But they’ll only cause more distortions… right up until things collapse.
Breaking up is hard to do
My best guess is that social instability will cause one or two exits from the union. The authorities will then, and only then, establish northern and southern blocs.
Of course nobody wants to see this happen; it would mean a financial horror show. The banks, even the central banks, would have to crystallise inevitable and massive losses in one hit.
But surely at some point our great leaders will have to recognise that it’s the only way? I mean, the losses are already baked into the cake. The euro has sucked in commercial banks, and it then sucked in central banks. And now it’s sucking in the IMF and all manner of new institutions set up specifically to fund these ridiculous (and avoidable) trade imbalances.
• Avoid the banking sector – it’ll probably end up nationalised.
• If you’ve got euro deposits, shift them to the northern European banks.
• Continue to manage your portfolio on a very conservative basis. 25% cash, 25% bonds, 25% equities and 25% commodities (including gold) remains my target allocation.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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