The Wall Street Journal is not the first to comment on the magnitude of the wagers against the euro (the Financial Times took note nearly two weeks ago: “Speculators raise record bets against euro“). But the Journal offers a spectacle sure to inflame sentiment in Europe: that of major hedge funds feasting first on lemon-roasted chicken and filet mignon and later the euro:
During the dinner, hosted by a boutique investment bank at a private townhouse in Manhattan, a small group of all-star hedge-fund managers argued that the euro is likely to fall to “parity”—or equal on an exchange basis—with the dollar….
An SAC manager, Aaron Cowen, who pitched the group on the bearish bet, said he viewed all possible outcomes relating to the Greek debt crisis as negative for the euro.
Yves here. The article contains some comment that I consider to be misleading:
There is nothing improper about hedge funds jumping on the same trade unless it is deemed by regulators to be collusion. Regulators haven’t suggested that any trading has been improper.
Through small gatherings, hedge funds can discuss similar trades that can on each other, in moves similar to those criticized by some investors and bankers in 2008. Then, big hedge-fund managers, such as Greenlight Capital Inc. President David Einhorn, who also was at this month’s euro-dominated dinner, determined that the fortunes of Lehman Brothers Holdings and other firms were dim and bet heavily against their securities, accelerating their decline.
Yves again. The first paragraph gives the mistaken impression that foreign exchange markets are regulated. They aren’t. Spot and forward markets in foreign exchange in the major currencies are close to unsupervised (for instance, there is no mechanism for collecting transaction activity, which would be a critical way to look for odd transaction patterns and volumes), so the notion that there are growups that are supervising that trading or prepared to intervene is oversold. Now there are currency futures that trade on the IMM, Euronext, and ICE and these traders may well prefer to use exchange traded futures (options are largely traded OTC). Those trades would be subject to meaningful oversight.
Using Einhorn as an example in this context is also peculiar. First, Einhorn shorted Lehman’s stock, which meant he was operating in a highly regulated market, which is very different than some of the avenues open for wagering against the euro. Second, given his history (the SEC investigated Einhorn for possible market manipulation when he shorted Allied Capital, when Einhorn’s stance was ultimately vindicated, and the SEC later launched an internal probe in response to Einhorn’s charge that it mismanaged the situation, and appeared to discover some irregularities) my impression is Einhorn went to some lengths to make his case against Lehman in a highly public way. So while there is nothing inaccurate, narrowly speaking, about mentioning Einhorn, conflating his short of Lehman with a currency short is disingenuous. The standards for collusion in SEC-land are very different from those in the wild west of OTC markets.
But then we get to a more complicated dynamic. Truth be told, eurozone members should want a cheaper euro. A favorite crude measure, the Economist’s Big Mac index, suggests that fair value would be 1.1 versus the dollar, well below its current level of 1.35. Of course, the old nostrum that a cheaper currency is better for growth generally (by helping export competitiveness) does not mean that a shift would not be disruptive and leave many individuals worse off (particularly since energy imports in particular would become more pricey).
But a fall now, particularly a sudden one, would be seen a a repudiation of the euro. There is more at stake than just the level of the euro; many observers see this as a test that was inevitable when the euro was established, that a number of crucial issues were finessed and now have to be resolved. But some go further, and argue that while the eurozone will not break up, that it includes too many heterogeneous nation-stated to be viable. FT Alphaville (hat tip reader Richard Smith) quotes Paul Donovan of UBS:
That the Euro area is not an optimal currency area is generally agreed upon. The European economies are sufficiently diverse that external shocks hit different economies with differing degrees of severity. The asymmetrical nature of any shock is also likely to persist for longer. This is something that has been well understood for some time. Indeed, fourteen years ago UBS economists concluded that “a monetary union extending beyond the core six [European] economies would not work properly in economic terms.” The analysis identified those economies that could realistically be called an optimal currency area, those economies that could satisfy the Maastricht criteria (on a relatively liberal interpretation), and those economies for which there was a strong political will in favour of monetary union. The analysis suggested that Greece, Spain, Italy and Portugal failed to meet real economic or financial criteria. Ireland and Finland were felt to meet the financial and political criteria, but also failed to meet the real economic test. The Venn diagram UBS originally published is replicated [here], for the benefit of those with an interest in economic history….
The most optimistic scenario for the Euro probably lies in some kind of parallel to the experiences of the US in the 1930s. Then, a fragmented banking system, with powerful regional central banks, failed to deal properly with an asymmetric shock to the economy (and to the financial system). The problem fostered significant regional differences in economic performance. This motivated financial reform, and a greater fiscal transfer mechanism to turn a sub-optimal currency area into a sub-optimal currency area with the mechanisms to smooth the consequences of shocks.
Yves here. So see, it IS possible to be a “sub optimal currency area” if you can muddle through devising the right mechanisms. And the analogy to the US in the Great Depression is apt in another way: a complicating feature is that a sovereign default or restructuring will hit European banks, many of which have fragile balance sheets.
It is important to note that while the symptoms may show up as a “Greece problem” or a “Spain problem”, the root cause is a one-size fits all monetary policy (that is not to say that country-level monetary policy guaranteed good outcomes, individual governments can still make poor choices).
Reader Richard Kline’s remarks in comments yesterday illustrate the considerable variations among the eurozone members the top of most worry lists (and as some readers correctly point out, the UK also has a looming external debt problem, but is not in the firing line right now):
Protests: By whom and to achieve what? Those to me are the principle questions. It would appear that the protests were primarily organized by unions and in particular by public employee unions. That is understandable because theirs are the jobs most likely to be lost, but if they are protesting in isolation—and it would appear to be so—their cause is already lost. Without broader support in their countries, they can make a lot of sound and fury, but the flutter of a redundancy slip will have the final word. I take that as the undercurrent of some of the well-intentioned pushback in comments in this thread. Part of me wants to be sympathetic to part of the problem, but the fact is the context has changed, and strategy needs to change.
Greece’s problems aren’t a result of the financial crisis. Greece has run unsustainable deficits for decades, finally turning to accounting chicanery. Greece has had do-little public sector jobs as buy-offs for social peace, too many jobs, and these wealth-transfer posts can’t be funded, now. The political counterweight for those jobs was a tax system which more or less allowed there significant domestic wealthy elite to live in a domestic tax haven, paying virtually nothing. All of this was possible while phoney ‘growth’ was happening due to the credit bubble making Greece’s sovereign debt fundable on capital markets without qualm—once it was euro-denominated. (Greece had financial crises in the recent past before the currency union.) Greece’s problems have been, in fact, made in Greed. —So it would be a good thing if those who live in Greece got on the stick and came up with some solutions. The solutions at present appear to be, ‘Shaft the common man, and bill him for the surgery.’ That proposed VAT is brutal . . . but then that’s one of the few taxes which is relibably collected there. And the rise in the retirement age hits the poorest with particular force. What is not on the table are effective tax enforcement upon the wealthy, and at higher rates. This, too me, is what protestors should be protesting, not the evaporation of do-little jobs which the country can only afford if someone else is picking up the tab. Then too, another goal of a demonstration which would be reasonable would be to demand a ‘renegotiation’ of existing debt over longer terms at lower rates; ‘reasonable’ because the banks who snapped up Greek sovereign debt in the good times did it in full knowledge of the situation but were quite willing to leap in as ‘enablers’ as long as they got their money rent on it. French, Swiss, and German officials would find if hard to defend against a demand for renegotiation in a situation where they are insisting that the Greek citizenry work two, four, seven years more of their lives to pay that debt off. To me, the point is as you say, Yves, to keep the impacts of necessary changes from being excessively and unfairly taken out of the hides of the poorest.
Portugal’s problems are also not caused by the financial crisis. PJM above sums them up well. Portugal joined the euro, and this was both necessary and good as it brought cross-border investment from within Europe, gave increased access to markets there, and (in normal times) gave increased access to capital markets there. But the export sector, and overall productive sector there is too small yet to support services and government at a ‘European’ level, all efforts to expand them notwithstanding. Just as PJM says, remittances from abroad are still a very important part of the local financial system, a real indication of production imbalances. What has happened is not that Portugal has ‘overspent’ or ‘overborrowed’ but that the borrowing they have done was only possible at the excessivly low rates of the credit bubble: Portugal can’t afford a rate spike, and so services are squeezed with funding becoming dear. The alternative to that are long-term development funds from within the EU, but that was controversial (as a matter of competitive advantage) even before now, and will be very difficult if not impossible to get funded in present conditions. Portugal’s economy is small and weak relative to stresses around it, and is getting bruised. That is not their ‘fault,’ even if it is their pain.
And so on, and so on. The points to me are: a) the immediate crises are by-products of lending squeezes, and b) stink of predatory instigation by third-parties speculating against the weak countries involved. If the poor in the affected countries aren’t to take the hit for everyone, they need to get out in front with solutions rather than just saying no. I think most in those countries know this better than I do.
Update 3:30 AM: From Eurointelligence:
FT Deutschland leads the paper with the story that leading German banks announced that they would not be buying Greek bonds at a forthcoming auction (very unhelpful such an announcement, but this is what happens once a panic starts). Eurohypo, Hypo Real Estate and Postbank are the banks mentioned in the article, and Deutsche Bank will only get involved in its role as an investment bank. The paper quoted sources from two Landesbanken as saying that investments in Greece are hardly thinkable. So, these banks are already distrusting any possible guarantees they might receive from the German government as part of a rescue package. Die Hypo Real Estate is the German bank most exposed to Greek debt, with about €10bn.
Jean Quatremer says in his blog that a monetary union with full fiscal independence is not going to be sustainable in the long run. He also writes that Athens is threatening to borrow unilaterally from the IMF if the euro area is not helping – or attaching further pre-conditions – which would a massive embarrassment for the EU.