Monday, 29 November 2010

No parallel between the Eurozone currency club and the federal system behind the US Dollar

The Irish Independent ran a story on Sunday November 29th which is worth reading for illustrating how troubled peripheral Eurozone states can best negotiate terms for EU bailouts...just threaten default.

With French and German policymakers issuing hyperbolic (and desperate sounding) statements in support of the euro currency on Monday as the markets seem not to be overjoyed by the Irish "rescue" package, the Achilles heel of the EZ currency club is becoming all too apparent.

The major flaws in the EMU and the procedural shortcomings of the EZ management system have been only too obvious since the Irish have had to air their dirty linen in full view of the world's financial media and analysts. But even more revealing has been the extent to which the German government in particular has had to back down on the issue of bond haircuts. The lack of resolve on the issue of how to allow insolvent, but totally inter-connected, banks to fail within a mechanism for re-structuring all stakeholders, including the claims of senior debt holders, is now the glaring weakness of the EZ and its interface with the global banking system.

One could even make the case that Europe is simply in the vanguard of the eventual unraveling of the many dodgy bank balance sheets which have been subjected to a low tech shell game of financial engineering with bad assets simply being shunted through a maze of obfuscation.

The architectural flaws of the EZ currency club are almost too numerous to mention but can be framed essentially in the following question - How does one expect a "union" to survive under a common currency, which has to be supported by a central bank, when any and all of the member states are free to issue as much debt in the collective currency as they deem necessary?

While the US dollar bloc is similarly exposed to hide the salami accounting shenanigans the lack of a parallel between the EZ currency club and the USD regime which is under-written by the truly centralized Federal Reserve system is highlighted by the Irish negotiating tactic alluded to above.

Imagine the circumstances where to take just one example, say California, threatened to default on its obligations and how this would impact the US dollar. It clearly would be a distressing circumstance and likely to cause major disruption in asset markets but would it trigger a cascading of defaults on vast numbers of daisy chain obligations denominated in US dollars? California is not obviously a sovereign in the same sense that Ireland is and the defaulting by the state of Ireland would have wiped out in a second hundreds of billions of euros of loans by global banks to not only Ireland per se but all of its banks which are subject to the guarantee of a state which had just defaulted. Would the capital markets be convinced if the ECB stepped in and was prepared to guarantee all of Ireland's obligations? What about the credibility of a promise by the EFSF (an SPV which derives its AAA credit rating from the creditworthiness of all EZ states - including the so called PIIGS!) to honor all of Portgual's and Spain's liabilities?

The US Federal Reserve could much more readily and convincingly undertake to protect debt holders in the case of a unilateral default by one of the US states than the European central bank, and this is underlined by the fact that the idea of a state like California declaring its currency independence from the USA and floating a rival currency seems like a nonsense.

When all of the impossibly awkward repercussions of the EZ bailout process and the flawed architecture of the underlying EMU are fully exposed - and they surely are close to that point already - the non-survivability of the euro currency will become obvious to all.

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