Germany Tip-Toes Toward a Euro Exit

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The Daily Reckoning | Monday, October 1, 2012 Calculating the incalculable: Dire straits for the future of the EU... Plus, Dan Amoss on the likelihood of Germany leaving the euro, and plenty more... ------------------------------------------------------- Planning on buying a smart phone, tablet, or HD TV? You may want to wait... Industry insiders at some major electronics companies know something you might not... And if you did know this was happening, you probably wouldn’t want to buy a smart phone... tablet... or HD TV for at least two more months. Find out why in this special presentation.   Quote of the Day... “The euro is in danger... If we don’t deal with this danger, then the consequences for us in Europe are incalculable.” — German Chancellor Angela Merkel Greg Kadajski, checking in from Baltimore, Maryland...   Greg Kadajski Get out your calculators! The above quote from German Chancellor Angel Merkel is from a very dire-sounding speech she gave to the Bundestag...in May of 2010! That’s right... It’s been more than two years since the good Chancellor alluded to the “incalculable” consequences of a euro- collapse, and in those two years, not much has been done to change the euro’s (ultimately downward) trajectory. Sure there’ve been plenty of bailouts and austerity measures and all manner of political promises... But it seems as if none of that has done anything to alter the underlying market sentiment: “The euro is in trouble. Not sure where it’s headed. Probably down.” Of course, while the “when and how” of a euro-collapse is impossible to know for sure, that can’t stop one from speculating on what it might look like. Dan Amoss offers one of the most intriguing scenarios for such a collapse in today’s guest essay. Read on...   Why “gold $2,000” is a joke... On April 24, 2007... one gold expert said “gold is on its way to $2,000 per ounce.” At the time, gold was trading around $688 and the mainstream figured he’d lost his mind. But anybody who listened had the chance to make up to 175% on the metal alone... and up to three times more on related metal plays, as I write you today. So what’s this gold expert’s latest prediction? Click here to find out. The Daily Reckoning Presents Germany Tip-Toes Toward a Euro Exit   Dan Amoss The stock market will not remain in its current tranquil state. Investors will soon be roused from their blissful trance. This trance traces its origins back to the mass self-delusion that central banks can revitalize multi-trillion-dollar economies, simply by prodding investors into stocks and other “risk assets.” Investing is not that simple. The comparison between bond yields and stock yields — two completely different investments — has become absurd. Bonds are contracts involving a fixed stream of cash flows and a predetermined maturity date. Stocks are claims on highly uncertain streams of future free cash flows that often stretch out for decades. Many risks can enter the picture and alter the trajectory of free cash flow — and investors’ expectations of them. Risks tend to appear out of the blue and smack investors out of their blissful trance — a trance created by central banks that have shifted far too much attention on the returns of stocks versus bonds... Here is just one negative catalyst growing closer as the weeks and months pass: Germany could exit from the euro and return to the deutsche mark. While a German exit would offer long-awaited clarity about the future of Europe, it would also spark a mad scramble to adjust to a new reality. A German exit would trash the euro’s value against the currency that’s steadily becoming the reserve of choice: gold. Only weak economies with bankrupt governments would be left standing behind the euro. The European Central Bank (ECB) would be free to monetize as much Italian and Spanish debt as it wished (i.e., print euros to buy the government bonds of Italy and Spain). The economists calling for a weaker currency to restore prosperity to the PIIGS countries would get to see their prescription play out in a real-world laboratory. Results would show that currency debasement does not create stronger, more competitive economies. Countries left in the euro would see collapsing living standards: import prices would rise and capital investment would fall amid a chaotic currency regime. ECB president Mario Draghi famously deemed the euro “irreversible”; he would do whatever is necessary to preserve it. But what Draghi sees as necessary will eventually be seen as intolerable in creditor countries like Germany. Once Draghi starts monetizing Spanish debt, Germany and other wealthy countries will view the euro’s costs as greater than its benefits. The German central bank — the Bundesbank — still exists. The Bundesbank could convert its liabilities from euros to deutsche marks at a predetermined exchange rate and take a one-time write- down on assets related to claims on PIIGS central banks. It would certainly be costly, but the alternative is worse: perpetually financing eurozone states unwilling to restructure public benefit programs unaffordable for their economies. Having seen the example of Greece, the Spanish public suspects that austerity will only make things worse. Spain will come to believe that its salvation lies in the printing press — in the ability to inflate away its heavy debt burden. After promising markets that the ECB would buy Spanish debt, Mario Draghi now has no choice but to fire up the euro printing press. Most other debt holders will flee the chaos unfolding in Spain. They’ll refuse to hold Spanish bonds at yields too low to compensate for default risk. The ECB, once it establishes a fake, above-market price for Spanish bonds, will ultimately find itself the only holder of those bonds. This is what happens when central planners impose prices far from what private investors consider fair value (in this case, pushing Spanish debt yields to below 4%, versus a much higher market-based yield). Once the German taxpayers see that the ECB will become the majority holder of Spanish debt, they will insist that German politicians plan an exit from the euro. What to Expect in 2013... Between 2004-2007, Bill Bonner and Addison Wiggin did their best to alert their loyal readers to the dangers of the housing bubble well before the mainstream said anything about it. Well, today, they see something even worse looming just over the horizon. It’s not often our Reckoner-in-Chief agrees to appear on-screen, but this was just too important. Click here (or the image below) to see what they’re talking about now... The next act in this long-running tragedy involves Spanish Prime Minister Mariano Rajoy officially requesting a bailout from the EU. Rajoy’s bailout-stalling is only a negotiating tactic to get the easiest terms possible. His so-called “austerity” budget, released this week, shows that he’s still far from the demands of EU bailout bureaucrats. For example, Rajoy’s budget ignored the EU suggestion that Spain raise the official retirement age for pensions. Once the negotiations end, the bailout will commence. The ECB will sprinkle its fairy dust and enter a Spanish bond market that others are fleeing. The investors who are dumping Spanish bonds know that Spain’s experience will resemble Greece’s experience: a series of EU bailout checks, failed austerity programs and probably steep haircuts for bondholders. That’s why the folks who are still holding Spanish bonds will be happy for the ECB to take them out of their positions with newly printed euros. Rajoy’s budget cuts will not be enough. Spain can’t afford to fiddle around the edges. It needs a financial restructuring focused on the zombie banks. The banks still haven’t come close to admitting their real capital shortfalls. Until there is a restructuring, with substantial haircuts for bank shareholders and bondholders, projections of economic recovery are pure fantasy. Even if proposed budget cuts satisfy Germany and the EU, there is no political will for austerity in Spain. That much is clear from the rising energy of protests in the streets of Madrid. Protests against budget cuts have only just begun. Debilitating strikes are on the way. We may even see the wealthy northeastern region of Catalonia vote to sever financial ties to the national government. Ambrose Evans- Pritchard summarizes Spain’s fragile political cohesion in a recent UK Telegraph column: “I have no idea what Spain will do, but emotions are running high and the country — in the words of Confidencial this morning — risks ‘disintegrating.’ We watch and wait to see whether the Basque revolt or the Catalan revolt will detonate first, and whether the Spanish will really use ‘all means’ to hold the union together. “The newspapers ABC and La Razon both called on the government to deploy ‘the arms of the state’ to stop Catalonia holding an independence referendum. “It is as if The Daily Telegraph were to call for coercion to stop Scottish independence. Imagine the response in Scotland.” Do you think many investors would hold Spanish bonds while whole regions were threatening to secede, fighting a central government that might morph into a military dictatorship? Or that in this scenario Germany would tolerate staying in a euro collateralized by Spanish bonds? I don’t think so. Germany will watch as all of this unfolds and realize that Spain’s austerity promises will be broken. The ECB will be left holding hundreds of billions of Spanish debt, with no possible exit and constant pressure to continue monetizing Spanish debt. It will be then that the drive to exit the euro will pick up speed. Enjoy the blissful trance while you can; it is about to come to an end. Regards, Dan Amoss for The Daily Reckoning ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com   Downside: After the Returns Stop Diminishing, Part II Downside: After the Returns Stop Diminishing Too Much of a Good Thing, Part III Optimism For Spanish Banks US Postal Service to Default... Again! 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