The Euro Is Done For

The EU probably needs about $3 trillion in euros just to get them to 2014. I doubt they pull it off without the euro taking a hit.

As of my writing this, European leaders have not come to an agreement on any solution for the debt crisis plaguing their countries. But never fear, they shall surely reach just such an agreement, or else come up with some other small victory to parade in front of journalists before tomorrow Morning.

Sarkozy and Merkel have nothing to gain from failing to meet their own deadline, so I can’t imagine they won’t figure out something they both agree on to send to the table, just so they can create a victory here. I don’t really question that will happen although I suppose it could.

Also, with regards to the sums of money being discussed, I want to say that if the European Union can muster $2 trillion, that would be more than enough to end the European debt crisis.

I do not contest that point.

Italy, Spain, Portugal and Greece have a combined rough $3 trillion in national debt (if the records are to be believed). But even if they have another $1 trillion combined in off-the-record debt, then $2 trillion will still more than suffice to put an end to the solvency debate surrounding Europe.

Italy owes just under $1 trillion from now until 2014. It’s heavily skewed to the front end. I didn’t bother checking the others, because even assuming that all four countries are in as bad of shape, with about half their money owed due by 2014, they would only need about $1.5 trillion to get them there. Throw in our $1 trillion “dirty bastards” allowance, and $2 trillion would still about do the trick.

That would buy the EU two whole years, during which any number of wonderful things could happen. You can bet that if I thought the only issue was time, I would not be short oil here like I am. I have no desire to be short oil for 2 years; or another 2 thereafter…

No, the real issue has always been that even if the Europeans decide to bail themselves out, they cannot possibly do it without destroying the value of the Euro.

Consider: according to the ECB, there was about €900 billion in circulation this year – an increase of almost 50% from 2006. This compares with about $2 trillion U.S. dollars in circulation. So on face value, the euro to dollar exchange would be 2:1.

Now presently the euro trades for about 1.4 dollars, a discrepancy which exists for two reasons. The first is opportunity cost – my understanding is that most goods like gasoline are more expensive in Europe so there’s no reason to make the exchange at 2:1. The second is speculation – in this case, that the euro will get weaker against the dollar.

So the first real challenge is to figure out what the real exchange rate would be without the speculation. You could compare the CPI’s of the U.S. and Europe, which I was going to do. But then I decided instead to just run with the 2:1 number and see what popped out.

It’s faster and if the conclusions are big enough, then they translate to a weaker euro.

There are two main points of view you need to consider when looking at the European problem.

The first is that the European debt crisis is also a financial crisis. It has infected their banking system, sparking the beginning of necessary bailouts. Now we’re hearing talk of European banks being made to raise their reserves by $1 trillion across the board.

In the U.S. we were forced to raise our currency in circulation by 50% while implementing the bailout funds, such as TARP. If Europe is in a similar situation, then some of the $1 trillion may have to come from government backed loans similarly weakening the Euro.

At the 50% level, that would place the EU M1 level at about €1,300 billion, lowering the face value exchange rate of the dollar to euro to around 1.5 from the theoretical 2 to 1 rate that exists now. That number is subject to error.

The second point of view is that there are not enough savings in Europe to cover the hyped $2 trillion bailout fund they’re supposedly considering right now. So who can fill the gap? There is much talk of China stepping in and levering the ECB bailout fund to the $2 trillion number.

China, after all, has over $3 trillion in foreign currency reserves.

However, that number is not necessarily helpful. How much of the $3 trillion is in actual euros? After all, if the Chinese convert dollars to euros and then loan those euros to Europe, while they may have succeeded in keeping the euro strong, they have simultaneously weakened the dollar. That’s a relationship which China is keeping in very tight control.

Based on the latest few trade deficits, I figure the most euros China could have accumulated over the last six years is about €1 trillion. If China has held onto all of them, then they themselves could barely fund the full, speculative $2 trillion fund.

But even if the Chinese do jump in and stopgap the entire difference, then what? As a European, would you want to be holding a currency which is about to have an addition one trillion notes find active circulation? What would that do to EU inflation rates?

Basically, what I’m thinking is that in order for Europe to fight off their financial problems, they will need to take the euro’s theoretical value to about where it stands today. Except that the real exchange rate stands where it is today for a reason; there is much less encouragement to hold euros which limit you to trade in Europe, than dollars, which allow you to trade pretty much anywhere. That act alone probably puts the value of the euro to dollar inside of 1:1. Then the Europeans need to fight off insolvency, which at best does not increase the number of outstanding notes but does increase the circulation of money; creating a huge disincentive for Europeans to hold their own currency or invest in euro denominated fixed income investments. That will make it harder for European countries to finance the remaining debt after 2014.

The EU participants have a huge need of currency. Their banks need more euros. Their governments need more euros. And no one in their country has enough to cover the full amount. The difference is going to come from someplace, and that someplace is going to broadly weaken the currency.

Now, again, I think the final price tag is $3 trillion. Anything less and they’re in trouble, but even if they pull it off, no way they do so while maintaining the current strength in the euro.

Or, of course, they could always just elect to fail tomorrow. Either way, I would not be holding the currency right now. Best case, it’s undervalued by about 10%. But worst case, the euro is about to lose more than 1/3 of its value.

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