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Euro shambles nowhere near resolution

We shall see how the outcome of the European Union summit, starting yesterday in Brussels, will turn out.

Opinions among the leaders of the EU are still far apart over how to fix the financial crisis that looks mathematically impossible to repair.

Italy, France and Spain, in particular, have been pressing for Germany to agree to share debts. They would also like the European Central Bank (ECB) to play a more active role in mending the crisis. The International Monetary Fund has also argued the same line. It fears that if the EU leaders fail to take a strong collective decision, the euro will be damaged and the global economy could be at risk.

But Germany's Chancellor Angela Merkel has insisted that it would be no use to rely on short-term solutions such as pooled debt unless the troubled countries manage their budgets. Merkel also wants a grander political union for the EU.

For the EU, time is running out. We could see a euro implosion over the next few months if the leaders cannot agree on tough decisions.

Fundamentally, the EU is facing a banking and sovereign debt crisis. The EU banking system is huge at US $46 trillion, which is nearly three times the EU's entire gross domestic product of $16 trillion. The EU banks are in shambles from bubbles that have gone bust. When Thailand faced financial crisis in 1997, its banks' bad debts were equivalent to about 60 per cent of the total loans. This forced the Thai government to spend Bt2.2 trillion in taxpayers' money to bail out the banking system.

Let's assume the EU banks are now carrying bad debts of $20 trillion (less than 50 per cent of total loans). Practically speaking, there is no money to bail out the banks. For the size of the bad debts is far higher than the EU's GDP of $16 trillion. So far we have not heard of any serious bank restructuring. The EU governments are now already running high deficits to keep the economy alive and prevent unemployment from going sky high. There won't be any taxpayers' money left to bail out the banks. If the EU leaders rely on the ECB to print money to fill up the holes in the banks, Merkel will not agree to this, which could unleash inflationary pressure.

Moreover, the EU's banks are highly leveraged at around 26 to one. When Lehman Brothers collapsed in 2008, its leverage ratio was 30 to one. This implied that the investment bank, which had a tiny capital base, relied on short-term funding to massively speculate in long-term assets. When the market lost confidence in Lehman, the creditors demanded their money bank. This led to a run on the investment bank and its subsequent collapse because the high leverage ratio made it impossible to raise fresh liquidity in time to meet the demand of the creditors.

The EU banks could face a similar run if confidence in the euro is further eroded. Already, many EU banks are facing heavy withdrawals, while deposits are heading to safe havens such as Germany or Switzerland. By the way, the ECB is in no better shape since its balance sheet has a leverage ratio of 36 to one.

If different opinions between Germany, which commands the strongest economy in Europe and has the deepest pockets, and fiscally bankrupt EU nations continues, chances are high that it will leave the euro. For the German voters aren't likely to agree to spending their tax money on other EU nations that are not willing to manage their budgets. Germany also will not agree to money printing by the ECB due to its bitter experience with money printing and hyperinflation during the Weimar Republic in the early part of the 20th century.

In such a scenario, Germany would go back to the Deutschemark. That would unleash financial turmoil in Europe on an unprecedented scale. France, Italy, Spain and other EU nations might opt to stay within the euro zone. The ECB would then face little or no resistance to its temptation to print money en masse to save the banks and prop up the balance sheets of EU governments. After all, what is the printing press for if not for money printing?

The situation in the US is equally gruesome. The Federal Reserve is likely to approve a third round of money printing, "Quantitative Easing 3", in the third quarter of this year. The Fed is closely watching Europe. Any fallout from the euro crisis would lead the Fed to further money easing and money printing.

When both the ECB and the Fed print massive fiat money, we'll all be drowned in paper money and inflation or hyperinflation. Along the way, be prepared for further geopolitical conflicts, if not a global war.


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