'Eurogeddon' approaches

Jeremy Warren at the Telegraph writing about the German bond fiasco this past week and the coming disappearance of the euro:

If you are tempted to think this another vote of confidence by international investors in the UK, don't. It's actually got virtually nothing to do with us. Nor in truth does it have much to do with the idea that Germany will eventually get saddled with liability for periphery nation debts, thereby undermining its own creditworthiness.

No, what this is about is the markets starting to bet on what was previously a minority view - a complete collapse, or break-up, of the euro. Up until the past few days, it has remained just about possible to go along with the idea that ultimately Germany would bow to pressure and do whatever might be required to save the single currency.

The prevailing view was that the German Chancellor didn't really mean what she was saying, or was only saying it to placate German voters. When finally she came to peer over the precipice, she would retreat from her hard line position and compromise. Self interest alone would force Germany to act.

But there comes a point in every crisis where the consensus suddenly shatters. That's what has just occurred, and with good reason. In recent days, it has become plain as a pike staff that the lady's not for turning.

This has caused remaining international confidence in the euro to evaporate, and even German bunds to lose their "risk free" status. The crisis is no longer confined to the sinners of the south. Suddenly, no-one wants to hold euro denominated assets of any variety, and that includes what had previously been thought the eurozone safe haven of German bunds.

That last may be an exaggeration. As Brad DeLong points out, German bond yields do not reflect a crisis in faith regarding Berlin's euro denominated assets:

At a current ten-year nominal interest rate of 2.268%, Germany's own credit status is not in doubt. Countries whose credit status is in doubt do not have their ten-year bonds selling at a yield-to-maturity of 2.268%.

What has shifted over the past week is that U.S. ten-year Treasury bonds at a yield of 1.95% are now significantly stronger than German ten-year Treasury bonds at a yield of 2.268%. We can hope that this is because the market sees good news: perhaps it expects the ECB to raise short-term interest rates more and sooner because European growth will be faster than was anticipated (but that is extremely unlikely). This may be bad news: perhaps the market expects the ECB to raise short-term interest rates more and sooner to demonstrate that it is tough. Or perhaps the market fears some future chaos event involving the breakup of the euro will make its German bund holdings illiquid just when it would want to sell them to raise cash. This may simply be a recognition, finally, that there are about to be shifts in eurozone political economy and governance that are likely to give the eurozone a slightly higher inflation rate than the U.S. over the next generation.

But Warren insists that contingency planning across Europe is more than just an academic exercise:

What we are witnessing is awesome stuff - the death throes of a currency. And not just any old currency either, but what when it was launched was confidently expected to take its place alongside the dollar as one of the world's major reserve currencies. That promise today looks to be in ruins.

Contingency planning is in progress throughout Europe. From the UK Treasury on Whitehall to the architectural monstrosity of the Bundesbank in Frankfurt, everyone is desperately trying to figure out precisely how bad the consequences might be.

What they are preparing for is the biggest mass default in history. There's no orderly way of doing this. European finance and trade is too far integrated to allow for an easy unwinding of contracts. It's going to be anarchy.

Chancellor Merkel is set in her opposition to the European Central Bank being allowed to print money and issue bonds. As the strongest member of the single currency bloc, she knows who will be expected to pony up the most cash necessary to turn the central bank into a bail out of last resort. Even if there wasn't stiff political opposition from the German people to strengthening the ECB, Merkel can't increase the exposure of German banks to the contagion.

The changes in the EU constitution she is currently negotiating will seek to build a firewall around the stronger economies in northern Europe to protect them from the southern tier's massive problems. Whether the euro will survive the coming reorganization is a question as yet unanswered. It may be that no amount of rearranging the deck chairs can save the Titanic from eventual destruction.

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