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Abandon the Euro, Shy Away from Treasuries

Prof. Peter Morici - 11/28/2011

I. Time Fast Approaching for EU to Abandon the Euro


As Italy teeters on insolvency and the euro on collapse, European leaders are desperately seeking amendments to EU treaties that would legally limit national budget deficits. However, a new fiscal discipline would not address fundamental flaws in the euro architecture that caused Mediterranean states to become uncompetitive and borrow too much.

In the last week, Germany could not sell a significant share of a new bond offering, France and other stronger governments saw interest rates on their bonds rise to alarming levels, and European banks are scrambling to hold onto deposits and raise collateral to finance borrowing from the European Central Bank.

Capital markets are locking up, because large institutional investors recognize what French President Sarkozy and German Chancellor Merkel seem unable to accept—the euro makes little sense.

When the euro was created, wages, private debts and government bonds were converted from national currencies into euro according to prevailing exchange rates at the end of 1998. To the extent those rates reasonably reflected market prices, the euro adequately priced labor, private contracts and public debt across borders.

Unfortunately, those cross-border relationships change over time. Member states in the currency union have labor market policies, tax systems and social programs that vary more widely than those of the 50 U.S. states. As productivity and investment grew more rapidly in Germany and other strong economies, labor and exports became overpriced in Greece, Italy and other troubled economies.

Generally, the ECB has not intervened in foreign exchange markets and the value of the euro has tended to reflect wages, productivity and economic strength of the 17 euro countries as a whole. The upshot—the euro is undervalued for the German economy, making it an export juggernaut, and woefully overvalued for Greece, Italy and other Mediterranean countries making them debtor states.

For the latter, imports were financed by private borrowing from stronger EU states—Mediterranean country banks financed some mortgages and consumer debt by borrowing from German and French banks—and by governments borrowing from abroad—Mediterranean states sold bonds to German and French banks.

Sovereign borrowing shored up social programs made expensive by less productive private sectors and padding public payrolls to hide unemployment. Now these governments owe more than they can repay under any reasonable scenario for European growth rates and future borrowing costs.

Austerity and loans from Germany, France and other strong governments won’t help. To pay what they owe, even with large haircuts for private creditors, Greece, Italy and other troubled economies must earn euro by exporting much more than they import. However, the structure of the Euro Zone leaves their labor and exports too overpriced, unless they endure tortuous recessions for 5 or 10 years to sharply push down wages. Even such deflation may not be enough to make their economies competitive.

The draconian austerity prescribed by Germany would leave those economies with insufficient infrastructure and outdated private capital. No matter how much wages fell, those handicaps would keep overall productivity too low for exports to be competitive.

The only sane option is for Greece, Italy and other troubled economies to reform social programs, drop the euro, remark public and private debt to the reestablished national currencies, and let falling values for those currencies in foreign exchange markets impose haircuts on creditors.

Devaluation would permit the Mediterranean economies to increase exports and repay more of what they owe. The losses imposed on creditors by devaluation would be much less than the losses they will endure in the panic building in European capital markets and long recession that now appears inevitable.

Prior to the euro, the EU enjoyed much success facilitating intra-continental trade, and an orderly demise of the failed experiment in a common currency could permit the EU to hang together.

If Germany and France continue to cling to the myth the euro is essential to European unity, the EU will likely collapse altogether in the acrimony of the sovereign defaults and bank failures that follows.

II. Investors Should Be Wary of Buying U.S. Treasuries


The Super Committee’s failure to compromise on $1.2 trillion in budget savings won’t much affect the deficit and U.S. credit ratings—or the interest rates and prices of U.S. Treasuries. Still investors should limit holdings of those securities—the long term outlook is not good.

Although the Super Committee did not reach consensus on a combination of spending cuts and tax hikes, the Budget Control Act automatically triggers $1.2 trillion reductions in defense outlays, nonentitlement domestic spending and some payments to hospitals and health care providers.

Savings from winding down wars in Afghanistan and Iraq were already scored into budget projections; hence, new defense cuts will be from the “base” military budget that maintains readiness and defends U.S. security interests around the globe.

The Budget Control Act, passed in August, already cut defense spending by $450 billion over ten years, and another $500 billion is simply unacceptable. U.S. hardware is aging—sons fly the same fighters as did their fathers; cyber warfare requires new capabilities beyond conventional land, air and sea forces; and China is building a navy and will spend on defense 60 percent as much as the United States within a decade—with lower personnel costs and without America’s global responsibilities. More, not fewer, naval resources are needed to meet that challenge in the Pacific—on a recent trip to Asia, President Obama committed to a beefed up U.S. presence.

Republicans in Congress will propose repealing the $500 billion cut but liberal Democrats will demand that spending be refinanced with other cuts or new taxes. Grover Norquist won’t be able to stop such a deal—hard realities, especially national security concerns, have a way of neutralizing the clout of mono-line political activists.

A deal on defense spending will legitimize similar tradeoffs to reduce other Budget Act mandated cuts and make some tax increases acceptable, even among many conservative Republicans.

Consequently, the impact on the deficit of the Super Committee failure will be marginal. The budget dance that follows should not provide a basis for S&P to lower its AA+ bond rating on U.S. bonds, or for Moody and Fitch to lower their AAA ratings.

Longer term, the cuts the Budget Act required won’t be enough. The United States will continue to borrow too much and grow too slowly until more important structural issues are addressed. Within a few years, U.S. borrowing costs will be much higher than today.

Currently, Washington enjoys low borrowing costs, because foreign central banks, private institutions and ordinary investors are all fleeing European debt. Similarly, China’s shaky banks and dodgy accounting standards, along with Beijing’s exhortations that yuan appreciation has run to course, are causing money to flee China for America. That money is dumping into Treasuries, solid corporate and state debt, and even junk bonds.

Within a few years, that money will leave, after Europe has its ultimate financial crisis and then recovers and investors realize that China’s sovereign debt is no more risky than U.S. paper. Rates on Treasuries will rise, as investors become much more nervous that either Washington won’t be able to continue floating $1 trillion a year in new debt or the Fed will simply roll the printing presses to buy what Treasuries investors won’t take.

Long bond rates will rise, and Treasuries bought today will lose value. Simply, in 2014, why would someone pay as much for Treasuries maturing 27 years later and yielding 3 percent, when a new 30 year bond pays 5 percent. At that point investors who purchased bonds today either must wait for those to mature and endure low interest rates, or take a haircut if they sell.

The message to the ordinary investor is simple, Treasuries are safe up to a point—the U.S. government can always print money if necessary to honor its debt—but those investors should only buy bonds with maturities no longer than their circumstances permit them to have their money tied up. Treasuries won’t long be a liquid investment.