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Euro Crisis: About to Wake Up Again

The Eurozone seems to have forgotten its troubles of late. That won't last...

IT SEEMS the Euro crisis has taken a late summer vacation, writes Martin Hutchinson for Money Morning.

Since it would be very inconvenient for a disaster to erupt while everyone is on holiday, it doesn't. 

That's not to say this rule is infallible. One year, all the decision-makers went on holiday in late July, and came back to find themselves embroiled in World War I.

What traders and decision makers will find waiting for them when they get home from the beach could be almost as serious. Greece has done nothing to redeem its position other than prepare an application for more money. Italy's GDP declined by 0.7% in the second quarter, and we are shortly to enter the run-up to the next Italian election. 

What's more, Spain is trying desperately to avoid asking for a bailout, and may just succeed in doing so, but one more hiccup in its recalcitrant provincial governments will push it over the edge. 

Then there's Portugal, which has entered a deep recession, and is showing signs of missing its budget targets again.

And that laundry list of potential problems doesn't include the biggest one of them all. That is reserved for France, which elected a Socialist government on an anti-austerity ticket in the spring, and is now proceeding to undo the modest progress towards fiscal sanity made by the previous government. 

The new French government has raised the already onerous wealth tax and has partly reversed the previous government's modest pension reforms. For many, the retirement age is back to 60 again, compared with an actuarially sensible 67 in Germany. In the fall, France also plans to change the top rate of income tax up to a punitive 75%.

Of course, this is nothing more than economic suicide. The rich are much more mobile than they were in the 1980s, the last time a French government tried this kind of thing. 

Even then, Guy de Rothschild, Jewish head of the famous banking dynasty, moved to New York, remarking "To be a Jew under Marshal Petain (the World War II leader who collaborated with the Nazis) was bad enough, but to be a banker under Mitterrand is insufferable." 

These days there are many civilized places with low top tax rates and good broadband connections who would love to welcome French millionaires – not just the United States, but Singapore, where the top tax rate is 20%, and Dubai, where it is zero.

Assuming the French government goes ahead with its plans, the result will be a massive budgetary and economic crisis, starting in early 2013. GDP will decline fairly sharply and the tax base will decline even more sharply, as emigration will be accompanied by tax evasion. 

The point is, even if the Eurozone scrapes by with its current problems, there's another biggie coming soon.

Meanwhile, the bond markets have muddled the relative risks involved – after all, it's August, so only the most junior traders and analysts are at their desks. 

They've priced Spanish 10-year bonds at a 6.24% yield, still uncomfortably close to the 7% yield at which government debt is currently supposed to be unsustainable (remembering as I do the days when 10-year US Treasuries yielded 15%, I doubt this, but I let it pass.) 

Italy, where the current Monti government was imposed by the EU and faces elections next March against Silvio Berlusconi (who seems likely to run on an anti-Euro platform) has a 10-year yield of 5.55%. 

Finally France, which has the worst policies of all and higher debt and deficits than Spain, enjoys a 10-year bond yield of only 2.14%.

One further complicating factor is that the bad boys' nominal debt levels are not the full story. Because of the immensely foolish design of the Eurozone's "Target 2" payments system, huge obligations have grown up between the central banks. 

The German Bundesbank is due 727 billion Euros ($850 million) from other countries as of July 31, while Greece's obligations under Target 2 are themselves over 100 billion Euros. 

Since Greece has no hope of paying an extra 100 billion Euros on top of its official debt, that's not a cost of Euro breakup; it's money already lost, which will have to be repaid by German taxpayers. Presumably Chancellor Merkel is aware of this, and will thus be flinty against Greek pleas for more money. 

In any case, a "Grexit" is only a matter of time, and from the point of view of both Greece and Europe, the sooner the better. 

However, given the other crises looming, Greece won't be the only country to exit. At some point, probably after the top traders' vacations end but before the French crisis actually looms, the markets will wake up to the French risk.

At that point, the game will be up, and the Euro will be forced to break up of its own accord.

There are a number of possibilities for what follows. My guess is that since both France and Italy are badly run, they will see the Euro breakup as a chance to spend some more mad money. Thus both countries will go their own way, restoring the franc and the lira. 

On the other hand Germany, Scandinavia and the Netherlands, all well-run, will want to keep the benefits of a common currency, and so will form a strong "Northern Euro" which will rise in value steadily against the Dollar and other currencies. 

The most interesting possibility is that Spain and Portugal, fairly well run but unable to bear a strong common currency, may combine with Slovenia, Slovakia and possibly Ireland and Belgium, to form a weak but stable "Iberian Euro." 

Greece and probably Cyprus, meanwhile, will be sent off to the dunces' corner, to join the likes of Bulgaria and Romania outside any common currency.

It promises to be an interesting fall. 

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Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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