Built on a Lie The Fundamental Flaw of Europe's Common Currency


Part 2: Unpalatable Alternatives

This adjustment mechanism is absent in the monetary union, with dramatic consequences. For instance, if a country has gone too deeply into debt, the government can no longer choose the gentle option of devaluing its currency. Instead, it must impose austerity measures that directly affect the standard of living of its citizens, as is currently the case in Greece, where wages and pensions are being reduced and government expenditures slashed.

This is the unavoidable consequence of monetary union. But European governments were in denial about the risk, and they were certainly unwilling to openly own up to their mistakes. Instead, they maintained the status quo and took a devil-may-care attitude. For a while, it even went well. But now the imbalance can no longer be covered up. Not just Greece, but other euro countries, as well, have accumulated towers of debt that now threaten to collapse. A number of countries, known informally by the acronym PIIGS (Portugal, Ireland, Italy, Greece and Spain), are at risk.

If one of the large nations on the continent were to go bankrupt, Europe would face two equally unpalatable alternatives. If such a bankruptcy were simply accepted, it could trigger a disastrous chain reaction in the financial markets, much like the one that occurred after the Lehman Brothers bankruptcy in 2008. But if the remaining euro countries decided to come to the bankrupt country's aid with loans, "Germany's creditworthiness would eventually be threatened," says Deutsche Bank chief economist Thomas Mayer.

No wonder the poker game over Greece has caused such frayed nerves in Europe's capitals. The stakes are high, and the many players are financially strong. They can be found in Manhattan office buildings, luxury condominiums on the Cayman Islands or at the headquarters of major international banks. They all share a common interest: to make money from the Greek drama, or at least to ensure that they don't lose any money because of it.

The latter is the objective of many European banks, which have significantly expanded their holdings of Greek bonds in the last two years. German financial institutions like Commerzbank or HRE currently have about €32 billion worth of Greek treasury bonds on their books, while the Greek holdings of French banks are almost twice as high.

Tempting Deals

The deals were simply too tempting. During the course of the financial crisis, banks were able to borrow money from the European Central Bank at lower and lower rates, culminating at a mere 1 percent. When they used the cheap money to buy Greek bonds, with yields upwards of 5 percent, it was a -- supposedly -- surefire deal, practically a license to print money.

The credit managers were all the more horrified when their supposedly highly solvent customer turned out, in recent weeks, to be a candidate for bankruptcy. Since then, they have been urging European governments to come to the Greek government's aid with comprehensive state-backed assistance as quickly as possible.

The pressure is being amplified by influential major investors who are at home in the trading rooms of powerful investment banks and on the executive floors of hedge funds. For some of them, the fall of the euro is a done deal, and they are doing their utmost to make sure that their predictions come true.

One of the attackers is New York hedge fund manager John Paulson, who controls a fund worth $30 billion. He has been considered a guru in the investment community ever since, beginning in 2005, he bet on a collapse of the American real estate market -- with resounding success. He told a hearing before the US Congress a few weeks ago that he just wanted to "protect our investors' money." He sounded as cold and unemotional as if he were ordering a plate of French fries.

Betting against the Euro

The enemies of the common currency also include John Taylor and Jonathan Clark, two major American speculators who run New York-based FX Concepts, one of the world's largest hedge funds. The traders in their Global Currency Program alone have $3 billion at their disposal. "We are betting on a decline in the price of the euro," Clark said in early February. At about the same time, speculative net short positions in the euro rose sharply on the Chicago Mercantile Exchange.

An investigation launched by the US Justice Department two weeks ago suggests that the attackers may have taken a conspiratorial approach at times. The authorities suspect that hedge funds run by Paulson and other industry giants, including the fund headed by legendary investor George Soros, were planning a concerted attack against the euro. They also believe that the players may have reached illegal agreements over speculation.

Germany's Federal Financial Supervisory Authority (BaFin) also has significant evidence that speculators have increasingly targeted Greece recently. In doing so, they have apparently employed their favorite toy, the credit default swap (CDS), which already played a notorious role in the financial crisis.

Insurance Policy

A CDS is a contract under which one side pays an annual fee to buy protection against default, while the seller promises to cover losses in the event of a default. They are in effect an insurance policy against defaults of bonds and other debt. The buyer gets a payoff if the underlying bond goes into default.

In February, investors held CDS's for Greek government bonds worth $85 billion, twice as much as only a year earlier, according to a report BaFin officials prepared for the German Finance Ministry.

The German bank regulators warn that these CDS's could grow into a real problem for the Greek government's money-raising efforts, as well as for the cohesion of the monetary union. As CDS's for Greece become more and more expensive, investors could lose confidence in Greek bonds. This, according to the BaFin report, could lead to a "buyers' strike" for Greek bonds, which would create "the risk that the refinancing is unsuccessful, resulting in default."

To curb future speculation with CDS's, the bank regulators propose establishing a central European authority where the controversial financial instruments would be registered. This would enable authorities to recognize immediately where trouble is brewing as a result of speculation. The BaFin experts are opposed to a general ban on CDS's, however, arguing that it would be "counterproductive."

Keeping an Eye on Bankers

In addition to CDS's, financial regulators are also keeping a watchful eye on top bankers, who have been meeting with European leaders. One of them is Deutsche Bank CEO Josef Ackermann, who flew to Athens two Fridays ago to meet with Prime Minister Papandreou and discuss how the country could borrow fresh capital at reasonable terms.

After meeting with Papandreou, Ackermann spoke by phone with Jens Weidmann, an advisor to Chancellor Merkel. To solve its problems, Ackermann said, Greece would need €15 billion in loans. How, he wanted to know, would the German government feel about a consortium of private banks and government institutions, like the state-owned bank KfW, dividing up the amount? Deutsche Bank, he added, could manage the deal.

But Weidmann rebuffed Ackermann, arguing that the deal he was proposing would not only have violated the European monetary treaties, but it would also have reduced a large share of the credit risk of the participating commercial banks -- at the expense of German taxpayers. "Under those circumstances, we might as well have issued the loan ourselves," German government representatives said indignantly.

A few days later, politicians in Berlin were in for a surprise that was no less unpleasant. Despite Berlin's rejection of the idea, British papers reported that the German government was developing a rescue package based on Ackermann's plan.


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