The Coming French Credit Default

It was only about six weeks ago that the long, slow Greek credit default came to its tiny, whimpering conclusion. Recent prices of Spanish credit default swaps, and the clear French political posturing as a run-up to a "stand up to big bad Germany" meeting indicates that things are definitely not solved in the euro zone. If anything, tensions are as high as they have ever been.

The euro zone is headed for a dramatic, catastrophic dissolution.

When the EU was first announced, some wondered how such an entity, a collectivist agreement among individual, independent nations, would last. National norms vary enormously from EU state to EU state. The approaches to saving, spending, and investing, as cultural elements, are very different. Since the basis of a currency are the nation's collective ability to spend, save, and invest, as a unit, the prognosis, at least as I saw it, was for continual and enormous tensions that would tend to pull the union apart.

The creation of a monetary union and the lowering of tariffs created some growth that ameliorated the underlying tensions. But when that palliative is removed, the forces of dissolution are unchecked, except for diplomacy and time.

It seems that the euro zone is running out of both at this moment. Germany is seen as the evil, successful, mean daddy with all the money, who pushes around and bullies all of the less successful little states, like Paul Krugman, whose head believes it is a state all to itself. Germany, as always a stickler for the rule of law, points out the requirements of the union, while the other governments, one by one find that they cannot get re-elected if they follow the austerity policies they agreed to in their "weaker" moments.

A side comment in an April 23 article on CNBC:

"The problem is that governments across the euro zone are finding it very difficult to live up to commitments on austerity and stay elected."
http://finance.yahoo.com/news/happens-plan-usterity-fails-132827914.html

Exactly. Let's work out the conclusions that naturally follow.

The people don't want austerity, hence they soon will get lack of austerity. Governments will begin to spend on infrastructure, unemployment, and other benefits. The resulting pressure on the Euro will be to cause inflation, but only if Germany allows it. Germany, with a cultural abhorrence of inflation borne from a very real portion of its history not so long ago, will logically resist the inflation at first. Of course, events of the past two years could very well be said to already have been Germany's resistance to inflation, so Germany may itself not have much patience left for tolerating the blows it will need to absorb to preserve monetary stability.

What happens next is entirely up to Germany. For decades later, people in Spain, Greece, France, and many other euro zone countries will find fault, scapegoat, and lie in order to convince themselves that someone else (Germany) is to blame, and not themselves. But what will happen is this:

Germany will leave the euro zone and go back to the Deutsche-mark.

It will do this strictly from a sense of self-preservation. The alternative is to "donate" through inflation and other corrosion of its finances 20%, 30%, or even 70% of its annual GDP to the union as the other members spend far, far ahead of their ability to actually produce goods and services. After all of the years of a divided Germany, the trials of reunification, and the sacrifices made on behalf of the EU the past several years, Germany will not be able to withstand the thousand cuts of all the favors and supports asked of it by its neighbors.

I have picked on Germany here only because it is the obvious country to break from the union in order to avoid its own death, but there are other countries that could leave the monetary union first, as they would be less visible and suffer fewer consequences from their actions.

The Euro will lose value against other currencies, especially the dollar. Expect high inflation in Italy, Spain, Greece, and France. Expect rates of inflation high enough that current sovereign debt and bonds of companies are eroded significantly in value over the next three to five years. In short, this is a very poor time to be buying European debt, and an excellent time to sell. U.S. Treasury bonds are not a good investment either, but not for the same reason. With European inflation raging, expect a new avalanche of imports into the U.S. from euro zone countries, with prices for European luxury goods dropping, in some cases. No doubt there will be a certain amount of price gouging of American consumers, so watch Euro-dollar exchange rates closely and negotiate hard with your local wine and cheese shop for better rates on Bordeaux and Manchego. Want a BMW or Mercedes? No need to wait, as if Germany drops the Euro, you would be exchanging dollars for Deutsche-marks, and that exchange rate is not going to suffer like the Euro will, so you won't be getting any discounts there.

[updated 4/30/12]