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Draghi Will Fail to Save the Euro

Despite his big words, the ECB chief is fighting an unwinnable battle...

GOVERNMENTS and banks have perpetrated all manner of pyramid schemes in the last decade. Of them all, the Eurozone debt crisis is the most damaging, writes Martin Hutchinson for Money Morning.

No amount of posturing by European Central Bank President Mario Draghi can change that fact.

The market may like what Draghi has to say about the fate of the Euro, but today's big ECB meeting will change little. 

The massive amount of money Draghi will need to print is far too great for the German taxpayer or the ECB's balance sheet. 

Eventually, the Eurozone will break up and drag the global economy right down with it.

In the long run, that will mark the beginning of the recovery, but in the short run it will precipitate a banking and economic crisis that will make 2008 look like child's play. 

As investors, we had better be prepared. 

The Euro was a reasonably sensible idea, although without political integration it was always likely to cause trouble. 

What's more, the technical side of it was for the first ten years handled very well by Otmar Issing at the European Central Bank. Issing spent his career in the Deutsche Bundesbank and knew what a decent currency looked like.

However, two decisions taken by politicians doomed the currency. 

One was to admit Greece into the union, which to any competent observer was a hopelessly corrupt and uncompetitive economy propped up by giant EU subsidies. 

More important, though, was the design of the TARGET (Trans-European Automated Real-time Gross Settlement Express Transfer System) payments system which was replaced in November 2007 by TARGET 2. 

It is the secret system that blew another hole in the Euro. 

Target 2 requires all payments between banks in different countries to go through the national central banks (thus giving those otherwise redundant entities something to do). 

Theoretically that's the same system as in the US, where many payments are made through the regional Federal Reserve Banks. 

However, in the US the larger banks deal direct, and outstanding payments in the regional Fed banks are cleared regularly. What that means is that if Alabama runs a payments deficit with New York, no large balances are allowed to build up. 

Conversely, there has been no automatic clearing between the central banks in Europe. This may sound arcane and boring, but I promise you it is not. These payment imbalances have two nasty side effects.  

First, in the boom years of 2005-06 money should have drained from countries like Spain that had real estate booms. That would have raised Spanish interest rates and calmed the real estate boom. 

Needless to say, that didn't happen – instead interest rates between different countries converged, intensifying the bubbles in southern Europe. 

Second, because payments are never cleared between the central banks, the Deutsche Bundesbank and other surplus central banks in places like Finland and the Netherlands have huge holdings of dodgy southern European paper. In the Bundesbank's case alone it is 729 billion Euros ($900 billion) as of June 30. 

Now guess who is on the hook for all of this mess?...Add it to the backs of German taxpayers. 

And it was all completely unnecessary. Too bad someday it will help sink the Euro. The Eurozone crisis is now showing signs of becoming self-perpetuating. Greece has passed modest austerity measures, but nowhere near enough to satisfy the tough conditions the Eurozone imposed in its latest bailout package.

Currently, the IMF and the EU both have monitors there, and it's likely that when their results are released, Greece will finally exit the Euro. The "grexit" will be complete. That would not matter too much, though – it has already been discounted by the market. 

However, here's what would get the market's attention: signs that matters have deteriorated significantly in Spain, Italy and France. Given the Eurozone economy has descended into recession again, everything has become that much more difficult.

On a country by country basis here's a rundown of the house of cards as I see it:

In Spain, while the national government finances are in relatively good shape, the regional governments' are not. One of them, Valencia, has now threatened to default on its debt unless it gets a bailout from the national government. With Valencia adding to its burdens, Spain itself will need another bailout from the EU. In response, Spanish bonds are now yielding well over 7%, thought to be the tipping point at which finance becomes effectively unavailable.

In Italy, the Monti government has failed to pass the labor law reforms Italy needs to become competitive. The Monti regime has now become very unpopular – not surprising since it was imposed on Italy by the EU bureaucrats in Brussels. Italy must hold elections next March and two populist movements are running well in opinion polls. One is a leftist, headed by comedian Beppe Grillo. The other is on the right, headed by former Prime Minister Silvio Berlusconi, who is showing signs of running for election on an anti-Euro platform. Meanwhile, Italian debt yields are following Spanish yields--ever upwards.

In France, the most alarming developments have occurred. The new Socialist government has imposed a 75% income tax on the wealthy, plus a substantial wealth tax (almost nowhere but France has tried this form of extortion). They also reversed the previous government's sensible-- if modest-- pension reforms. This should cause a substantial exodus of the rich to London and (if they can get visas) New York. It will certainly make the French economy even more uncompetitive. French bond yields have not yet moved up to join Spanish and Italian yields, but I can't believe bond dealers will prop up France much longer. For lovers of the Euro this could be the big one.

Whether Draghi wants to believe it or not, there are now simply too many things going wrong in Europe for the current system to survive. Each attempt to solve the problem provides respite for only a few weeks or even days. 

The more dangerous possibility, becoming more likely with Draghi's recent statements and the support for it from national leaders, is that the EU will devote yet more money from the solvent parts of Europe to prop up the losers. That won't prevent the eventual crash, but will make it much worse when it finally arrives. And arrive it will.

At some point, when you're in a big hole, you simply have to stop digging.

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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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