The ECB Risks Another ERM Disaster

Montreal, Canada

By September 16, 1992, the grand experiment was over. The British pound and the Italian lira devalued and exited the European Exchange Rate Mechanism (ERM), resulting in the effective collapse of the single currency grid.

George Soros would walk away making a few billion dollars that day after betting the British pound would face a humiliating exit and subsequent devaluation. He was right.

The ultimate test of whether a currency grid can accommodate divergent economies running at different speeds has come to the fore again in 2011. In Europe, it’s the fiscal hawks versus the austerity jackets.

The EUR, Europe’s boldest currency experiment since ERM, is doomed to either failure or years of mismanagement and probably, a bear market in the single currency as policy-makers bungle the sovereign debt crisis still unfolding at the periphery.

In April, the European Central Bank, or ECB, under great pressure from the hawks at the German Bundesbank, will raise interest rates for the first time since July 2008. The July 2008 rate hike preceded a top in financial markets by three months and was the absolute worst timing in ECB history; by October, the EUR would crash vis-à-vis the dollar and yen, and European capital markets would be reeling following the collapse of Lehman Brothers.

Europe’s balancing act is impossible. On the one hand, the fiscal conservatives led by Germany and France are trying to sleep in the same bed as the big spenders at the periphery – Ireland, Portugal, Greece and Spain. Perhaps we can even add Italy and Belgium to this debt-orgy. These are strange bedfellows by every measure.

A grand bargain will be almost impossible because the hawks are still clashing with the doves and a workable long-term solution seems extraordinarily difficult at best. The odds continue to favor a 1992-replay whereby one or more countries will default or restructure once the EU’s cash pile runs dry in a few years or less.

One currency doesn’t fit all – it never has. Bismarck tried it, France tried it in the early 1970s and again, the Germans vis-à-vis ERM.

One of the greatest speculations for big risk-takers is buying volatility on the EUR, which currently sits close to a 24-month low. Also, buying Swiss francs and gold with a stronger EUR recently is a smart long-term swap; both trades have come off considerably this year.

Europe’s circus act will fail. The ECB’s actions almost guarantee it.

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