The Twists and Turns in the Euro

We seem to have this peculiar tendency to associate positive feelings with rising prices and negative feelings with falling prices. When it comes to the Euro (along with many other things), this way of viewing prices can be rather misleading. Here, I get to grips with the Euro and the mechanics behind its peculiar twists and turns.


Cartoon about the Euro

Click to enlarge.


A Swollen Supply of IOU Claims on Euro Notes & A Relatively ‘Inflexible’ Euro Note:


I often say here on that money is to profit-seeking individuals as the sea is to fish. Money trades on one side of every transaction in an economy, and so monetary matters have a tendency to affect all walks of life in some way or the other. In the Euro Area (as with the entire developed world), the propensity for the ‘private sector’ to produce IOU claims upon Euro banknotes (i.e. demand deposits) reached a peak in 2007/2008. With it, reached a peak in economic misallocation as described by the Austrian Business Cycle Theory and a realization that the European banking system was insolvent or at least perilously close to insolvency.


To be sure, the same kind of thing happened – essentially – worldwide, and so begun a trend toward a declining stock of ‘IOU money’ (i.e. demand deposits). The US and the UK dealt with this scenario in a way that was distinctly reality-denying. That is, they debauched their respective central bank notes (Federal Reserve notes & Sterling notes) in order to reduce the stresses upon those institutions that owned things and owed those notes (most notably their respective banking systems).


On the other hand, the Euro – as it is often said – is more like a gold standard. What is meant by this is that Euro notes (and reserve balances) are more ‘stationary’ in value. Whereas the Federal Reserve made Federal Reserve notes (& Fed Balances) ‘good for’ MBSs to alleviate the stresses on supposedly ‘systemic’ MBS holders, the Euro stayed (relatively) similar to what it was before. Hence, the burdens upon the Euro Area banking sector remained high, whereas the burdens upon other banking systems were alleviated somewhat.


The Implications for Existing ‘IOU Euros’:


Of course, this scenario has not been very comfortable for the holders of Euro Liabilities (namely the Euro Area banking system). Whereas their American and English counterparts were granted the gift of a Zombie-like existence, they were not (to the same degree).


This has two important implications:


  • The viability of a great proportion of the stock of ‘IOU Euros’ has come and is coming into question.
  • The stock of Euro Banknotes & Reserve Balances remains (relatively) intact.


So, when crisis hits the Euro Area there are two conflicting forces at play. On the one hand, the relative strength/’stickiness’ of the Euro note hurts the European banking system. And yet that is precisely what compels people to get rid of their ‘IOU Euros’ with such a vengeance. Just as you’d want to own physical gold during a run-of-the-mill gold standard bank run, you want to own Euro notes in the Euro system. Looking at the chart below, it is clear that I am not alone in this conviction (i.e. people are withdrawing Euro banknotes from European banks):


Changes in European Banking System Deposits

Click to enlarge. Source: ECB


However, in the short-term, this can imply vicious sell-offs in the Euro as people rush (at once) to swap their IOU claims on Euros for IOU claims on Dollars, Sterling, Yen etc. So, although the long-term trend may be towards (relative) stability in the Euro, there can be huge temporary sell-offs in the short-term. This is what Jim Rogers alluded to in his recent CNBC interview:



Even if the Euro sells off in a desperate attempt to exit IOU claims upon Euros, the Euros that end up surviving could potentially rise in value (due to their scarcity).




As ever, it doesn’t pay to look at markets in a mechanistic fashion. Euro Area troubles have no direct causal link to an exclusively higher or lower dollar price of the Euro. Instead, there are bound to be violent twists and turns on the path to Sovereign defaults and/or bailouts.


Although I am tentatively bullish on the dollar right now, I can certainly conceive of a scenario where the ‘short squeeze in Euros’ gains momentum before the ‘short squeeze in dollars’. This – ultimately – would be positive for surviving Euros (i.e. Euro banknotes themselves & Euro deposits at rock-solid banking institutions). It takes a fair amount of stress to get the ECB to debauch its liabilities (i.e. Euro banknotes), whereas ‘the Ben Bernank’ is so frightened that he prints whenever the S&P 500 drops by 50 points:



Elliott Wave Ebook on the Euro

See here for our collection of rare historical economic data.

Posted May 10, 2011