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Will Europe impose exchange controls to head off disaster?

Section: Daily Dispatches

By Ambrose Evans-Pritchard
The Telegraph, London
Friday, November 23, 2007

The die is now cast. As the euro brushes $1.50 against the dollar, it is already too late to stop the eurozone from hurtling into a full-fledged economic and political crisis. We now have to start asking whether the European Union itself will survive in its current form.

It takes 18 months or so for the full effects of currency changes to feed through, so the damage will snowball late next year and beyond into 2009 -- although "damage" is a relative term.

As Airbus chief Thomas Enders warned in a speech to the Hamburg workers last night, Europe's champion plane-maker -- the symbol of European unification, in the words or ex-French president Jacques Chirac -- is now facing a "life-threatening" crisis.

Mr Enders said the company's business model is "no longer viable" and "massive losses" are on the horizon. So much for all those currency hedges that analysts like to cite. Have they ever tried to buy a currency hedge? They would discover how expensive these instruments are. Hedges cannot protect a company with $220 billion in delivery contracts priced in dollars when the euro/sterling cost-base is leaping into the stratosphere.

The sudden rocketing in sovereign bond spreads this week between core German Bunds and Club Med debt -- Italian, French, Spanish, Portuguese, Greek, as well as Irish, Belgian, and Slovenian -- is a clear sign that markets are starting to price in a breakup risk for the single currency, however remote. Italian spreads have risen beyond the danger point of 40 basis points. This is less than the 100 basis points or so seen in Quebec (viz Ontario debt) when it looked as if the separatists might prevail. But it is dangerous nevertheless.

Moreover, these bond spreads are telling us that liquidity is drying up and that monetary policy is now too tight for the eurozone, as it is across much of the developed world. Two-year bond yields are collapsing in the US, Britain, and the Anglo-Saxon states, a signal that markets are now discounting possible recession. The whole central banking fraternity seems behind the curve, spooked by residual (lagging) inflation -- and prisoners of a defective economic model (Neoclassical/New Keynesian synthesis). This is how the 1930 recession metastasized, although one doubts that Ben Bernanke will allow Part II to unfold this time. He has spent half his life studying the blunders of the Fed in 1930-1932.

One thing is sure: French President Nicolas Sarkozy will not let Airbus go bankrupt, nor see decimation of the French industrial core, without an almighty fight against those countries deemed to be engaging in a beggar-thy-neighbour strategy of currency devaluation -- benign neglect in Washington, less benign in Beijing.

He will have allies soon enough, once the housing bubbles collapse in Spain and across the Med. Mr Zapatero will not be in power for long in Madrid. Mr Prodi is on borrowed time in Rome. A new political order will soon take hold in much of Europe, bringing in a new wave of prickly national populists.

So how will they fight? Will Mr Sarkozy and his allies resort to 1970s-style exchange controls to stem the rise of the euro?

They certainly have the power to do so. Four years ago a little-known cellule at the European Commission wrote a report -- on prompting from Paris -- exploring the legal basis for measures to stabilize the currency.

After combing through the EU treaties and court judgments, it concluded that Brussels may impose "quantitative restrictions" on capital inflows.

"Should extremely disturbing capital movements endanger the operation of economic and monetary union, Article 59 EC provides for the possibility to adopt restrictive measures for a period not exceeding six months," it says.

It would be renewable each six months, so the policy would in fact become permanent.

Any decision would be taken by EU finance ministers under qualified majority voting. Britain would have no veto, even though the effects of such a move on the City of London would be catastrophic -- and trigger the certain withdrawal of Britain from the EU. (And good riddance, some might say in Paris.)

This "disturbing" capital movement is occurring right now. Portfolio inflows into the eurozone reached a record E46.2 billion in September. China, Asian wealth funds, Petrodollar sheikdoms, and now even Nigeria have all joined a stampede into euros, utterly disregarding the underlying reality that Europe is in no better shape the United States itself. It is in worse shape, though this is disguised by the cycle. It is much worse in terms of economic dynamism and demographics.

Confidence has cratered in Germany, and the Netherlands, not to mention Belgium -- which has not had a government for 165 days and is now sliding toward disintegration. Since Belgium is a metaphor for the EU -- an arranged marriage of squabbling tribes, speaking different languages, who do not love each other and never did -- this in itself amounts to a tremor for the EU system.

EU industrial orders fell 1.6 percent in September. Spanish, French, South Italian, and Irish house prices are already all falling.

Spreads on the iTraxx financial index of 25 European bank and insurance bonds have jumped to a fresh record, worse than during the depths of the August crunch. The iTraxx Crossover of low-grade corporates is back to crisis levels above 400.

The European Covered Bond Council suspended trading in covered bonds this week because the spike in spreads had become disorderly, and three-month Euribor rates have gone through the roof again, and that is the rate that sets Spanish and Irish mortgages. Bond issuance in Europe is frozen.

France is in the grip of a national strike costing E2 billion a day. The railways are paralyzed. The country's 5.2 million public workers are staging walk-outs.

Is this a currency bloc that should be now be deemed the ultimate safe haven, the repository of trust in a dangerous economic world? This hodge-podge of disputatious clans, lacking a central Treasury, government, debt union, and guiding philosophy -- let alone the sacred solidarity of a nation?

Returning to the commission cellule, it said that: "Among the actions that can be undertaken when a member state experiences serious balance of payments difficulties, Articles 119 and 120 EC provide for the possibility to reintroduce 'quantitative protective measures' against third countries."

The measures are of course exchange controls. This is the nuclear option, but Europe's politicians could equally invoke Article 104 of the Maastricht Treaty giving politicians the power to set fixed exchange rates (by unanimous vote) or a dirty float for the euro (by majority).

The document is annexed to the Commission's 2003 EU Economic Review. Nobody paid any attention at the time, just as the Commission had hoped -- at least that is what one of the authors told me. This is the EU's Monnet Method, one silent fait accompli after another.

President Sarkozy certainly seems inclined to go this route. He has again invoked his ideas for "Community Preference" -- that is, a closed trade bloc -- in a speech this month to the European Parliament. Contrary to claims, he is not letting go of his mercantilist plans.

The ECB may or may not intervene in the currency markets to cap the euro. But this is a red herring. Europe's retort -- if and when it comes -- will be far more political, and far more dramatic. We are at one of history's "inflexion points."

One recalls the months leading up to the collapse of the Gold Standard in 1931. That was triggered first by Credit Anstalt in Austria and then by a British naval mutiny in Scotland.

Any bets on what will trigger the collapse of Bretton Woods II?

I wager that it will be a decision by the Gulf states to break their dollar pegs, leading to a temporary surge of euro purchases. That will tip Mr Sarkozy over the edge.

Just idle speculation.

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