Is it Greece or a Stealth Euro Devaluation?

The euro has fallen to $1.2954 - its lowest level for more than a year.

One obvious way for Europe to get out from underneath its internal debt crisis would be for it to devalue the Euro, decrease imports and increase their export market. A falling euro would help tourism and housing. The Germans have been dragging their feet in resolving their problem and yes the Greek problem is in reality a German problem.

German exporters take full advantage of the Greek perpensity to consume more than they produce. Greeks are also huge users of the underground economy, probably as high as 25%.

Are there some European puppet masters, a la George Soros, manipulating the finacial markets? It has happened before. Who benefits? We shall see.

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The crisis is catching

May 4th 2010, 15:29 by R.A. | WASHINGTON Economist

IT'S shaping up to be an ugly day for European markets, which is making for an ugly day for American markets. The big European indexes were off 2% to 3% on the day, and the euro fell to its lowest level against the dollar in over a year. The decline is likely related to renewed increases in yields on government debt across southern Europe. These had fallen from recent highs in the wake of the weekend announcement of a €110 billion package for Greece. But for the moment, it appears that European leaders and the IMF have not sufficiently ring-fenced the Greece crisis. Contagion looms.

It's surely not helping matters that rumours are circulating that Spain will soon ask for €280 billion in aid. Spain's prime minister said the rumour was unfounded, calling it "madness", and I believe him. But the nature of contagion is that people act on the rumour and ignore everything else. Back in 2008, markets attacked financial firms indiscriminately, even as bank executives pleaded that their finances were sound. They were, in some cases, quite right. But liquidity crises, if left unchecked, become insolvency crises. The panic becomes self-fulfilling.

It may be that European leaders have insufficiently demonstrated their awareness of the difference in the two kinds of crises. Aid to Greece has been generous, but it's not clear that it will address the underlying insolvency of the Greek government. Forbearance worked in the case of the American financial system because banks could borrow cheaply from the government and then lend at a higher rate, thereby slowly recapitalising themselves. The 5% interest rate Greece is getting from Europe and the IMF is much lower than market rates, but it's higher than Greece's expected growth rate. The aid strategy has bought time, but it won't save Greece unless growth surprises strongly to the upside.

Most of the other troubled European nations do not face a solvency crisis. Assuming that they can rollover their debt, their fiscal positions are strong enough and expected growth is significant enough that the debt levels can eventually be brought down. Aggressive European aid to these countries should definitely work. So long as they don't face a liquidity crunch during their adjustments, the bills will all get paid.

So perhaps Europe has erred in its strategy. To properly ring-fence the crisis, ministers should probably have acknowledged the need to restructure Greece's debt and worked to do so in an orderly fashion, all while extending unlimited liquidity and significant lines of credit to European economies threatened by contagion.

In the scheme of things, a Greek default is not a big deal. Greece is a small country, and exposure to Greek debt is relatively limited. A Portuguese default would be a little worse than a Greek default, and real trouble in Spain and Italy would be very bad indeed (see this very helpful chart). It makes little sense to fret over the sacrifices Greek citizens can or cannot make to achieve the necessary fiscal adjustment. The first, second, and third priority have to be containing the crisis. European leaders seem depressingly slow to grasp this.