Making money from junkies

February 16, 2010
Bangkok, Thailand

The popular press has been bandying a lot of cute acronyms for the ‘sick’ European countries. I have seen PIIGS, STUPIDs, and DUHs… and while the individual circumstances of each country are different, they all have one thing in common–

Their obligations far exceed their assets, and they have to borrow money just to pay interest on the money that they’ve already borrowed.

We don’t need a new acronym because there’s already a word for it: junkie. Before too long, the entire euro zone may be heading in this direction… in fact, while the final nail may be a long way off, markets are clearly starting to build a coffin for the euro.

To give credit where credit is due, I believe that Doug Casey and Jim Rogers were among the first well-known figures to declare the euro ‘doomed’ from its inception.

Their idea, long dismissed as a delusional paranoia for the better part of a decade, is now cascading through financial markets as a distinct possibility.

I came to my own conclusions a few years ago when I was traveling through Europe looking for cheap property; I didn’t find any. European costs are much higher than most of the world, and one of the chief reasons is that the governments tax everyone and everything to death.

Yet, despite the high taxes, most European governments were still run budget deficits to pay for legions of useless, omnipresent government workers and social welfare program.

I remember the day very clearly when I came to this realization– I was sitting on a train bound for Giulianova on the Adriatic coast with a gorgeous Italian girl, and the newspaper headline she was reading said “Italy’s budget deficit to exceed the EU limit of 3% of GDP”

That was in 2004 when times were good. I remember thinking to myself, ‘How are these people going to make it during a down cycle when they can’t get their act together during the up cycle?’

More importantly, since European tax rates are among the highest in the world, and the individual governments of the eurozone cannot simply print more money at will, the only way out of a fiscal pinch is to borrow.

It seems so strange that Italy, which collects 43.4% of GDP in tax revenue, can’t figure out a way to make ends meet… and because it cannot realistically squeeze out too much more tax revenue, the government must borrow compulsively.

Italy’s debt level is now well-over 100% of GDP, and investors are rightfully worried.  Given the even more dire situation in Greece, markets are now finally starting to question the legitimacy of the common currency euro zone.

Like all fiat currencies, the euro is fundamentally toxic. It is in a unique situation, though. Unlike the US, European governments don’t have room to raise taxes because their taxes are already so high. What’s more, they have many more social welfare programs and lack the political will to cut them.

That makes Europe first in line for judgment day.

The junkie countries like Greece and Italy will be the catalyst– they refuse to cut their budgets with any serious meaning, and are thus unable to raise any more debt capital from the markets.

That only leaves the prospect of a bailout from Europe’s stronger nations… except that even Germany and France cannot withstand the brunt of multiple bailouts. Obviously, if Greece is bailed out, Spain, Italy, etc. will line up with hat in hand as well.

And while the Greeks may be holding mass demonstrations to protest budget cuts, what will happen when the French start rioting in the streets to protest Greek bailouts?

European financial solidarity cannot stand, and there is no long-term solution except for a breakup of the eurozone. For now, the politically expedient answer is the current dog and pony show– bureaucrats gripping hands in a charade that is long on theatrics, short on substance.

Eventually, though, and it will have to be soon, something has to give. Greece is going to run out of money in a few weeks… so it’s either bailout or default. Neither will be pretty for the euro in the medium term.

The euro may rise briefly if Germany and the ECB signal a bailout, but the long-term implications of the moral hazard will be detrimental for the single currency.

One way to invest is to short the euro against gold and silver (XAUEUR and XAGEUR); I recommended this trade two months ago, and each has returned about 8% so far. I expect precious metals to keep rising against the euro, and to hold their value even if the world resuffers another deflationary cycle.

Another implication to consider is the effect on the Swiss franc; the Swiss do not want their currency to appreciate too much against the euro, and the government there has a history of intervening when necessary, so it may be worth opening a short position on the franc in the next few weeks.

Lastly, the implications for the US dollar and yen are significant. Until the global financial system agrees on another safe haven that can absorb massive capital inflows, the dollar and yen should see continued appreciation against the euro until the market’s anti-euro fever has bottomed out.

More on this in future letters. Happy investing.