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I’ve said there are only two options in Europe – fiscal union or break-up, but in his latest investor letter John Hussman discusses the three outcomes he sees as being possible:

“we can expect to observe one of the following three outcomes:

1) A European Federal System emerges whereby each country surrenders its own fiscal sovereignty, losing the ability to set fiscal policy without broad approval from a central European authority. This is the only condition on which Germany would be likely to agree to a change in the ECB’s mandate to allow it to broadly purchase weaker European debt. It is difficult to see how a sufficiently binding enforcement mechanism could be created to prevent individual countries from acting in what they see as their own best interests. In my view, any hope for this solution has a shelf-life of about three months, because as a broadening recession becomes clearer, the willingness of individual European countries to give up their own fiscal reins may vaporize.

2) Heavily indebted European nations begin to adopt versions of a dual-currency system, issuing various forms of IOU’s or convertible debt, thereby creating the longer-term option of converting their debts into currencies that they can print and devalue individually. This is probably the best option for Europe, but is not one that distressed countries will choose on their own so long as bailouts can be extracted.

3) Germany adopts a version of a dual-currency system by itself. This is something of a “nuclear option” after failing all other approaches. The benefit of this is that it would effectively allow Germany to issue new debt at negative real interest rates in euro terms, as Germany’s own inflation and exchange rate credibility is greater than that of the euro itself. Indeed, Germany could likely convert its entire stock of euro-denominated debt to deutschemark-denominated debt within about a week, and could legislate DM as legal tender just as quickly. This would also free the ECB to print euros to its heart’s content, without extracting seigniorage from the German people. It would, however, accelerate the depreciation of the euro since a reinstated German mark would be viewed as a safe-haven, much like the Swiss franc. It would also create some difficulty for German companies with long-term contracts having revenues payable in euros, and would sharply narrow Germany’s trade surplus with the rest of Europe. The benefit is that technically, the peripheral European countries would be saved from default. Moreover, Germany could conceivably re-join the common currency on more favorable exchange terms, post-depreciation, so it would not necessarily be the end of the euro.

In short, if you can’t save the euro by restructuring the debt of the weak members, or by having the weak members leave, or by having the fiscal costs fall squarely on the German people, the remaining option is for Germany to leave, inflate the heck out of the euro to deal with the debt problem, and reinstate Germany on post-devaluation terms.”

He says there are no good options at this point.   Read the full piece here.

Source: Hussman Funds

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