Each day more pressure builds to end the euro. The Danish Krone is crumbling this morning after a statement made yesterday by the head of Denmark’s Economic Council, Hans Jorgen Whitta-Jacobsen. He said that the country would use “capital controls” if necessary to defend the peg to the euro. With the euro rapidly losing its footing, and a Greek exit from the currency imminent, many forex traders were betting that Denmark would be forced to abandon the currency peg and see a spike in value.
After the statement was released by Denmark’s Economic council, traders moved to dump the Krone and the currency fell against the euro by the most since 2001.
Last month, Switzerland removed the peg of the Swiss Franc to the euro and saw the currency spike more than 20% overnight. The move was made in advance of the start of the European Central Bank’s Quantitative Easing program and the election of the anti-austerity Syriza government in Greece. The move caused a run on the banks as Swiss citizens realized they could suddenly get 20% more in currency swaps. ATMs in the country ran out of euros.
The ECB stimulus program of Quantitative Easing devalues the euro and continues to put downward pressure on the Krone. Despite what Hans Jorgen Whitta-Jacobsen wants to do, Denmark may have no choice if the euro fails completely, and many expect it to do just that in the near future.
If it does fail, the IMF’s Special Drawing Rights, or SDR will become unbalanced, which could have dramatic effects on not just the economies of Europe, but on the stability of the dollar as well. According to the Council on Foreign Relations, the dollar and euro “make up nearly 80 percent of the value of Special Drawing Rights, the reserve asset used in transactions between the International Monetary Fund (IMF) and its members. Of all debt securities denominated in a foreign currency, more than three-quarters are in dollars and euros. The two currencies together account for nearly two-thirds of all trading in foreign exchange markets worldwide.”
The SDR would essentially become the dollar. With the massive debt to GDP ratio of the United States, the strength of the dollar is largely dependent on faith that the U.S. will continue to do whatever possible to kick the can farther down the road.
The Council on Foreign Relations warned three years ago that our current dual monetary system is paralleling exactly what happened with the International Monetary Collapse of the 1930s:
“It, too, was organized around two currencies: the British pound and the U.S. dollar. With the United Kingdom and the United States making sterling and dollars available — and other countries accumulating them — global foreign exchange reserves more than doubled between 1924 and 1930. Trade credit was readily available, allowing deficit countries to finance additional imports. As a result, during the 1920s, global trade rose twice as fast as global output of goods and services. International capital flows similarly expanded more rapidly than global output, peaking in early 1928.”
“The boom in trade and in the movement of capital created global imbalances similar to those of recent years. Some surplus countries, notably France, accumulated vast quantities of reserves. Others, such as the United States, recycled their surpluses by lending to the deficit countries of central Europe, mainly Germany. But the deficit countries spent the capital they imported on consumption rather than investment. The world saw the rapid expansion of credit and an alarming run-up in asset prices. As the decade drew to a close, doubts grew about the resilience of this precariously balanced system.”
Sound familiar? The “key difference” between then and now, of course, was gold. “At the close of the 1920s, central banks held between 60 and 70 percent of their international reserves in the form of gold. They used that gold, together with foreign exchange reserves, principally bonds issued by the U.S. and British governments and bank deposits in New York and London, as backing for their money supplies. They stood ready, as a matter of legal obligation, to convert their monetary liabilities into gold at a fixed domestic-currency price.”
And in 1928, when the Federal Reserve was concerned about the “exuberance” of the markets and over-inflated assets, they began to raise rates. Many believe the Fed will raise rates again later this year to gently put the brakes on the economy. The last time they raised rates was in 2008.
Janus fund manager, Bill Gross (formerly of Pimco) has pointed out that whenever short term rates exceed the GDP, stocks and housing falls, “The reason is that whenever the cost of capital (Fed Funds) moves above the return on capital (Nominal GDP) then assets dependent on leverage (stocks, houses) suffer negative or more restrictive cash flows and are liquidated at the margin.” said Gross.
Just two days ago the Fed released minutes of their latest monetary policy meeting and expressed obvious concern but still did not offer a timetable for raising rates.
So when the Fed does once again raise rates, there will be a credit crunch, the dollar will rise, and U.S. exports will continue to drop. When this happened in 1928, the U.S. economy hit a peak in the summer of ’29 and then we all know what happened next. a global recession followed by the Great Depression. It caused a domino-effect of bank runs throughout Europe and forced the Bank of England to abandon the gold standard. Banks around the world failed.
The Council on Foreign Relations reminds us: “The chaotic liquidation of foreign exchange reserves made credit scarce and put upward pressure on interest rates at the worst possible time, making it hard for firms to finance not only international transactions but domestic investment, as well. Disorderly exchange-rate movements disrupted trade flows, making it harder for countries to export their way out of the Depression. Nations now losing gold and foreign exchange reserves imposed capital controls that hindered foreign investment. It took years, well into the post-World War II period, for international trade and investment to recover to the levels that had prevailed prior to the collapse of the international monetary system.”
Even when countries were still using the gold standard, much of the value of currency was based on confidence. With no gold standard, if the euro falls, and the IMF’s SDR becomes a proxy for the dollar, the next major global currency crisis could happen much more quickly and be much more difficult to recover from than during the Great Depression. At that point, the only choice might really be World War 3.