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How to profit from the collapse of the euro, courtesy of Goldman Sachs

Euro break up | How to profit from the collapse of the euro, courtesy of Goldman Sachs Economy Watch

On the 16th of August, Goldman Sachs released a report, 'State of the Markets – Long and Short Risk Strategies', that is currently making its way around the Internet. Originally intended as a private report for its institutional clients – hedge funds, that is – a copy was leaked to The Wall Street Journal, which was also the first media outlet to break the news. Though the international mainstream media has been largely silent, the Goldman report has been causing quite a stir with the online community.

The author, Alan Brazil, a key Goldman strategist who sits on the firm’s trading desk, made three major calls about the state of global markets.

Firstly, that China’s growth is unsustainable, and, secondly, that the U.S. economy is still languishing and small businesses that have traditionally been the key drivers of job creation were still fighting to stay afloat. Finally, Mr. Brazil declares that European bank funding requirements may be substantial compared to their sovereign capacity, estimating that close to US$1 trillion in capital may be needed to shore up European banks.

In Mr. Brazil’s pessimistic report, he also provides various charts and figures, detailing the numbers surrounding European financial institutions and expounds upon the depth of the problems in Europe, the U.S. and China. In particular, he spells out in detail the borrowing by 77 European financial institutions, identifying some that are highly leveraged.

Yet, such gloom and doom reports are nothing the markets have not heard of. The financial markets have been moving erratically, reacting sharply each time a negative data report is released – a key sign that investors are paranoid, jittery and staring out into an uncertain future for the world economy. Economists and governments have also been sounding out the same worries for quite some time. So why is there so much chatter surrounding the latest report by Goldman Sachs?

Repeat offender

To be fair, Goldman Sachs does not have the best track record in methods of profiteering. In 2009, Rolling Stone magazine published an extensive and scathing article about Goldman Sachs, 'The Great American Bubble Machine', alleging that Goldman has manipulated markets for its own corporate gains in numerous instances and way. On July 9 2009, Matt Taibbi claimed that:

“From tech stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression – and they’re about to do it again... If America is now circling the drain, Goldman Sachs has found a way to be that drain... Goldman scammed housing investors by betting against its own crappy mortgages... Goldman turned a sleepy oil market into a giant betting parlor – spiking prices at the pump.”

In the aforementioned report by Goldman, Mr. Brazil suggests ideas for trading on the downward analysis; a fancy option play the offers a way to take a bearish bet through an index of insurance contracts on the credit of European financial stocks. The Wall Street Journal said, in September 2011:

“Goldman sometimes took the bearish end of such trades even as it was selling the bullish end to clients.”

Perhaps, it is because the painful reminiscences from the 2008/09 financial crisis are still deeply etched in the memories of many, causing the burst of dissonance within the online community. However, there is perhaps a worthy takeaway from this contentious Goldman report.

Moving beyond the fuss, a pertinent question to ask is: Given the position Goldman Sachs is advocating, should we prepare for the euro’s break-up?

Many have been quick to jump into the popular rhetoric surrounding the possibility of a euro break-up. But such arguments often miscalculate the consequences and the political, social, and economic costs involved. Many who advocate a euro break-up also fail to account for the legality of such propositions.

Constitutionally, the Treaty of Lisbon addresses the issue of withdrawal by a European Union (hereafter, EU) Member State in its Article 50. Article 50 explicitly states that a member state is able to negotiate an exit from the EU, though it fails to provide details about execution. Most importantly, however, Article 50 provides a legal framework for a Member to leave the EU, but not to leave the European Monetary Union (hereafter, EMU). An appropriate remedy here would require an amendment of The Treaty of Maastricht. Yet, constitutional changes governing the EU and the EMU calls for unanimous consent from all 27 EU Member States.

Assuming all legal obstacles were out of the way, there is also a need to account for the high costs involved should the euro break up. On September 6, UBS published a research paper on the euro, and quantified the economic costs at stake should a country like Germany leave the euro.

“Were a stronger country such as Germany to leave the euro, the consequences would include corporate default, recapitalization of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around €6,000 to €8,000 for every German adult and child in the first year, and a range of €3,500 to €4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over €1,000 per person, in a single hit.”

The same report goes on to say that “the economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.”

Fatally flawed?

The problem with the euro is that it was promoted (to the general public) as an instrument towards foreign exchange integration. What was not acknowledged initially was the immense difficulty in achieving fiscal integration, or at least fiscal coordination, between member countries with distinctly different economic repertoires. Romano Prodi, Former Italian Prime Minister and EU Commission President, said in 2001:

“I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to introduce that now. But some day there will be a crisis and new instruments will be created.”

While many may not like what the Goldman Sachs report had to say, it is nevertheless time to rethink the outlook for the euro and the European Monetary Union.

This article was written by Michele Lin and was originally published on Economy Watch under the title: The Secret Goldman Sachs Report: Eurozone Collapse And How To Profit From It.

Further reading on Goldman Sachs:

Tags: Alan Brazil , Article 50 , China economy , collapse of euro , collapse of the euro , EMU , euro break up , euro breakup , European bank funding , European banks , european financial crisis , European Monetary Union , eurozone , Goldman Sachs , Matt Taibbi , Rolling Stone , Romano Prodi , State of the Markets - Long and Short Risk Strategies , The Great American Bubble Machine , The Treaty of Maastricht , The Wall Street Journal , Treaty of Lisbon , UBS , US deficit , US economy , WSJ
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