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Guest Post: Funeral Music For The Euro-zone?

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Submitted by Alex Gloy of Lighthouse Investment Management

Funeral music for the Euro-zone?

This week, EU leaders will try to agree on limited EU treaty changes
at a summit (December 16-17). The aim is to establish a permanent rescue
mechanism for countries in financial difficulties. On Monday and
Tuesday (December 13-14) foreign affairs ministers will meet in Brussels
to prepare draft conclusions. The BBC claims to have obtained a draft
communiqué. We will analyze if a new European Stability Mechanism (ESM)
has any chance to save the Euro.

It will be interesting to see how far the idea of eBonds
(supra-national bonds issued by the EU to funnel money towards countries
in difficulties) will get amidst opposition from the two largest
contributors – Germany and France.

It is unclear why it took a French-German summit[1]
to state the obvious, namely that bankrupt entities, including
sovereigns, should be allowed to go bankrupt. “Bankrupt” not as in “the
end of the world”, but rather as a way of making a debt problem
manageable by restructuring it. Orderly bankruptcy proceedings, by the
way, are in the interest of creditors (since otherwise creditors would
create more damage in a “first-come-first-served” rush to secure
collateral at the detriment of others).

After peripheral European bond spreads exploded, Ms. Merkel tried to
limit the damage by assuring investors that no haircuts would have to be
borne until mid-2013 (when the European Financial Stability Fund – EFSF
– is supposed to be terminated). In a desperate attempt to calm
markets, European finance ministers[2]
specified “that this does not apply to any outstanding debt”. But what,
should the Euro-zone still exit in 2013, would that mean in practice
(apart from the effect of having a two-tiered bond market[3])?

Euro-zone politicians to taxpayers: This mud-pie to hit your face by 2013

Sovereign bonds with issue date before mid-2013 would be “exempt”
from restructuring? Who in his right mind would venture out to buy bonds
issued by a heavily indebted country after that fatal date? Obvious
answer: nobody. Even if that country managed to sell a few new bonds –
those bonds would make up only a small percentage of total debt
outstanding (but would have to bear the full burden of haircuts,
dramatically impacting expected recovery value). Even if such an event
was to occur – how much debt relief would the issuing country gain (if,
say, 99% of bonds outstanding have been issued prior to mid-2013 and
hence will not suffer haircuts)?

This plan is not only half-baked, it is akin to a pile of sand and
mud mixed together by a couple of 2-year olds and presented to their
parents (the taxpayers) as a “beautiful cake”.

Euro-zone taxpayers might be in for another surprise. As Irish bond
yields kept rising even after the EUR 85bn bail-out was announced the
European Central Bank (ECB) bought Irish, Greek and Portuguese
government bonds in earnest. What will happen to those holdings in case
of a default? According to a statement by the Euro Group[4]
(meeting of finance ministers of the Euro zone) an ESM (European
Stability Mechanism) loan “will enjoy preferred creditor status, junior
only to the IMF loan”. FitchRatings agency warned[5]:
“The preferred creditor status of ESM lending and therefore the
subordination of private creditors’ claims could result in lower ratings
(…)”. While arguments can be made in support of seniority of ESM loans
(it is, after all, taxpayers’ money used to bail out other countries)
this has other consequences:

1. Crowding out of private investors: Private investors are being
subordinated (which alone should lead to rating downgrades and further
losses for bond holders). This will make their participation in future
government bond sales even less likely. ESM bail-outs effectively make
it more difficult, not easier, for a sovereign to access capital
markets.

2. Stealth shift of restructuring burden onto taxpayers: By loading
up on sovereign government bonds the ECB becomes a subordinated creditor
of over-indebted countries (not even mentioning ECB lending to
insolvent banks). Since the bonds are being bought in the secondary
market at steep discounts to par value the ECB is unlikely to be able to
claim same creditor status as ESM loans.[6] Should a bailed-out country finally default, the ECB might be left holding the bag, with the taxpayer footing the bill.

This opens an entire different thought: what if “strong” countries left the Euro ahead of
any sovereign bankruptcies? Surely those countries would set up their
own central banks and could leave countries stuck in the Euro-zone to
share ECB losses amongst themselves. There might be a “first mover
advantage”, as those who stay until the end of the party usually are
being recruited for cleaning up the mess.

While Euro Group claims to act in the interest of taxpayers (“…in order to protect taxpayers’ money”)[7]
they achieve the opposite. Bail-outs are neither in the interest of the
recipient (i.e. Ireland, as only more debt is added to an already
indebted creditor), nor in the interest of taxpayers in contributing
countries, nor in the interest of bond holders (subordination). The
question may be raised in whose interest those bail-outs really are.
Many fingers point towards French, German and British banks who risk
becoming insolvent should their foolish loans go up in smoke.

De-leveraging (reduction of debt levels) leads to lower GDP growth
and, possibly, to deflation. As seen in Japan, nominal GDP will trend below real GDP[8].
As debt is supported by nominal GDP, deflation makes elevated
debt-to-GDP ratios more difficult to bear. I doubt there is any chance
for Ireland to achieve the overly optimistic GDP growth numbers of its
National Recovery Plan (“The Plan projects that real GDP will grow 2.75%
on average over the 2011-2014 period”)[9], and any spells of deflation will make the situation only worse.

Can the Euro be saved?

It seems politicians in the Euro-zone are trying to save the Euro by
shifting the burden of debt restructuring onto taxpayers and allowing
enough time for financial institutions to get rid of their loans.
Reduced debt levels would give a couple of years of “breathing room”,
but not address the problem of diverging trends in unit labor costs and
trade balances. It would merely postpone the unavoidable. As argued earlier,
a Euro exit would lead to the same “punishment” as bankruptcy (elevated
interest rates and limited capital market access) for a limited period.
It should be noted that yields of some countries government debt (i.e.
Greece) have already reached levels more consistent with the event of
re-introduction of their own, weaker currency.

Apparently Sarkozy threatened leaving the Euro in May (in order to
force Germany to accept the 750bn bail-out). This was clearly an empty
threat, but with Merkel partying with Putin in Moscow and the German
finance minister hospitalized the Germans took the bait.

Mrs. Merkel plays her highest card

Recently, The Guardian reported Mrs. Merkel to have threatened the same[10]
at an EU summit in Brussels at the end of October. Now, it is unlikely
the author suddenly found out about this threat more than a month after
the incident. Instead, it looks like an aide to Mrs. Merkel leaked this
information to a British newspaper (more credible than a German
newspaper). Threatening to leave the Euro is, of course, the highest
card Mrs. Merkel can possibly play. Playing the highest card smacks of
desperation and reveals huge differences among European politicians. Of
course, if everybody threatens to leave the Euro, that threat loses its
effectiveness. We might already have entered the end game.

The end game: Which one is the least chaotic option?

Assuming the end game is a break-up of the Euro-zone, which is the least chaotic option?

Imagine a single “weak” country leaving the Euro-zone and introducing
its own currency. Bank depositors would face a forced conversion of
their Euro savings into the new, weaker alternative. A bank run (into
gold or Euro deposits at banks in other countries) would be guaranteed
to ensue. Bank runs could destabilize other indebted countries, too.

However, should Germany (plus Netherlands, Finland?) quit the Euro
zone and introduce their own respective currencies, the majority of
savers in remaining Euro-zone countries might think twice before moving
their savings into new and unproven currencies. Of course, a New
Deutschmark would appreciate versus the “Mediterranean” Euro and lead to
problems for German exports. But those companies could be compensated
by currency gains stemming from paying old Euro debt with New
Deutschmark.

An independent Germany would surely want to have back its Bundesbank –
which would compete directly with the ECB (and I would not expect the
ECB to be keen on such an outcome).

The stakes are high. Even the IMF has gotten cold feet ahead of the
vote by the Irish Parliament on the EU-IMF Financial Assistance Program
(December 15th) and delayed a vote by its own board until the 16th. A
“no” from Dublin would be a significant blow for the Euro – but a huge
win for Irish taxpayers.

Alexander Gloy is founder and CIO of Lighthouse Investment Management


[1]
Merkel and Sarkozy concluded at a meeting in Deauville on October 18
2010 that future rescues of Euro-zone states should involve losses for
private bond holders.

[2] G20 meeting in Seoul, November 11-12, 2010.

[3] Sovereign bonds of, say, Ireland would trade at different yields depending on their issue date.

[4] Statement by Eurogroup, November 28, 2010, page 2

[5] “Contagion, Support and Euro Area Sovereign Ratings”, Comment, by FitchRatings, December 2010

[6]
See “The seniority conundrum: Bail out countries but bail in private,
short-term creditors?” by: Daniel Gros, Center for European Policy
Studies, December 5, 2010

[7] Statement by Eurogroup, November 28, 2010, page 2

[8]
Real GDP growth = nominal GDP growth minus rate of inflation. If
inflation is positive, real GDP growth is lower than nominal GDP growth
(and the opposite in case of deflation).

[9] “The National Recovery Plan 2011-14″ leaflet, page 1

[10] “Angela Merkel warned that Germany could abandon the Euro” by Ian Traynor; in: The Guardian, December 3, 2010

 

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Mon, 12/13/2010 - 11:35 | 801504 Confused Indian
Confused Indian's picture

Why is Euro shooting up today then?

Mon, 12/13/2010 - 11:36 | 801509 Confused Indian
Confused Indian's picture

Is it a pre-funeral custom or slp on face of the article? 

Mon, 12/13/2010 - 15:20 | 802216 dlmaniac
dlmaniac's picture

Hard to say who sleeps with fishes first b/t Euros and US$. I think Euros beats US$ by a nose.

Mon, 12/13/2010 - 11:42 | 801524 tmosley
tmosley's picture

Here is a technical diagram explaining the answer to your question: http://i101.photobucket.com/albums/m56/Aaron1927/titanjc0012211.jpg

Mon, 12/13/2010 - 11:52 | 801548 Confused Indian
Confused Indian's picture

Nice technical diagram Sir. But unfortunately this technical picture is status quo for last 6 months and only those who dared to go short or sold off their holdings have sanked. The slogan of the decade is "dont fight the fed" and "buy the dip" and "technicals and fundamentals are for fools"

Mon, 12/13/2010 - 11:42 | 801525 Sudden Debt
Sudden Debt's picture

I stopped looking for a sence in this market at newyear eve 2008

Mon, 12/13/2010 - 12:38 | 801662 erik
erik's picture

Where is it going?  That's the answer I want.  ~1.36 seems to be likely, maybe even by Wednesday.  1.36 is the 50% re-trace of the down move since QE2 day.  Look for consecutively weaker green candles on EUR-USD over next couple of days as supporting evidence.

At that point, you'll have very over-extended stock markets per RSI and sentiment readings, and we'll be ripe for a correction.

Russell 2000 will likely be most overbought market.

Mon, 12/13/2010 - 12:40 | 801669 erik
erik's picture

Remember, Wednesday is the EU/IMF bailout vote in Ireland.  Right now it is expected to pass by a narrow margin.  That sets up "buy the rumor" in the Euro right now.  Then a quick final ramp on the news, before selling commences again.

If Euro bond spreads stay even or grow over the next couple of days, that'll be more support for going short the Euro at 1.36.

Mon, 12/13/2010 - 13:42 | 801891 knukles
knukles's picture

How It Works.

The Euro is shooting up because all of the EU/EMU member countries are going to contribute real money to an emergency bailout fund, to be funded from proceeds of bond issues that they each float in the bond markets and contribute the money they raised in the bond market to the emergency bailout fund to buy the bonds they just sold in the bond market to raise the funds to fund the bailout fund to buy their bonds they just sold in case nobody else will buy the bonds they just sold.

Elegance.  Pure fucking brilliance.

Mon, 12/13/2010 - 15:10 | 802190 Reggie Middleton
Reggie Middleton's picture

It really gets interesting if traders truly percieve that Spain is going to default. See http://boombustblog.com/reggie-middleton/2010/12/13/will-spain-default-the-answer-is-not-that-hard-to-determine-if-you-take-and-objective-look-at-the-numbers-and-your-recent-history/

Even if Spain were to receive assistance in the form of a bailout from the IMF/EU, the problem is simply kicked down the road, and not rectified. Again, the year 2013 is the magic number and the day of reckoning.

 

Mon, 12/13/2010 - 11:37 | 801510 Rogerwilco
Rogerwilco's picture

"Permanent rescue mechanism", aka fascism. You go girls!

Mon, 12/13/2010 - 12:01 | 801569 nonclaim
nonclaim's picture

Like a intensive care unit to a critical patient...

Mon, 12/13/2010 - 12:37 | 801660 Hugh_Jorgan
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Permanent rescue mechanisms will also mean automatic mechanisms, thus bailouts would no longer need to be debated in Parliament and tried in the court of public opinon. (Kinda' like Fanny and Freddy here). There is nothing to see here *cough, cough*, just the end of, *cough* life as you know it!!!!!

Mon, 12/13/2010 - 11:37 | 801513 PaperWillBurn
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The High Card is the Freegold card. Buy physical gold hand over fist until it breaks free of it's paper chains. The new price wipes out Euro debt problems (minus Ireland) and not only keeps the Eurozone intact but makes the Euro the go to currency as their gold reserves give the euro much greater credibility than the $.

Mon, 12/13/2010 - 11:42 | 801521 shortus cynicus
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New Deutschemark and other country-currencies would be grate deal for EU, competitive currencies are best for a market, assuming that Banksters are forced by low to lower exchange rates ( Onda or some peer-to-peer exchange web sites can do that, so why not Banking Cartel ? ).

For securing confidence and making accounting books clear, the introducing of new Deutschemark should start with figuring out, where and why have Bundesbank lost its claimed 3200 tones of "Gold holdings".

Mon, 12/13/2010 - 11:42 | 801522 francismarion
francismarion's picture

Germany seemed to think that the weakened euro was a good idea as long as their exports could burgeon. But now that Germany has to bail out the peripheral nations, the whole thing is up in the air.

There can be no fiscal union without political union. United States of Europe?

Mon, 12/13/2010 - 11:47 | 801539 Rogerwilco
Rogerwilco's picture

"United States of Europe?"

Deutschland über alles has a nice ring to it.

Mon, 12/13/2010 - 11:44 | 801530 RobotTrader
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NY Composite is now at a new 2-year high.

Mon, 12/13/2010 - 11:45 | 801532 Sudden Debt
Sudden Debt's picture

funny you Americans constantly seem to forget that a lot of your states that are way bigger then most European countries are also bankrupt. :)

What if the last few states that still have growth would cut of the sucker states?

Here in Europe we just say: Those Americans can print whatever they want, SO DO WE!

 

Mon, 12/13/2010 - 11:49 | 801542 Rogerwilco
Rogerwilco's picture

No, we haven't forgotten their insolvency, we're just too busy buying the dips to pay much attention right now.

Mon, 12/13/2010 - 12:11 | 801594 Shameful
Shameful's picture

There are a few differences.

1. Masters of the Ponzi Universe.  America can generate a lot of innovation.  For the last generation or more we have focused on creating nothing but fraud, so we are really good at it.  I daresay that in ponzinomics we are unparalleled.

2. $$$ for Goodies.  The world is retarded and refuses to realize that we will print worthless dollars to buy their assets till the sun burns out or they free themselves from the shackles of slavery, whichever comes first.  And for some reason dollars are the preferred form of global funny money.

Totally agree that many US states are totally irreparable bankrupt.  There is no way to even fix them in our legal structure.  However EU may still fail first because we are masters of extend and pretend and the world will still accept freshly printed dollars for their goods and labor.

Mon, 12/13/2010 - 12:50 | 801700 dark pools of soros
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any chance the real Ben will be this candid in his next meet with Ron Paul??

Mon, 12/13/2010 - 14:41 | 802095 MachoMan
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Sudden Debt, the biggest problem I see with this approach is that the "growth" states would need to be able to defeat the standing army of the united states.

Mon, 12/13/2010 - 11:46 | 801534 Jason T
Jason T's picture

LaRouche suggests, the entire world monetary system is going down by around Christmas time. This guy is classic.

 

http://larouchepac.com/node/16785

Mon, 12/13/2010 - 15:14 | 802195 dnarby
dnarby's picture

Couldn't spare an hour to watch that, but I think he's right - Just a year early.

Mon, 12/13/2010 - 11:48 | 801540 Cdad
Cdad's picture

The criminal syndicate known as Wall street has kicked the crap out of the US dollar to the tune of almost 1% [against the basket], and rallied the laughable Euro against the dollar a fully penny, and the result of this damn near crime is a 3 pt. bump in the S&P.  Great!  Seems like a fabulous deal.

Oil hits a new year high, to be followed by surging natgas prices, soon enough, and farmers wake up each morning shocked at their suddenly good fortune selling corn at $5...while Bank of America tries desperately to cover its criminal tracks and burn the bridges behind them "dumping" mortgages.

And The Bernank continues to fabricate more and more US dollars while calling all of this "the wealth effect."

Do I have all this right?  I am trying to figure out if I actually missed my alarm and am still sleeping.  Please let me know.

 

Mon, 12/13/2010 - 12:55 | 801711 dark pools of soros
dark pools of soros's picture

spot on...  i think it is time to get around to sell sell sell all my extra crap on ebay and craigslist and then buy gold/silver

Mon, 12/13/2010 - 15:33 | 802263 erik
erik's picture

lol, cdad.  nice recap. 

Mon, 12/13/2010 - 11:56 | 801550 Sean7k
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Since the captive populations of the US and Europe are incapable of paying said debts, it is really a question of when the time comes, will the people revolt when saddled with the cost of the bank's criminal actions? 

Will the people turn to their own currency,gold or silver, and walk away from the machinations of the central bankers? 

Will a two tier monetary system develop that works locally in metals and internationally in new forms of money substitutes? 

If governments lose control over money, how do they maintain control over the people they hope to rule? Because outside of murderous slaughter, state starvation and water witholding, the state is incapable of controlling the given populations- especially in the US with the number of weapons available.

It appears they are betting the sheep will remain sheep through the slaughter, we shall see...

Mon, 12/13/2010 - 13:36 | 801874 AnAnonymous
AnAnonymous's picture

Since the captive populations of the US and Europe are incapable of paying said debts,

 

That is the point. A  point the article ignores.

'Defaulting' does not make the debt more manageable when you cant pay the debt, that is direct repo.

All that is done is a theater of illusions performance: people pretending they can pay the debt to put off the great revelation they can not pay back.

Under this light, the European issue is totally another one. It is  make or break time in Europe, forced march towards the European State. There is no other way out. 

Mon, 12/13/2010 - 11:59 | 801563 Quinvarius
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All this Euro bear nonsense.  The Dollar bounces and everyone suddenly forgets how to do math.  We borrow more every month than it would take to bail out all the PIIGS put together.  The Eurozone will only dissolve if there is a war.

Mon, 12/13/2010 - 15:49 | 802315 GoinFawr
GoinFawr's picture

Hahah! Ain't it the truth! Denial loves a distraction...

Mon, 12/13/2010 - 12:09 | 801589 carbonmutant
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ROME (Reuters) – Italian Prime Minister Silvio Berlusconi said rebel lawmakers could pitch Italy into the middle of the euro zone's debt crisis if they voted against him in a no-confidence vote on Tuesday.

Speaking in the Senate a day before a showdown that could force him from office and trigger early elections, Berlusconi said his government had kept Italy out of the turmoil seen in Ireland or Greece but that the threat of instability remained.

"It is madness to initiate a crisis without any foreseeable solutions," he said.

A year of party infighting and corruption and sex scandals has hit Berlusconi's leadership credentials while a scandal over waste management in Naples has made piles of uncollected garbage an embarrassingly visible symbol of the government's weakness.

Mon, 12/13/2010 - 13:21 | 801681 TruthInSunshine
TruthInSunshine's picture

Has Ben 'quadruple down on that which has never worked before in the history of global commerce & economics because I want to be a pioneer risking taxpayer money' Bernanke opened the gates of currency swaps far and wide again?

(Yes, the nickname above is long, but it works....it works for Ben)

Mon, 12/13/2010 - 12:51 | 801703 TexDenim
TexDenim's picture

The Germans have more to lose from a dying Euro than they have to gain. They may want us to believe the Euro is on its way out, but they will change their tune at the last minute, after they have extracted the concessions they want.

Mon, 12/13/2010 - 12:57 | 801717 dark pools of soros
dark pools of soros's picture

the Germans or the German Banks?    the Germans make tons of stuff people want so they will get outta the storm while others drown 

Mon, 12/13/2010 - 18:55 | 802888 TexDenim
TexDenim's picture

I meant the German nation. Yes, that's exactly right, they are a nation of manufacturers, and they do it near-perfectly. But they benefit from the Euro in the sense that the Greeks can't change the terms of the game by devaluing their currency. If Europe goes back to multiple currencies, the biggest long term loser will be the Germans, because they won't be able to make long term contracts they can rely on.

Mon, 12/13/2010 - 13:03 | 801735 francismarion
francismarion's picture

According to a poll conducted in Germany, found in 'The Local' (German news in English):

"Sixty percent of those polled said they preferred the euro, while one-third said they longed for the return of the Deutsche mark, the survey for broadcaster ARD found.

The nostalgia for the former German currency was highest among less-educated. Forty-nine percent said they wanted to fill their wallets with the mark once again after 11 years with the euro.

Meanwhile 80 percent of the highly educated participants said they were against the reinstatement of the old bills and coins."

                                                                       -The Local

Mon, 12/13/2010 - 13:22 | 801825 Goldenballs
Goldenballs's picture

Believe this crap and you believe anything.Germany is awash with safe deposit boxes stuffed with Gold and Silver,its called insurance for those in the know.

Mon, 12/13/2010 - 14:27 | 802054 NotApplicable
NotApplicable's picture

I would've thought that Germans would be smarter than to keep real money in Merkel's safe deposit boxes. Have they never heard the term "bank holiday?"

Mon, 12/13/2010 - 13:08 | 801759 milanitaly
milanitaly's picture

I hope Merkel doesn't think to ask Italy something for Euro survive.

We have no more options to reduce our debt. And if interest rates will increase ...... boom!

 

Mon, 12/13/2010 - 13:35 | 801872 dark pools of soros
dark pools of soros's picture

deliver more pizzas in those lambos

Mon, 12/13/2010 - 15:41 | 802289 Sudden Debt
Sudden Debt's picture

A Lambo can only transport 6 pizza's in the trunk. A Maserati can carry a whopping 8!!

THIS IS THE CHANGE ITALY NEEDS!! PIZZA DELIVERIES WITH MASERATI'S!

Mon, 12/13/2010 - 13:20 | 801816 Goldenballs
Goldenballs's picture

The Sooner the EU dies the better.Contributions to the EU are just Stolen money people can,t afford anymore.

Mon, 12/13/2010 - 13:46 | 801907 Padrone
Padrone's picture

The bankers in Europe will not let the Euro project fail,.. just a matter of extending and finding escapes and let the taxpayer pay.

Mon, 12/13/2010 - 13:48 | 801916 AnAnonymous
AnAnonymous's picture

This article suffers from a complex of superiority and feign to ignore that what is going in Europe is big, big as big.

 

Sarkozy deceiving Merkel with a threat of leaving the Euro? Come on, you need to believe this drivel to pay attention to it. The Germans did not believe it one second. Mere bucket  passing, the Germans and the French want the same outcome but do not want to be held responsible for it. On this one, the Germans could blame the French for forcing their move. Notice how the Germans scratched back the French.

 

We have there a zone of the world that has been boasting about its history, its culture and so on.

A Eurobond is another step in moving the power of taxation from national states to the European state. As Europeans know it well, this is the recipe to perform the dissolution of a nation, a culture and so on. They know it perfectly as they performed it lavishly through colonization.

What we are living right now is the end of the Germans as a national people, French, Spanish, Italian etc...

This is big and no politician want to be associated with that directly.

But it is in motion. They have already moved toward more political union with this emergency fund facility.

Dont pay attention to people claiming the end of the Euro. They are only (sometimes paid) shills busy with covering the big affair going on in Europe: end of European nations and dissolution of the european cultures.

Better to side track with Euro end than facing and discussing this hand  burning topic.

Tue, 12/14/2010 - 05:18 | 804027 youngandhealthy
youngandhealthy's picture

One thing is for sure. I will not invest my money with Lighthouse Investment Management.

What a complete mass of drivel!

Do NOT follow this link or you will be banned from the site!