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Betting Against the Euro

Why euro-bashers could turn against the dollar, and how they might be stopped.

The destruction of Greek credit on international markets this year has been framed as a drama between laissez-faire instincts in Britain and the United States on the one hand, and slower, cud-chewing, pseudo-socialist European tendencies on the other. "There is a part of the Anglo-Saxon press that no longer bothers to hide its desire to see the euro zone disappear," Jean Quatremer wrote in Libération in February, referring to Anglo-American economic areas by the traditional misleading term.

Europeans like to talk about a conspiracy against the euro. But was there really some kind of financial patriotism at play in the markets? No, says Claus Vogt, a German economist who predicted the American mortgage debacle in a book called Das Greenspan Dossier. Vogt argues that this year's pressure on the euro involved no rational assessment of the currency's structural problems compared with, say, the dollar.

Hedge funds and investment banks, Vogt said, could easily turn their attention to any other currency — for exactly the same reasons they found to dog pile on the euro. "Last year, dollar-bashing was in fashion, but all these governments follow the same, completely frivolous monetary and fiscal policies." he said. "So as long as they march in lockstep toward the abyss, the currencies will fluctuate with respect to one another."

The euro assault started on the currency markets, where speculators logged a record number of short trades in late January, betting that the value of the euro would drop. Europeans complained of an "Anglo-Saxon" conspiracy, but the short trades were relatively harmless. (It would have taken a far larger volume to wreck the euro.) Later, though, it came out that Goldman Sachs and other investment houses had found ways to mask Greece's debt by concocting financial instruments that allowed Athens to raise money against assets like lottery profits or airport fees. The bankers, in other words, were in a unique position to know how riddled with debt — how weak — the euro zone was.

So last fall, Goldman and a number of other investment banks, including JPMorgan Chase & Co., backed a company called the Markit Group Limited of London, which established an index called "iTraxx SovX Western Europe," where investors could bet on the likelihood that, say, Greece might default on its bonds. The more investors piled into these trades, the more expensive it became to insure Greek debt, which in turn made it harder for Greece to borrow.

"You are the bookie, you are the house," is how U.S. Sen. Claire McCaskill put it straight to Goldman Sachs executives at a hearing in April. "You had less oversight than a pit boss in Las Vegas."

The debt-masking derivatives amounted to a destructive way for Goldman to earn a lot of money at the expense of Greek taxpayers, who protested violently in Athens when Prime Minister George Papandreou presented them with a bill in the form of austerity measures and higher taxes. The destruction continued in April after a downgrade of Greece's credit to "junk" status as derivative markets continued to make it harder for Athens to climb out of its hole.

What can be done? The EU expects to have a draft bill to regulate derivatives by July, with the aim of setting new rules by 2012. Regulation is obviously a good idea. Derivatives trading needs to be made transparent enough to keep an investment bank from serving as both "bookie" and "house." Goldman CEO Lloyd Blankfein admitted in the Financial Times last year that Wall Street firms had failed to unravel the dangers inherent in their own derivatives. If investment banks — never mind their regulators — can't make sense of some financial instruments, the obvious question is why are they legal at all?

But one simple rule that would bring more honesty to financial markets is a ban on naked short selling, or setting up a short position on an asset without first borrowing real shares of it. (Short trades normally require traders to borrow the shares they wish to bet against.) A proper ban would keep the shares from being promised around to multiple traders like a magician's disappearing cards.

Regulation would have to be general across U.S. and Asian markets as well as the cautious, cud-chewing euro zone. (Otherwise these destructive financial storms can just migrate to capitals with the loosest laws.) But these rules have found no traction in Washington.

Beyond regulation, of course, governments on both sides of the Atlantic need to be serious about their national debt. Claus Vogt says the euro looks healthier to him than the dollar, structurally, because the euro zone sets goals for national debts and deficits (which it obviously hasn't observed). The U.S., he said, has no similar rules to ensure sound money.

"It's when you look at a graphic of the currencies against gold that you can see where the true music plays," Vogt said. "Both currencies have lost value drastically against gold — not just the euro and the dollar, but also the pound and the yen — which supports my theory that all these paper currencies have unified themselves around a frivolous fiscal direction."