So what are the options?

1) One solution, which further develops the Euro project, is for full fiscal integration. This would be a major step and involve the Euro authorities taking over the management of individual countries fiscal responsibilities, outstanding debts and all future decision making over taxation and borrowing. It’s an ultimately surrender of financial sovereignty for all countries in the Eurozone. As with EU membership, this would favour the economically weaker countries as their borrowing rates would fall. Sadly for some, like Germany, their borrowing rates would rise, as there would be one single Eurobond, financed at an average rate of all the countries combined. It would most certainly be lower than the average rates now but still above where the most creditworthy (if there is such a thing) pay. The chances of this happening are slim to none, even though Merkel and Sarkozy have discussed moves in this direction. Behind this idea sits the possibility of a fully fledged Eurozone Government, the fear of many Euro-sceptics over the years. The reality is that this proposal can only work if there is a USE – United States of Europe.

It’s very hard to see this getting past voters in any country unless there is a financial meltdown of apocalyptic scale at which point “emergency measures may be justified” to coin a favorite term of “shock doctrine” watchers. For an amusing fictional account of how things may turn out, read this gem of a story “Berlin gets ready to leave the Euro”. Merkel’s electoral setback is hardly likely to shift matters forward.

2) The middle ground is for some of the weaker countries to leave the Euro and re-create their old currencies. These would be set initially at a rate which would enable some form of devaluation to help their export markets recover. This would entail quite a tricky transition process, both legal and financial, and the sheer mess it would cause logistically is enough to put many off, notwithstanding the theoretical attractiveness of a clean cut. The debt picture would be less fun: it’s hard to imagine anything less than a complete default if there was no further support from the EFSF . ANy debt denominated in local currency would face exorbitant rates meaning, in reality, those countries would not be able to borrow money. In effect, any country leaving the euro would result in default and an inability to raise money. The outcome of this would be complete financial chaos……initially. However, as with Iceland, it could lead to a complete restructuring of their economy at a completely new level.

In some ways this situation parallels that of some clients I have as a budget advisor. Some come with simple problems: a need to budget better, clear debt, sort out messy financial positions. However, some come with debts that are not possible to restructure in any way. They simply have no chance of ever repaying them, barring a lottery win. In these situations, they have been allowed to take on more debt than they can possibly service and often they have depreciating assets against an outstanding debt (a car for example). They are usually finished off by the compounding interest. It’s clear in these cases that lenders have been very, very sloppy. Often, as with professional investors, the search for yield or the desire to sell a loan overrides a proper analysis of the risk profile. This is how people end up with a debt mountain.

Insolvency is, sadly, the only answer. Life after insolvency is a, in current market parlance, an austere one. But it’s not the end of the world….life goes on. However, for the lender, it is a total loss…..though in many cases the debt has been packaged up and sold off, down the debt collection food chain.

Sovereign debt is no exception. Sure some countries can sell as much as they like (the US and Japan for example) but for others, with less collateral (whether in the form of private savings, trade surpluses or simply a reserve currency), there is a limit. Those limits have been breached and there is simply no way out. As I say to some clients: spend less, earn more or default.

This leads us nicely to:

3) Muddling along and trying to keep things as they are. This has been the course charted for the last few years: bank bailouts, sovereign bailouts and major cuts in public spending. This is akin to bailing out a sinking ship with water removed from one area whilst it pours in from another. As with option 1) there has been a reluctance to take action that would create some long term obligations for the major Eurozone underwriters (mainly Germany but also France to some extent). So funds have been created for special purposes to buy the sovereign debt of stressed countries. This has worked in part but again the markets can do the sums and see that they don’t add up.

At fault here, as usual, are the lenders. They have been happy to buy up sovereign debt on the basis that it’s too big to fail (TBTF) and that rates were attractive given the implicit support from the Eurozone. Why buy German Bunds when you can buy Greek paper at a much better yield? The market is supposed to be the restraint on government borrowing, knowing when to demand higher yields and when to say no more. But the post-EMU convergence desire for yield at any cost remains core to the investment approach of many. EMU was a big fudge to start with: how on earth did Greece, Italy and the other laggards suddenly reduce their budget deficits to 3%? It was all too tidy because it was always a political rather than economic project.

So governments spent too much and were able to borrow freely to support this. Investors were unconcerned knowing ultimately, it’s all underwritten by someone. The numbers now are too big and if underwriting as in option 1) is not the chosen path then the muddling along will have to involve some serious haircuts (read: partial defaults) in order for the system to continue to function. And why not? Investors have made poor decisions and have to pay the price. So why the reluctance to proceed down this route?

Well here’s where we get to the crux of the matter. European banks, and others, have invested heavily in sovereign bonds. If we see partial defaults or major restructuring then banks will be in trouble again and we will be back to 2008 in a flash. The reality is though that banks should have been allowed to fail back then with investors taking their losses as would be expected in a market system. Bailing out the banks in Europe and the US, whilst making no real reforms, has simply multiplied the problem and led us to where we are now.

At some point, the loss has to be taken by the investors and not the public.

It’s clear that none of the 3 options are palatable. But as I say to my budget clients, that’s the whole point. They never are. Debt is a miserable beast at best and when it climbs all over you there is no easy way out.

The Euro was always a pet project of Germany and France, a chance to unite Europe and create a powerhouse to rival the US and the ASEAN block. It was a project birthed from centuries of conflict and huge loss of life. Europe’s leaders stand at a crossroads. No path is easy to take: to go forward would see the European Project move towards its eventual conclusion, a true European Union. To go sideways means and end to the dream and a system in tatters.

The former is most unpopular, the latter a financial disaster. There really is no room for soft solutions here. It could be the end of the dream or the start of  a new future. Either way there are hard times ahead.

We are starting to hear more overt language from both officials and the general media about the potential for currency way, namely competitive devaluations, capital controls and other measures to shift currencies to where they should be or where officials would like them to be. Sovereign states have always messed with their currencies whether to screw their own people or other nations. It’s always about self-interest. But at some point the beggar they neighbour approach fails and we race to the bottom. There is no doubt that China is the key here but it’s played a very smart hand and has the US over a barrel. The geo-political arm wrestle is at full bore here and we don’t get to see much of it in the news. At some point though the surplus nations must adjust their currencies to bring the trading world back into equilibrium otherwise the whole system will fall apart. Keynes predicted this would happen and its been a 70 year work in progress. Kondratiev would be impressed.

The question is why hasn’t that happened already. You would imagine that a country with a trade deficit and an ongoing current account deficit (swollen by interest on borrowings to cover the trade deficit) would see its currency weaken and surplus countries would see the opposite. THis change in currency rates would, other things being equal, reverse the flow of trade and all would be rebalanced. On paper maybe but in the real “free market” that doesn’t happen. Why? Because deficit countries tend to have higher interest rates (in order to attract the capital it needs to pay off its debts) and those higher yields attract more and more capital looking for a home. So we have the ludicrous situation of one country lending another country the money to buy its goods…….that is not a recipe for long term success….unless you happen to be running a criminal organisation where your goal is to get your clients hooked on the product…..

It’s also known as debt slavery. And it must stop.

So does this mean we are headed for a new Plaza/Louvre Accord? I think that will be very difficult to achieve at the moment. It’s unlikely the Chinese would accept a single focus on the Yuan. It would almost be better to completely realign the whole global currency system where all surplus/deficit currency rates were realigned to new levels. The obvious problem (other than agreeing new rates) is that there would be nothing to stop markets moving rates right back. This suggests capital controls may come into play (Brazil is already trying something here with its bond market) perhaps in the manner of Malaysia.

More over steps such as currency intervention can be a problem unless the stars are aligned in your favour. Trying to weaken a surplus currency is next to impossible as the SNB found to their chagrin when buying huge amounts of Eur/Chf at a time when the market was actually desperate for Chf. The Japanese are repeating the same mistake as the Swiss by intervening, cutting rates, increasing liquidity and generally flapping about in the Yen. At this point in time they have made no progress at all. Why? Because the market wants to own surplus currencies and not the $. At some point $/Yen will collapse which will suit the US though probably not the Japanese.

For deficit countries with an appreciating and overvalued currency like New Zealand there may be better opportunities for influence. More on that net time.

For now though begun the currency wars have.

So back then I suggested the RBNZ should think about selling as much NZ$ as they could. Why? Why go against prevailing market sentiment which is that intervention doesn’t really work and simply provides a target for the speculating hordes which incidentally account for 95% of the volume of daily trades.

That’s a fair sentiment when your currency is falling but when it’s rising? And when you have an eye popping foreign debt of almost 140% of GDP……that’s foreign debt not overall debt.

And yet the punters keep buying the NZ$. Perhaps they know something I don’t. Maybe 50 years worth of oil has been discovered in the Southern Basin. Who knows?

The point is that at some point that money has to be paid back and at the moment, due to the sneaky monster that is compound interest, we can’t even get close to reducing it.

But now is the time to strike.

Again I would like to suggest that the RBNZ starts selling NZ$. When you have a lot of something to sell it’s always best to do it when others are keen to buy. Now is that chance.

By selling NZ$ now and paying back, or at least holding for that same purpose, it will take the pressure off the very precarious dependency we have on overseas lenders.

This doesn’t eliminate the debt but simply transfers it to a domestic situation where it can be managed at lower rates and where there is no threat of having to suddenly repay.

How can the RBNZ do this? Again this is very simple. Print NZ$ and buy US$. There is no change to the actual money supply just how the debt is denominated.

Considering the implosion Iceland experienced and the unfolding disaster that is Ireland (surviving only due to its membership of the Euro), it makes complete sense just to get on with this now.

To allow foreign debt to be run at such a level is financial mismanagement of the highest level.

It also shows a willingness to be dictated to and dependent on overseas interests. This makes no sense at all when the country’s economy security is at stake.

As usual it was the Russian President, Dimitry Medvedev, giving the $ a good roasting and moving the debate forward to the minting process. But really how far advanced is this process and how serious are they? More to the point what would a global currency unit look like?

To answer the first question is simple: I have no idea. At the political level it is mere grandstanding usually for the domestic audience. Sometimes it’s easy to forget that most politicians have little understanding of how the global financial system works (no different from anyone else!) but back in the offices of Treasuries and Central Banks it may be a different story.Though I was struck by the recent bizarre questioning of Bernanke over the issue of $ currency swaps with central banks. It’s a classic.

I do think though that the Eurasian block are serious about making this move. Each step is a step closer to creating a multipolar currency whether its based on the Special Drawing Rights (SDRs), a Commodity Backed Currency (CBC) or an Energy Backed Currency (EBCU). Even the Amero could be a consideration.

But the key outcome will be whether we move from a Fiat based system to a hard currency system. That would make a major change in the structure to the global system perhaps taking us back to Keynes’s suggestion, the Bancor. If we stay with a Fiat system then we simply exchange one piece of paper for another.A hard backed system would certainly restore some much needed reality to the meaning and value.

What’s clear is that the US has become a fiscal disaster and holders of paper issued by the US have said enough is enough: your paper is not “as good as gold“.

As I’ve discussed before there is a major shift underway in the way the global market is structured. Not just in terms of currencies but also trade and influence. The BRICs have a powerful case to make: 40% of global currency reserves and almost half the world’s population (though Russia’s population is declining, a somewhat serious issue).

There is a strong feeling that the US has acted recklessly overt he last 30 years in flooding the world with $ and creating huge imbalances which have caused such chaos in global markets. So whilst there is always plenty of posturing and grandstanding, especially from the Russians, there is a real case for the US to answer:

- Global trade imbalances.

- Cowboy capitalism.

- Turbo boosted monetary expansion.

- Instability in global financial markets.

It’s also interesting that the meeting of the SCO (Shanghai Cooperation Organization) was held at the same tim and the US was not invited even though it wanted to attend. There is a strong argument that there is no real alternative to the $ but that doesn’t excuse the facts. One dominant currency has not helped create a stable system. It has simply allowed to issuer to experience huge profits from seigniorage and wield extraordinary political and economic power.

And can we really take the rating agencies seriously? They are all US based organisations. Ultimately whether the $ loses influence or not depends on the alternatives. I still believe a commodity backed currency is a likely development, given the nations involved.

At the same time the development of local currencies will help create a more stable and complex system. For now though expect more talk about a $ alternative and expect it to be driven by the BRIC crew starting with the upcoming G8 summit in Italy.

In the last few months we have seen markets bottom and even recover some poise, aided and abetted by the action of nearly last resort, quantitative easing. There was nothing left in the toolbox really.

So far so good in some respects. The S+P has rallied 37% off its lows…….mind you its lows were 57% down from the highs and the index still stands 42% off the highs of the last few years. Not that the numbers really matter. The main news is that markets are functioning…still.

And the $ balloon has finally burst with QE signaling a chance to sell the $ without worrying what the equity markets were doing. The Kiwi$ has rallied 32% from its March low even outpacing the hammered Pound, up 21% from its low of $1.35.

Markets can do very strange things. Even whilst the $ was rallying to extreme highs against all currencies, no one really wanted to own it. Now people really really don’t want to own it.

This is all very well but this type of volatility is impossible to manage. How can any investment manager talk about average returns of 10% a year when markets are moving at this rate. How can any business hedge currency risk when currencies are moving like this.

The bigger problem for the US is trying to stop the snowball effect that may happen if markets really decide to dump the $. The noises coming from China may be regarded as monetary brinksmanship but with Russia, looking very wolflike these days, nibbling in behind, it’s becoming a more serious issue.

There’s a lot of politics involved in this but the positioning is clear: the US is weak not just economically but militarily. The exhausting foray into Iraq has stretched the US war machine as well as seriously impacting on its reputation. Historically the ability to create coin or currency was usually backed up by military power. One of the first actions by invading nations was to replace the local currency with its own.

This makes currency both a political and economic issue. So whilst there is unlikely to be any immediate change in the $ role as global reserve currency, there is no doubt that the dance of change is underway.

The short term problem for China is its huge ownership of US bonds and other paper. So they wouldn’t be happy with a complete collapse right now but it seems like less money will be staying in $ and more will be finding a new home whilst they work out how a new global currency system might operate.

But with GM falling apart and US unemployment rising to severe levels, concerns over the health of the $ will only continue to mount.

So far we have seen Iceland bankrupted, South Korea facing a huge run on the Won, Argentina seizing private pensions, Hungary and Denmark raising rates and general deleveraging in emerging markets.

At the same time even the majors have taken a pounding. In the last 3 months against the $ the Euro has fallen 22%, the Pound 22%, the Aussie 38%, the Kiwi 29% and the Canadian 28%. The latter 3 suffering more because of their links to commodity markets which have also collapsed.Against the Yen just add another 10%.

Those falls are enormous.

The major factors here are:

- Credit issues.

- Current Account position.

- Commodities.

- Interest Rates.

If you have a large current account deficit and huge overseas borrowing (like Australia and New Zealand) then you will struggle given the problems with credit availability. At the same time lower currencies provide an opportunity to reduce those deficits. No more cheap imports for the Antipodeans.

This poses real problems for the US. Although the Yen is taking some of the slack with a major appreciation, a strong $ is hardly what the US are looking for at the moment given their huge current account problems. However we are entering into a situation where there are bigger issues at play.

A full scale unwind of the global currency net position would see surplus countries holding the upper hand. China with its vast $ reserves has plenty of options on the table. There is an interesting analysis on Naked Capitalism with some good links.

The most interesting proposal from Brad Setser at the CFR is for China (and other large $ holders) to diversify their $ holdings and buy assets from other deficit countries. Although its hard to see China doing this it makes sense as part of the eventual rebalancing of currencies and capital that must happen if we are not to see a huge race to the bottom in currency land.

This would help out the US in taking the heat over a resurgent $ and it would take the heat out of the impending meltdown of cross border capital flows. It may even help avert a potential meltdown in the Euro which grows closer by the day.

The era of running big deficits thanks to leveraged debt finance and derivative products is over. The November 15th War Council will certainly push to reform and regulate markets though that bolted years ago and the stable has burnt down.

Other suggestions proposed are:

- A return to a gold backed global currency. This is just fiat in a different form. It has some merit as a stable, hard store of value in which supply is reasonably easy to manage but it has already failed several times in recent memory.

- A commodity/energy back currency. The EBCU proposal by Richard Douthwaite still is a favourite of mine because it links natural resources, climate change and money together. It’s real unlike gold as it connects energy to money and energy is what we are concerned with, in terms of transforming it and using it in our daily lives.

Hopefully all of these approaches will be on the table when our financial “wizards” meet shortly.

In the meantime it will be a case of holding one’s breath and hoping for the best with possible intervention ahead.

At worst expect markets to close and capital controls to be applied.

The horrendous spike in LIBOR rates has seen a reverse run on the $. From global pariah to this week’s must have the $ has risen at a rate of knots in the last month against all currencies except the yen, which has been used to fund most of the speculative investment activity. The Aus$/Yen cross rate is down over 40% in 3 months. The Eur/$ rates has fallen 20%. Eur/yen around 25%. These are not emerging markets, these are the main conduits for global trade and when added to stock market moves of between 25-50% one is faced with the realisation that the whole global financial system is at risk.

I wrote recently that at some point global markets will need to be frozen. That may well happen as not just stocks but currencies go into complete meltdown making any form of economic activity almost pointless.

The recent wholesale and blanket guarantees of bank deposits and lending in many countries have just added to the general lack of confidence in the global financial system.

Added to this commodities have collapsed in price also as that speculative bubble is popped. Even gold, something one would consider in the current situation, has fallen, over 20% in the last few weeks.

Nothing makes much sense at the moment except that the unwinding of years of excess is both savage and yet unpredictable.

One can only hope that somehow the markets can stabilise but the lower it goes the worse it gets as the spiral of margin calls increases and investors seek to recoup whatever they can. It’s probably not the time to sell but at the moment cash is king.

And surprisingly the king of cash is the $…….for now.

Germans are refuisng to accept Euros which have originated from the Latin Bloc, especially Italy. They want “hard” Euros issued by the almighty Bundesbank, that inflation fighting automaton. You can hardly blame them given the fiscal history of Italy, never mind Greece, Spain or Portugal.

But what this shows is the lengths to which people will go to mitigate risk. It seems a waste of time really given that the Euro is universal in its value and acceptance. But its a bit like English and Scottish Pounds. No one ever wanted a Scottish one even though they were both accepted as legal tender by the Bank of England.

Perception is everything and the Germans have long memories of inflationary times.

The sad fact is that if the financial system falls apart nothing will save you. Having a nice pile of gold soveriegns might but the reality is that there wouldn’t be enough to create a reasonable market for exchange. Now a nice veggie garden is more of a goer in times of monetary distress. This is where NZ has a major comparative advantage. Nearly everyone has a patch of dirt in which to grow stuff.

Our central banks have a lot to answer for but promoting home grown veggies is one good thing to come out of this debacle.

The reason I mention this is because of the highway robbery some currency exchange outlets are carrying out. To give you an example:

Last week I took a trip to Sydney. I bought some A$ at Christchurch airport through the BNZ. Their rates are always very good usually a spread of around 2-2.5%. Now that’s still pretty big but remember these rates are change maybe once a day max and the markets can be moving as much as that. I bought some US$ at 0.7929 knowing the market was actually trading at 0.7945 so i was getting an almost at market rate.

But when I arrived in Sydney I checked out the rates available at Travelex. These guys are offering outrageous prices (unfortunately they are at Auckland airport also).

Their spreads on A$ to NZ$, US$ and GBP were 20%, 15.6% and 22.4%.

Who are these guys kidding. In market vernacular I could drive a bus through that spread (more like a fleet of them).

So what to do? Well we have P2P lending now established in many commonwealth countries. So how about extending that to provide a currency service within the new distributed network.

It’s food for thought.