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Lloyd Blankfein is wrong about Europe

May 21, 2013: 11:45 AM ET

The desperate patchwork of fixes for Europe is deluding the best financial minds, including Goldman Sachs' Lloyd Blankfein, into believing that the euro is virtually certain to survive.

Lloyd Blankfein

Lloyd Blankfein

FORTUNE -- In an interview published last Saturday in the German national newspaper Welt am Sonntag (World on Sunday), Goldman Sachs CEO Lloyd Blankfein declared that the risk of a euro breakup has faded in the past year. Blankfein went on to argue that Americans typically underestimate the will of Europeans to "see through the creation of a united Europe," and that "I'm not going to make the same mistake myself."

What is Lloyd Blankfein thinking? The health of Europe's fragile economies has taken a gefahrhlich, German for perilous, turn since last spring. That puts the common currency in far greater danger than ever. The declarations of solidarity by European Union officials and heads of state, and a desperate patchwork of fixes that that only mask the members' basic weakness, are deluding the best financial minds, including Blankfein, into believing that the euro is virtually certain to survive.

The shocking deterioration in practically every economic metric points to the opposite conclusion. Unemployment in the 17-nation eurozone will jump from 11.4% in 2012 to a record 12.3% this year, according to the most recent IMF projections. The jobless rate in Spain and Greece will reach 27% in 2013, while around 2% of workers in France and Italy, the zone's second and third-largest economies, will lose their paychecks over the next two years.

Measured in GDP, the eurozone is now shrinking, and risks careening into a depression. After expanding 1.4% in 2011, the euro area retreated 0.6% in 2012 and will contract again this year, with only one of the troubled economies -- Ireland --showing any growth. Even France, long bulwark of the common currency, suffers dwindling output. Despite the much-vilified shift to "austerity," the mountainous debts continue to rise. This year, France's borrowings will reach 92% of GDP, versus 62% in 2008. For Italy, Portugal, Ireland, and Greece, that figure already exceeds 100%, and Spain is fast approaching triple-digits.

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So given the dreadful numbers, why are the bulls gaining confidence that the euro will pull through? If the southern members were making fundamental, structural reforms to their rigid labor markets, the Blankfein view would make sense. But that's not the main theme in the eurozone. "The nations in the eurozone have a competitiveness problem far more than a debt problem, and it's been greatly underappreciated," notes Allan Meltzer, the renowned economist at Carnegie Mellon.

In Italy, Spain and France, "unit labor costs," the wages and benefits required to produce a car or sheet of steel, are far higher than in Germany or the Netherlands. That's hammering their exports. At the same time, they're importing heavily from the lower-cost countries, from Germany to China.

Only two solutions are possible. The weak nations need to radically reduce wages and pension costs, and reform restrictive work rules, or shift to cheaper currencies. Progress on the former has been extremely disappointing, with Italy and France already retreating on pension reform. Unit labor costs have fallen in response to rising joblessness, but not nearly enough to make their exports competitive or garner required reductions in imports. With the traditional safety valve of a falling currency no longer available, these nations are drifting further and further into debt and decline.

The euro-optimism is totally unjustified by the fundamentals, according to Yanis Varoufakis, an economist at the University of Athens. "It's all smoke and mirrors," says Varoufakis. "The eurozone is continuing on a path to disintegration." He credits three special factors with creating the illusion that that the euro's prospects are radically improving.

First, investors everywhere covet high-yields. That makes the sovereign debt of Italy or Spain, yielding in the 4% range, far more attractive than in a typical market where overall rates are far higher. "Corporate junk bonds are a roaring trade, and Europe is full of government junk bonds," says Varoufakis. Investors don't want to hold those bonds for long, but still feel it's safe to grab the fat coupons for a few months, and then sell.

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The second dimension is the surprising decision allowing Greece to remain in the euro. Last September, German Chancellor Angela Merkel visited Bejing on a mission to raise money for an EU fund designed to recapitalize failing banks. The Chinese government agreed to buy bailout bonds -- with, according to Varoufakis, the proviso that Greece remain in the eurozone. Merkel strongly argued for keeping Greece in the fold, and fears that the eurozone was near collapse receded.

Third, Mario Draghi, chief of the European Central Bank, pledged to do everything necessary to save the euro. Draghi effectively promised to decimate traders betting against Italian or Spanish debt. The instant speculators attacked those bonds, or investors turned fearful, Draghi vowed to deploy the newly-created Outright Monetary Transactions plan (OMT) to purchase unlimited volumes of sovereign debt -- and push to hold yields back down. The speculators retreated, and so did the pressure on Spanish and Italian bonds. The OMT hasn't been activated, but its potential power created stability in the then-volatile sovereign bond markets.

Those three factors "put ice on the crisis on the monetary sector," says Varoufakis. But they do nothing to stem the crisis that's closing factories and stores from Paris to Madrid. "The continental plates are shifting, creating an even greater possibility of an earthquake," he warns.

What makes a euro collapse probable, if not inevitable, is the deepening credit crunch across southern Europe. Banks in Italy, Spain and Greece are losing deposits to Germany, and their capital is vanishing as more and more corporate customers become insolvent. Hence, small and medium-sized businesses are finding it extremely expensive to borrow, if they can find funding at all. "In Germany, companies are borrowing at 1.5%," says Varoufakis. "In southern Europe, it's costing them 7%." And that's if they can get financing.

MORE: Young U.S. workers are worse off than in parts of Europe

The ample credit in northern Europe stands in drastic contrast to the scarce liquidity in the south. As the tectonic plates of credit move in opposite directions, the euro moves closer and closer to fracture.

It's impossible to predict what will unleash that economic cataclysm, or when it will happen -- any more than seismologists can forecast when an earthquake will occur. It could come with the fall of weak governments in Italy or Spain, or another run-on-the-bank scenario like the ones that have plagued Greece.

What's amazing is that Blankfein and so many other smart people remain euro-fans when the data is so disastrous. Don't be deluded by the calm. The euro is in big trouble.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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