The Euro's Eastern Whiplash

It was only a matter of time before Eastern Europe made it all the way...

Just a few years ago, Latvia and its former Eastern Bloc neighbors were counting down the months until they joined the European economic elite in the euro.

At Europe's fringe, Latvia is set to go from 14% economic growth in 2006 to a forecasted 12% GDP drop in 2009! According to the country's biggest business daily, low-cost chain stores reminiscent of old Soviet days are being proposed by some politicians and cheered by the masses...

And it may be mere months before Latvia's financial and political system collapse completely.

Back in the Heyday of Debt

Ironically, it seemed that continent-leading growth would be the statistic to keep the "EU New Member Class of 2004" from adopting Europe's common currency― next door to Latvia, Lithuania and Estonia were literally decimal points away from hitting European Central Bank inflation targets. Latvia chose to keep its currency pegged to the euro, even if the country couldn't join right away.

Latvia's capital city of Riga, also a regional banking center, was the first place I learned about sovereign debt securitization and public-private partnerships back in 2006. The simple strategy of growth through debt took on many fancy forms and involved a glossary of new terms.

Overall, the leverage would work out and pay off, I was assured. Former Soviet Socialist Republics like Latvia and its neighbors Estonia and Lithuania needed loose money to make up for generations of stagnation. And at a gathering of investors and dignitaries I attended at the city's medieval town hall, Moody's Investor Service told us Latvia's creditworthiness was good and getting better.

But that's also what Moody's was saying for years about the strength of collateralized debt obligations (CDOs). CDOs, where base loans like mortgages got sliced up to spread out risk and reward, are now recognized as perhaps the cloudiest and most deceptively clever of the financial tools that rose to prominence in the past decade.

So rather than learn prevention techniques from the Russian debt default and Asian financial crisis of the late 90s, participants in emerging European investments thought of those previous contagions as the chicken pox... "We caught it once, so we can't catch it again!" seemed to be the rallying cry.

Fast-forward to early 2009, and some are still living the illusion. Finance Minister Atis Sklateris became a YouTube sensation for a marble-mouthed English interview with Bloomberg news in December during which he said Latvia's crisis was "nothing special."

Maybe it was nothing special if you shut your eyes, but all of Europe predicts the unique role of having to take Latvia on as a ward of the continent. Even in The New York Times, Nobel laureate Paul Krugman recently called Latvia the new Argentina, drawing an ominous link to that country's debt disaster a decade ago.

"Lots of businesses are closed, but locals are still driving around expensive leased cars and buying Armani," one local investor friend told me recently in an e-mail. "That's really the root of the problem―local politicians are idiots, and the populace has never seen this before and is totally unprepared."

From Breadlines to Beemers... and Back

It's all sadly understandable. Everyone was so quick to wipe away the memory of Soviet shortages and stagnation that overspending itself became a status symbol. The Museum of Occupation in Latvia's capital Riga is, after all, more about the Reds than the Nazis. What better assertions of the new Latvia are there than a BMW and a Rolex?

That mindset of lightning-in-a-bottle growth is very different from the prevailing mindset in older EU countries. There, 5% expansion is great. Though Latvia and nearly a dozen former Eastern Bloc countries have been part of the EU since 2004, they remained an arm's length away from full economic "Europeanness" because their growth was so far off the charts.

Now the Baltic States and others are focused on fighting deficits― slashing budgets and risking a spiral in which wages and prices could drop to official depression levels.

And there's less and less hope that Latvia's creditors will get their money back.

Upgrades by Moody's have kicked full-speed into reverse as the ratings agencies all try to play cleanup. They spent years rating the securities they invested in, coaching borrowers to get higher marks than they should have, and essentially switched money from one hand to the other.

At a summit in the beginning of March, the bulk of EU leaders refused Hungary's plea to set up a stabilization fund for young EU countries that are underwater. Their obligations are now piling into the hundreds of billions in this year alone, and the cost of insuring their debt is higher than ever.

Latvia's national debt is now junk-rated.

Eastern Promises

Western-style capitalism, the system these countries and people put so much faith in, has snapped back hard, and European bankers and politicians all know Russia is ready to point out the folly of leaning toward the Atlantic after the USSR collapsed― even though Russia is in shoddy shape itself these days.

The only way to stabilize the EU's border with Russia may be to sacrifice the euro, propping up balance sheets in Latvia, Hungary, and other countries on the brink without bringing those wobbly economies all the way in.

European Central Bank policymakers have already dipped far lower on interest rates than they intended, down to 1.5% expected by March 5. Low inflation data also point to the fact that instead of controlling price increases, fighting deflation and promoting economic survival for the EU's East are now paramount.

Whether it's a huge fund or piecemeal contributions to national coffers through the IMF, the euro will get watered down.

Even without the East, the eurozone includes Portugal, Ireland, Greece and Spain, now known by the newest unfortunate acronym in international investing―PIGS.

If you have been thinking of the euro as the best counterpart to the dollar, all this gloom for the euro means you should go for gold instead. Currency is simply no longer a winning redoubt.

Greg McCoach's Mining Speculator stock recommendation service is in prime position to take advantage of continuing weakness in the dollar, euro, yen... across the forex board.

In fact, Greg has just written a report in which he highlights not only gold's relative advantage to currency, but also the way to supercharge your gold investments and achieve real separation from tanking global markets.