No Ideal Solutions for the Euro

April 16, 2010

Greece is in perpetual check and facing checkmate unless officials get very creative.  Let me explain.  In return for the imposition of substantial fiscal cutbacks, an aid package will hopefully cut Greece’s long-term rates but not soon enough or deeply enough to forestall a severe recession. Greek authorities have no way to rotate growth toward exports because they do not have a currency to devalue, nor can they directly suppress short-term interest rates because those are the responsibility of a regional, not national, central bank. Greece’s economy will be much weaker than others sharing the euro, so the monetary policy imposed on it will be much tighter than what it should have.  The headwinds of tight fiscal and monetary policy will prevent the budget deficit from declining enough to stabilize the debt-to-GDP ratio, which will surpass 120% this year.  Seeing the trap that Greece has entered and how the problem has exposed shortcomings in the architecture of the common currency union, investors have been relentless in maintaining market pressure on officials.

Greece is not totally out of options.  Officials could concede checkmate and start a new game by leaving the currency union, devaluing the drachma sharply, accepting IMF austerity, and re-empowering the national central bank to run a monetary policy that is customized to address Greece’s own economic circumstances.  Aside from political humiliation, the fear is that the costs of such a decision, such as much higher long-term interest rates, would outweigh any gains.  Alternatively, Greece’s debt could be restructured, lengthening its maturity to decades and thereby trimming the near-term burden of servicing those obligations.  This is a drastic step, requiring consent and compromise from Greece’s reluctant creditors, who naturally worry about setting a precedent to be followed by other peripheral nations with bigger debts, such as Spain or Portugal.  Nothing has really happened thus far to move the solution in this kind of direction, and the crisis would have to get much more contagious first.

Another possible way out of the tunnel could be offered by an extensive decline of the euro, boosting the competitiveness of the entire region, including Greece.  But much of Greece’s trade would not benefit.  The lack of depreciation of a national currency leaves competitiveness with other euro area members unchanged, and Greek exports that compete with the exports of other EMU members in third markets would also not gain any edge.  An extensive, cumulating depreciation of the euro against the dollar over several years suffers the additional drawback of preventing what the world economy most needs, which is the incentive for U.S. consumers not to spend beyond their means and for U.S. growth to rotate away from domestic demand and toward net exports.  Unless this happens, the global economy will remain stuck in the pattern of periodic financial crises, which have been occurring since the early 1980s with progressively greater intensity.

Last week was in fact only a mediocre one for the U.S. currency at least until investors experienced a too-good-to-be-true moment on Friday, which saw frothy stocks sell off and — in a pattern reminiscent of the worst months of the 2008-9 recession — the dollar move oppositely on safety-seeking capital flows.  Even with today’s movement, the dollar at 16:15 GMT was for the week down 1.2% against the yen, 0.4% versus the Swiss franc, and 0.1% relative to sterling.  It showed no change against the euro.  Currency-sensitive currencies, which have been the best-bid group of 2010, typically suffered in the new circumstances.  For the week, the greenback had gained 1.2% against the New Zealand and Canadian dollars and was up 0.8% versus the Aussie dollar.  A dollar upswing that’s propelled by a downturn in equities would be self-limiting.  As seen in the spring of 2009, such an environment can be very toxic and elicits coordinated policy resistance eventually.

Monthly U.S. capital flow data released by the Treasury earlier this past week continued to document a less supportive balance of payments.  The so-called TIC statistics report three different definitions of U.S. net financial capital inflows.  Figures in the table below are period averages expressed on a monthly basis in billions of U.S. dollars.  A plus sign connotes a net dollar inflow to the United States.  Definition number one is the narrowest of the three and counts only certain long-term capital items.  Definition number three is the only one to include short-term capital.  The table also gives the goods and services trade deficit in each period.  Net capital inflows were smaller in January-February than in the final quarter of 2009, and the trade gap widened.

$ blns Jan-Feb 2010 4Q09 2009
Def’n #1 31.1 69.7 36.8
Def’n #2 16.5 57.4 20.2
Def’n #3 -0.6 19.6 -24.7
Trade -38.3 -36.3 -31.6

In the two periods when the dollar experienced multi-year appreciation, rising confidence toward the United States as well as concerns about other world regions were market factors.  In 1980-1984 while talk of Eurosclerosis was all the rage, U.S. inflation retreated sharply under a very tight monetary policy, and a sharp recession was followed by a very strong economic expansion.  A 17-year-long bull market in equities that saw the DJIA advance nearly 17% per annum began in August 1982.  American patriotism bloomed, as the hangover of Vietnam and Watergate hangover.  In the late 1990s when Asia suffered a financial crisis and investors viewed the coming European monetary union with doubt, booming U.S. growth and productivity and the perceived omniscience of the Greenspan Fed intoxicated investors with good feelings about the U.S. economy in an era of peace.

While some analysts proclaim that we are near the start of another multiyear era of dollar appreciation, I find reasons to sell Europe and Japan but a notable absence of reasons to embrace the U.S. economy.  The Great Recession has left two massive problems.  Public finances are in far worse shape than in 2006, and it will be even harder to craft policies that make the deficits more palatable ten or twenty-five years from now.  More worrisome is the mountain of structural and cyclical unemployment and the lengthening interval of joblessness.  National politics is polarized and more inclined toward extremism, and the nation is engaged in endless and costly wars to contain terrorism.  The present era doesn’t resemble either the early 1980s or late 1990s when the dollar was king.

Asia has the world’s most dynamic economy but will not produce a rival to the dollar for a generation or more.  Speculation is heating up that China will shortly resume yuan appreciation.  Singapore did just that this past week, and many expect a rising Chinese currency to promote greater buoyancy in the region’s other currencies including the yen.  Consequently, EUR/JPY has gained some appeal as a vehicle to short the euro without augmenting exposure to the dollar.  Empirical evidence from the three-year 21% rise of yuan against the dollar during 2005-8 does not support the belief that the yen will rise when the yuan advances, however.  One day before Chinese officials first allowed their exchange rate to move, the euro fetched 137.1 yen.  A year later, the EUR/JPY cross was at 147.7, and it stood at 165.9 two years into the experiment.  On July 23, 2008, just days after the rise of CNY/USD ended, the yen hit an-all-time low of 170.0 per dollar, 19.4% weaker than its level at the start of yuan appreciation three years earlier.  And during the 21 subsequent months while the yuan was pegged to the dollar, the yen has recovered 36% against the euro.

The recent setback of commodity-sensitive currencies has depressed the Canadian dollar below parity with the greenback and leaves the Australian and New Zealand currencies at only a little over 90 and 70 U.S. cents respectively.  The Bank of Canada holds the third of eight scheduled policy meetings this year at the beginning of next week. Canadian monetary officials will most likely not change raise the 0.25% target interest rate just yet, but the statement they release on Tuesday and the quarterly monetary policy report to be published next Thursday afford opportunities to prepare investors for a first rate hike at the following meeting on June 1 and perhaps to hint at how aggressively and how far rates might get raised in the second half of 2010 and 1H11.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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