Currency Thoughts

European Currencies Still Looking Pricey

May 7, 2010

The European sovereign debt crisis has revealed several truths. 

Public officials have thrown varying remedies at the problem, and none has reassured investors more than briefly.  The crisis involves decision-making mechanisms and long-term prospects, and it cannot be fixed with a lot of money alone.

Like the banking crisis of 2007-09, the response of policy-makers materialized too slowly.  Fuzzy details add to confusion and anxiety.  The Greek street riots added a new dimension of lawlessness, lending a middle-eastern tint to the problem.

The current crisis was caused largely by the policy response to the previous crisis.  World debt had become unsustainably excessive by 2007.  Households, businesses, banks, and governments had too much of it.  The distribution of debt was equally at fault in this perfect storm.  The existence of large net savers like China and certain oil producers enabled markets to tolerate dangerous imbalances for too long.

In hindsight, it seems no set of actions could have durably compressed the business cycle.  Officials were determined to counter the drop in demand more aggressively than had been done in 1929-32, stimulating fiscal policy and monetary policy and acting as lenders of last resort with unconventional measures to sustain market functionality.

Averting a depression that would have been much deeper and much lengthier came at a price.  Private-sector deleveraging was facilitated by deteriorating public finances.  Some core underlying imbalances persist like a 2.7% U.S. savings rate, Japanese deflation, and vastly unequal current account positions within the euro area.  Others improved because of the recession but seem poised to widen anew like the Chinese external surplus and U.S. current account deficit.

Although the euro area was not alone in developing unsustainable trends in its public finance, it was unique in creating an environment with no socially acceptable means to reduce the deficits and debt of the region’s worst offenders sufficiently.  Their competitiveness will remain deficient, so the restoration of decent longer-term growth with price stability is not even a medium-term possibility.

Bound within a currency union, the weakened members are truly trapped, unable to mitigate the impact of severe fiscal restraint with currency depreciation and a customized very loose monetary policy.  The euro will become a very unhappy marriage over time.

The framers of the Maastricht Treaty thought they were making the currency union more secure by not designing any process for a distressed member to leave.  The U.S. constitution likewise has no provision for the orderly secession of states.  Not drawing up contingency plans to allow decisions one wants to avoid is a tempting negotiating ploy that can boomerang with catastrophic consequences.

In the 2008-9 financial crisis, the public sector acted as lender and economic engine of last resort.  What institution is going to serve that function when the problem riling markets stems from the public sector?  The crisis that began when a weakening U.S. housing market whacked the sub-prime mortgage market leaped in unpredictable ways to other markets and across countries.  Japan, Britain and the United States could each be engulfed in the kind of dynamics that are now plaguing Euroland.  It’s happened sooner in the euro area because of the unique constraints there.  Because the long-term solution for stability entail one of two very difficult decisions — political integration or dissolving the currency union —  market speculation finds in the euro a less resistant path than attacking sterling, the yen or the dollar.

How far ought the euro fall?  Before the region’s sovereign debt problems exposed major fundamental shortcomings in the common currency’s construction, it had emerged as a contender against the dollar’s superpower hold over reserve currency portfolios.  Rumors surfaced often in 2009 about this country or that one discretely building up euro holdings to hedge foreign exchange risk.  The euro area has a larger population than the United States and engages in more two-way trade.  The euro is associated with lower internal inflation and has both a more balanced overall current account and a more hawkish central bank culture than the United States.  Being a currency with a possible permanent disability, the thought of it someday sharing the dollar’s spotlight in reserve asset portfolios seems inappropriate now.  It thus does not seem unrealistic to imagine the euro settling back to a level no stronger than its lifetime mean value of $1.1829.  An even more appropriate historical standard is perhaps the euro’s average value during its first five years of existence when doubts about the suitability of a single monetary policy but many fiscal policies were prevalent as they are now.  The euro’s mean value in 1999-2004 was $1.0350.

The dollar’s strength has not been limited to the euro, however.  Comparisons of the dollar’s weakest level in April to its strongest value so far in May show similar advances of 8.5% against the euro, 8.1% relative to the Canadian dollar, 7.8% against the Swissy, 7.7% versus the Australian dollar and Japanese yen, and 7.3% against sterling.  Recent U.S. economic reports like the jobs numbers, factory orders, purchasing manager survey readings, and chain store sales seemingly justify a buoyant currency.  Although Japan and Germany also have released several better-than-forecast statistics, the dollar has the added advantage that world financial markets seem to be regressing into a risk averse mind-set.  In late 2008 and early 2009, the U.S. currency reacted positively to poor U.S. economic data, often taking its cue from falling stock prices.  Stock prices oftentimes were free-falling back then, losing 15.5% in the 2-1/2 months to January 22, 2008, 42% in the 6-1/2 months to November 20, 2008, and 27.5% in the two months to March 9, 2009.  If the steep decline in stocks this month is not just an overdue correction but a reassessment of downside economic risk, major central banks like the ECB and BOJ but also the Fed will be prohibited from raising interest rates for much longer than is currently assumed.

Europe’s two other major currencies seem poised to move on opposite paths.  The Swiss franc tends to track gold, which benefits from fear of paper currency.  Swiss officials have now permitted two upward adjustments of their currency against the euro.  The first was to 1.433 per euro in mid-December after keeping the Swissy weaker than 1.50 over the prior nine months.  The second jump to 1.40-1.41 occurred this past week.  The British election will lead to a coalition government or a minority Conservative government dependent upon other parties for its survival in power.  Either way, it will be very hard to implement as much fiscal austerity as Britain requires.  Because of huge offshore holdings of sterling, the pound has been the recipient of some of the most powerful speculative attacks seen over the last 45 years.  The devaluation of 1967, sell-off of 1976, and departures from European joint float mechanisms in 1972 and 1992 come to mind.

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

Tags: Dollar, Euro, Sterling, Swiss Franc

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