Euro Fails a Big Test

October 26, 2008

The international monetary landscape is changing month by month, week by week and even day by day. Many analysts had long warned of a great deleveraging of debt and linked such a development to a shift in reserve currency portfolios away from the dollar. After bottoming  at $0.8228 exactly eight years ago today, the euro advanced no higher than $0.9595 in 2001 and $1.0505 in 2002. The rate of euro appreciation accelerated thereafter, and the common European currency hit highs of $1.2620 in 2003 and $1.3760 in 2004. Following a downward correction in 2005, the euro climbed to as high as $1.4966 last year and this year touched $1.6018 on April 22nd and $1.6038 on July 23rd.

As the global financial market crisis escalated, the stage seemed set for the dollar to relinquish its dominance of reserve asset portfolios or at least share that hegemony with the euro. But nobody told global investors. The euro’s slide has been attributed to Europe’s unexpected recession, demonstrating once again its dependence on the U.S. business cycle. If investors considered the euro a true dollar alternative, cyclical factors should not have depressed the exchange rate as much as such have. Average 2009 growth in European will be similar to the pace of U.S. growth, not below it. Big current account deficits tend to be a greater currency liability in times of credit market strain, and Euroland has a reasonably small current account imbalance, unlike the United States. Euroland’s budget deficit equaled just 0.6% of GDP, a smaller shortfall than America’s. GDP in the euro area is about 90% as large as U.S. GDP, and Euroland ranks somewhat above the United States in population. In rankings of trade, GDP, and population, the euro is significantly under-weighted in reserve asset portfolios. The financial market crisis affects everyone, but it originated in the United States. The policy modifications that governments are implementing represent a greater shift away from America’s purer blend of capitalism than of Europe’s, and the most dramatic macroeconomic change will be happening in the United States as the savings rate rebounds from zero toward the historical norm of 6-8%.

Several explanations may explain why the euro has taken a step backward, rather than forward, as the go-to currency when the going gets tough. The euro was launched in 1999 to a chorus of skepticism. Analysts felt it had put the cart before horse and predicted difficulty fitting one monetary policy to serve so many masters with disparate circumstances. Euroland lacks a monolithic foreign policy and, more importantly, a single fiscal policy. The Stability and Growth Pact, which was added to ensure similar fiscal stances, was blatantly disregarded by members, large and small, that exceeded the deficit guidelines.  The convergence of inflation rates, which were required for admission, was short-lived. Three of the 15 members have inflation of 4.5% or more, whereas inflation is six members is below 3.5%. As new members join, decision-making at the European Central Bank may become increasingly cumbersome. Efforts to forge a better regional constitution have been rejected. While Euroland has smaller government and current account deficits than the United States, its debt/GDP ratio of 66.3% in 2007 is much bigger.  The global crisis poses a serious challenge to the Euroland economy, and investors are not positively sure that the experiment of a common currency will survive the test totally intact. No such doubts are associated with the U.S. long-term viability.

Failing to rise in this crisis does not mean that the euro will forever play second fiddle to the dollar in reserve asset portfolios and as a magnet for flight capital. If EMU members stick together to the other side of the tunnel of global market turbulence, the euro will have weathered the storm of the century and may emerge as a more entrenched institution than ever. 



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