The Mark, the Euro, the Dollar and the Yen: Now and Then

February 12, 2010

Risk aversion has the dollar grinding higher, but I’d like to focus this week’s Foreign Exchange Insights essay on the longer term prognosis.

During the first 25 years of flexible exchange rates, the mark, yen and Swissy were called “hard currencies” because conservative monetary and fiscal policies in Germany, Japan and Switzerland promoted low inflation, strong growth, current account surpluses, and appreciating currency trends that were tolerated by officials.  Between late December in 1974 and 1998, the Swissy, yen, and mark appreciated against the dollar at annualized rates of 5.6%, 4.1%, and 1.6%.  Deutschemark strength in the latter years of that period was restrained by policy-imposed links to other European currencies in preparation for the common European currency.  The euro was launched on the final day of 1998.  In the prior 24 years, nonetheless, the mark had raced ahead of the other currencies that now use the euro.  Annualized DEM gains against the Italian lira and French franc amounted to 5.6% and 2.6%, respectively, and the mark also rose 4.5% per annum against sterling, which did not join the common currency in 1999 or any time more recently.

Considerable market skepticism surrounded the euro during the planning and early years of the experiment.  Germany was marrying its currency to others, which had far weaker historical performances, and enforcement of a codicil Stability and Growth Pact, which is meant to assure fiscal prudence by all participating governments, was considered unreliable.  We know now that suspicions were indeed warranted, but acceptance of the euro broadened with time, as price stability and and interest rate convergence were secured.  So after declining from $1.1720 at the start of 1999 to $0.8228 in October 2000, the euro has performed well on balance against the dollar. 

The net 1.4% per annum rate of rise in EUR/USD since the euro came into existence is not much different from the mark’s net trend during the prior 24 years.  Counting broad down then upward movements as one event, the euro is presently in its fourth cycle.  The first took the common currency to $0.8228 in October 2000 and back to $1.367 in late December 2004.  A second cycle saw the euro fall back to $1.1640 in November 2005 but rebound to $1.6038 in July 2008.  The euro’s high-point and low-point in that second period were each above the first cycle’s highs and lows.  In the third cycle between July 2008 and December 2009, the euro fell back to $1.2331 in December 2008 and recovered to $1.5141 in late 2009.  Those highs and lows were below the ones reached the second cycle.  So far, the euro has moved down as far as $1.3528 seen today, which remains above the third cycle’s low of $1.2331 and the euro’s average lifetime value of $1.1794.  Coincidentally, that mean value is extremely close to the euro’s starting dollar level.

The euro has not appreciated against other European currencies anywhere near as strongly as the mark had done, even though ECB policymakers did a pretty good job of adopting the price stability orientation of the German Bundesbank.  There has been no movement between members of the common currency.  The synthetic D-mark has the same implicit cross rates versus the French franc and Italian lira as it did at the close on December 31, 1998.  The euro has additionally strengthened much less sharply against the British pound, rising 1.9% per annum versus the mark’s gain of 4.5% per annum versus sterling in the 24 years to end-1998.

Internal imbalances have investors fearing that the European Monetary Union (EMU) could break apart.  The members in EMU are required to keep their fiscal deficits no higher than 3.0% of GDP and to strive for debt-to-GDP ratios that are 60% or less.  The Great Recession blew those good intentions out of the water to widely varying degrees.  Greece has the worst situation, as it is the only member with both a deficit of more than 10% of GDP and debt greater than 120%.  The credibility of Greece’s word has been compromised additionally by revelations that data were fudged often in the past to create a semblance of entitlement to EMU membership.   No other EMU partners  in fact have the combination of a deficit above 10% and debt greater than 100% of GDP.  However, Spain combines a deficit ratio of roughly 10% with expected debt this year of more than 65%, plus Spain is a much larger economy than Greece.  The Portuguese ratios are expected to hover near 8.0% and 85%, and Ireland’s will be above 14% and 80%.  Troubles even extend to France, the group’s second biggest economy, where the ratios will probably be marginally above 8% and 80%.  Current account and inflation performances are also very wide and diverging further within EMU.

The euro’s performance will not be governed by European considerations alone if European leaders manage to convincingly persuade investors that it’s a very long shot for any EMU members to drop out of the group this year.  The EU statement yesterday was admittedly a limp one, mostly stressing what Greek leaders must do and revealing no clue that details for outside aid are close to being hammered out.  The burden of leaving the group and reissuing a national currency would be huge and far larger than what was borne by countries that opted out of joining EMU in the first place.  The likeliest outcome is that investors will soon conclude that no break-up is near.  As a whole, Euroland’s fiscal ratios of 7.5% on the deficit and 84% on debt are not larger than their projected U.S. counterparts.

Neither the United States nor Japan have the economic credentials that they once did.  The net loss of nearly a million U.S. jobs between end-1999 and end-2009 is nowhere near on a par with the performances in the previous six decades, all of which encompassed recessions.  Also, the U.S. political landscape appears more fractious and less governable than anytime since the nineteenth century.  America paid an enormous price 150 years ago to preserve the union but one that was a bargain in light of the burgeoning nation’s potential.  The view now into the future is very ambivalent, so investors would be prudent to diversify away from the dollar, not entirely but a portion to hedge bets.  That’s enough to keep the dollar on a long-term downtrend and to mitigate the extent of any additional short-term rise.

Japan’s experience over the last twenty years sends a further warning against an undiversified reserve asset portfolio.  The genesis of Japan’s troubles also involved asset market bubbles.  Policy patches that coddled the banks followed.  In time, Japan became addicted to ultra-low interest rates and unable to tolerate any kind of exit strategy.  Fiscal policy became terribly over-extended.  Japan has a larger debt ratio by far than any other economy, approaching 200%, and its deficit ratio will be near to 9%.  Actual and potential GDP growth slowed to a shadow of their pre-1990 levels, and long-term interest rates never rose despite perennial warnings of that risk.  Japan had a broken political system, which failed to implement needed changes.  In spite of all that, the yen continued to appreciate against the dollar, supported by a chronic current account surplus.  Understandably, the yen’s rate of rise since the end of 1998, some 2.1% per annum against the greenback, was considerably slower than the advance of 4.1% per annum over the previous 24 years.  On both sides of end-1998, moreover, the yen outpaced Europe’s premier currency.

The Swiss franc also retains hard-currency credentials and its fundamental economic trappings of price stability, anchored inflation expectations, and a large current account surplus.  The Swissy advanced against the dollar since end-1998 at an annualized rate of 2.2%.  That’s very similar to the yen and better than the euro’s rate of climb but much lower than the franc’s performance in previous decades.  As a hybrid with no common  fiscal or political institutions, the euro carries baggage that other hard currencies do not share, but the euro for now is the only realistic alternative to offset the dollar in reserve asset portfolios.  The only feasible currency play to act on one’s misgivings about the U.S. currency is to acquire euros.

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

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