The Euro and Government Deficits

April 8, 2010

Let’s start at the beginning.  The euro got off to a poor start in part over misgivings over the lack of a single fiscal policy to complement the single independent monetary policy of the European Central Bank and over how vigilantly the ECB would guard the value of Europe’s new money.  When government deficit spending and debt appear unsustainably large, investors worry that central banks will accommodate the public sector, creating higher inflation and thereby trimming the real value of the debt.  Since the euro was created by the marriage of eleven currencies, an additional danger involved the possibility of defectors among the members.  The Maastricht Treaty that established the rules of the euro provided no contingency for countries within the bloc that subsequently wish to leave it because having no plan would make that scenario seem less likely to the investment community.

The euro is now getting shaken by the same basic risks that spawned doubts about the project in its early years but in a much less hypothetical form than then.  The table below is based on quarterly average spot rate quotes of EUR/USD and shows the euro’s percentage movement from the prior quarter for 1Q99 through 4Q02.  The rate used to calculate the mean in 4Q98 is based on the synthetic mark only.  Calendar year changes are also shown.

  1Q 2Q 3Q 4Q Yearly Chg
1999 -4.6% -5.7% 0.0% -1.9% -4.1%
2000 -4.9% -5.4% -3.1% -3.8% -13.5%
2001 +6.1% -5.4% +1.9% +0.7% -3.1%
2002 -2.2% +4.8% +7.1% +1.7% +5.6%


Last quarter saw the euro lose value more extensively than in any quarter of its early formative years.  The average value of the euro last quarter, $1.3767, was 6.9% weaker than the mean in 4Q09.  At $1.3350, the common currency has fallen another 3.0% below its average first-quarter level to stand 9.7% below its 4Q09 mean value.  Fiscal phobia in the currency markets is now directed at Europe, Euroland and Britain, not the United States, even though U.S. debt as a percent of GDP moved above 75% last year; 75% happened to be debt ratio of the original 11 EMU members in 1998 just before the common currency began.  Greece was not one of those countries, nor was Spain.

I submit that the big danger is the uncertainty that surrounds the process of members leaving Europe’s common currency, not the state of public finances in Greece or, for that matter, Spain or Italy.

  • The ECB has inherited a culture of obsessive/compulsive fear of inflation.  It will accept an economic downturn, however long or deep it might have to be, in order to defeat threats of inflation and, unlike the Fed, ECB officials rely on multi-year early warning embodied in money and credit growth.  The fact is that that those data are currently highlighting a greater danger of deflation than inflation.
  • Fiscal deficits are only inflationary if monetary policy permits it.  That’s why a combination of tight monetary policy but loose fiscal policy helps a currency such as the dollar in the early 1980s.
  • The ECB can extricate itself from unconventional monetary measures in a more passive way than the Fed must do.  The Fed is under closer political scrutiny than the ECB and is more likely to shy away from the risks of perhaps tightening policy too hastily or aggressively.  The ECB will move in increments of more than 25 bps at a time as it has done before.  With the Fed, one doesn’t know.
  • Some of the countries participating in EMU have smaller fiscal deficits than the United States, and so does the bloc taken as a whole.
  • ECB President Trichet calls talk about an EMU break-up “absurd” and likens the situation to the California or New York fiscal difficulties, which do not hurt the dollar’s credibility.  California sub-dividing into two or three states is actually not an absurd thought or possibility, but California leaving the United States of course is.  Defections from the euro would be more akin to the former example.

Some of the ancestral currencies of the euro would retain great attraction like the Deutschemark, Dutch guilder, or Austrian schilling.  The mark retired on the final day of 1998 at a value of 1.6790 per dollar.  That was 137% stronger than its value in the 1960’s, 108% better than its weakest ever post-dollar float quote in February 1985, and 94% better than its Smithsonian level after the dollar’s first devaluation in December 1971.  The level of the mark at end-1998 was even 2% stronger than its high in the final quarter of 1978, when the Carter Administration humbly announced an all-out rescue of the U.S. currency, including ramped-up intervention, the sale of Carter bonds, and a command that the Fed raise its interest rates by a then unprecedented 100 basis points in a single move.  At $1.3350, the euro has DEM-equivalent value of 1.465, and that is 14% stronger than the level when the mark was replaced by the euro.  $1.3350 per euro is only 4.3% weaker than last year’s average value and above its calendar-year means during each of the first eight years of the euro’s existence, 1999-2006.  The euro is still 62% above its lifetime low of $0.8228 in October 2000 and 40% stronger than its average value during the first thirteen quarter that it traded.

One can draw different conclusions from the euro’s strength relative to its lifetime experience.  If the euro is headed for a messy divorce, loads of room remain for it to plunge away.  But realistically, how long can this situation fester without something concrete getting done, even if it means some members leaving the band?  The financial crisis provides one yardstick.  It broke in August 2007, simmered for 13 months, and then exploded into flame.  Thirteen months from last December, when fears about Greece moved to the forefront, would be January 2011.

The largest calendar year drop of the euro against the dollar in average terms was 13.5% in 2000.  An equivalent move between 2009 and 2010 would result in an average EUR/USD level of $1.2065.  Amazingly, that would still be higher than the euro’s lifetime mean value of $1.1878.  Meanwhile, it would not serve the interest of ongoing structural economic adjustment for the dollar to move above its center of gravity against the world’s second most important currency.  Early in 2011, the Fed and ECB are likely to embark on rate tightening cycles, which will introduce an additional complication into the mix, unless the shift in currency values so spooks world investors as to create a new danger of recession.

Bottom line: it’s easy to conjure up more dollar appreciation/euro depreciation in the coming three-six months.  It’s much harder to imagine the trend lasting for years even if the euro breaks apart.  Certain components of any post-euro world would do very well, and a time will come when markets lose as much patience with U.S. public finances as they have already with Britain and Greece.   The Federal debt exceeded 35% in no calendar year of the 19th century, spiked to 41% in 1934 and over 100% right after WW2, but was under 32% in 1974.  There’s no exact science for telling when investors say enough already about irresponsible public finances.  But the magnitudes of present projections and the mood currently expressed toward other countries with big deficits and debt suggest a shorter rather than longer leash.

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



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