Euro Can’t Shake Gloom

June 2, 2010

An analysis by Ralph Atkins, Frankfurt correspondent for the Financial Times, in Tuesday’s edition lays out four long-term scenarios for the Euroland’s sovereign debt problem and their respective implications for the euro.  Bearing in mind the extreme and widespread gloom among analysts, I found the article’s framework to be a handy way to peer ahead.  The analysis is expressed in verbal terms without quantifiable forecasts of euro depreciation or appreciation, but the language is sufficiently descriptive for readers to take the next step and interpolate some numerical indications.

Scant probability is attached to two of the scenarios, one good and the other dire and spiraling to eventual divorce.  In one, the disciplining forces of the marketplace lead to credible and sustained budget consolidation and, equally important, other structural reforms that transform the region into a global “engine of growth,” and that empowers the euro to “challenge” the dollar’s role as “a strong and stable reserve currency.”  The handicapped likelihood of all this happening is “not impossible.”  Atkins attaches only a “remote” chance to the euro breaking up but adds that such “is not as remote as previously thought.”

The distinction between the two likelier scenarios is subtle.  One labeled “muddling through” depicts serious and sustained budget cuts but not the structural reforms that are needed to correct the substantially greater competitiveness of Germany than can be found in Spain, Portugal, or Greece.  Mechanisms that would harmonize Euroland’s economy and make it a suitable optimal currency area remain either absent, ineffective or unenforceable.  This view of the future is called “distinctly possible.”  The “walking wounded” scenario reads like a zombie state.  Nothing gets fixed.  Weak economic growth stays permanent and increasingly dependent upon resource transfers from richer nations and the policy support of the ECB.  Social strains are always present in this stagflation-prone world.  Talk of a break-up the the currency union with continue to flare up, and banks in healthier Germany and France would be adversely affected.  This script is given a probability of “fair.”

To what might these verbalized odds equate?  In forecasting jargon, “remote” certainly connotes 10% or less, and “not impossible” is another way of conveying essentially the same long-shot likelihood.  Possibility means less than 50%, and probable is used in situations that have greater-than-even odds.  Calling “walking wounded” a “fair” likelihood, suggests even 50:50 odds, more or less.  If the rare outcomes each have a 10% chance of occurring, the final script of “muddling through” becomes the residual with a probability of 30%.

The gestalt of these four scenarios is very grim for euro holders.   The implication is that only a 10% chance exists for a rising euro in the medium term, and even in that instance rough times could prevail in the short term.  The break-up scenario envisages a “dramatic” weakening of the euro beforehand.  Based on the euro’s own experience in 1999-2001 and on intra-European crises in the 1970’s and 1980’s, a drop to $0.75-0.85 would seemingly fit this description.  In the “muddling through” scenario, Atkins talks of a “piling on of downward pressure on the euro,” and the “walking wounded” description writes of “long-term weakness” in the currency.

Only an habitual currency market contrarian would not be gloomy about the euro’s prognosis.  The fundamentals are negative.  No socially feasible solution exists for correcting present imbalances, and the key EUR/USD relationship remains slightly stronger than its post-1998 average level. 

However, despite a 20% drop against the dollar since November, that pair has evolved in an orderly fashion since being created, suggesting that the euro will do better than Atkins’ article suggests.  Calendar year averages of EUR/USD for 1999 through last year were as follows:

Annual Averages Dollars per euro
1999 $1.0651
2000 $0.9234
2001 $0.8952
2002 $0.9454
2003 $1.1321
2004 $1.2442
2005 $1.2439
2006 $1.2559
2007 $1.3710
2008 $1.4707
2009 $1.3942

The year-to June 2, 2010 mean, by comparison, has been $1.3465, a stronger euro level than in all but three years of its prior eleven years.  If the euro averages $1.22 over the rest of 2010, which is its present value, the mean for the whole calendar year would be $1.2725, and if the unit posts  a mean value of $1.15 in the remaining seven months of the year, the full-year mean of $1.2320 still would not look out of bounds or in a state of pending disorderly.  To average $1.10 for the rest of 2010 almost certainly would entail a drop to parity at some point, yet the average value for the year would still barely exceed $1.20.  Meanwhile, the more steeply the euro depreciates, the more relief will accrue to exporters in Greece, Spain, Portugal and other members who could benefit.

A final distinction to bear in mind concerns how the EUR/USD trades versus whether the dollar’s hegemony in reserve currency portfolios is challenged.  The U.S. currency’s dominant international role has not been challenge since flexible exchange rates were established in the early 1970s, but secular dollar depreciation since levels in the fixed-rate era still occurred.  Being a reserve currency doesn’t translate to an appreciating direction all the time.

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



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