The Euro Has Baggage, but the Dollar’s Hardly Perfect

June 14, 2012

From it’s conception, the common European currency was a flawed economic experiment, but it’s raison d’etre lay in politics.  Time has increasingly exposed the economic misguidance of EMU.  Ironically, this unraveling reinforces the political calling of a single currency, stiffening the desire to hold things together.  The single currency almost didn’t happen.  A French referendum on September 20, 1992 approved the Maastricht Treaty by the narrowest of margins, 51% to 49%.  A 1.3 percentage point swing then toward the ‘no’ vote, and the single currency would have been deferred for at least a generation.  Europe would now be more stable politically if the referendum had been defeated, but it is feared that a break-up of the euro will usher in an era of extreme political friction in the region that politicians hoped to avoid with a common currency.  The tenacity with which politicians keep trying to keep economic and monetary union intact is not a mere case of saving face.  Their prime motivation is the same political goal that lay behind the euro’s creation, only with far greater associated urgency and fear than felt twenty years ago.

Economic considerations long ago made the possible break-up of the currency union a matter of timing only.  The system could not be sustained in the long run except under some very unlikely assumptions about shared sovereignty.  Since Europe’s debt and banking crisis began over two and a half years ago, future risks have collapsed into the present.  Some would say that the euro’s slide from $1.60 in July 2008 to around $1.25 prices in the euro’s risky baggage.  I disagree.  The high in 2008 was unrepresentative.  The euro is still more than 50% stronger than its October 2000 low-point and also pricier than its average lifetime level.  It seems inadequate to attribute the fact that it hasn’t already weakened further to continuing uncertainty about whether the euro will break apart and, if so, the details of the split-up.

The dollar is damaged as well.  Europe is in recession, but the U.S. economy has been also performing considerably more weakly this century than in the second half of the last one.  The relative ranking of the two economies hasn’t shifted much.  For years, U.S. GDP expanded more quickly than European GDP, and such didn’t prevent dollar depreciation.  President Obama unseated President Bush with a promise of “change.”  Now the Republicans are the ones calling for change with an agenda very similar to what America is already pursuing.  America doesn’t need change.  With change comes the implicit understanding that the old ways are wrong, but a new approach is right.  That logic allows for the possibility of changing back.  Enduring transformation, not change, is needed in which the old ways are not condemned so much as considered appropriate for a different time but no longer so. 

The survival of America and the world demands transformation, and time is getting very short.  Regrettably, such a development seems just as remote in America as an enduring economic and political resolution of Europe’s debt and banking crisis.  President Obama isn’t offering anything new, and his challenger is preaching dogma full of false predictions.  One of the Republican warnings has been that a spike in inflation lies just around the corner because of the increased fiscal deficit.  Instead, 2012 is the third straight year to see U.S. economic momentum falter in the spring, and deflation now looks more likely than inflation.  Fiscal policy will not respond, but the Federal Reserve might, and that’s giving some pause to the enthusiasm for holding dollars.

It’s possible for a U.S. current account deficit to coexist with an appreciating dollar.  However, such a juxtaposition generally requires solid U.S. growth and monetary policy that is either tighter or expected to become so.  Those conditions are not being met currently.  In the first quarter of 2012, the U.S. current account deficit widened by $6.2 billion per month and to 3.6% of GDP from 3.1% of GDP in both full-2011 and that final quarter of the year.  The table below compares the financing of the deficit in the first quarter of 2012 with each quarter of 2011.  We see an enormous swing in official capital movement from a $105.4 billion outflow in 4Q11 to a $119.0 billion inflow last quarter.  However, long-term direct investment and portfolio investment flows deteriorated between the adjacent quarters by $89.6 billion.  Even though the U.S. economy looked sounder in the early months of this year and seemingly helped the dollar rise, investors were becoming more guarded and hedging their bets.

blns of $ 1Q11 2Q11 3Q11 4Q11 1Q12
C/A -120.0 -119.1 -108.2 -118.7 -137.3
% of GDP -3.2 -3.2 -2.9 -3.1 -3.6
Official +68.8 +114.2 +14.7 -105.4 +119.0
Private +51.1 +4.9 +93.5 +22.4 +18.3
Dir & Port -97.1 -152.0 +53.3 +48.1 -41.5
T-Wt USD 71.9 69.8 69.8 72.4 73.1


A second table below focuses on the eight components of direct investment and portfolio investment.  Changes in each component between 4Q11 and 1Q12 are noted in the right-most column, where a positively signed change indicates an increased net inflow, a reduced net outflow, or a swing from a net outflow to a net inflow.  The eight elements of long-term capital are U.S. direct investment abroad, foreign direct investment in the United States, U.S. buying of foreign bonds, U.S. purchases of foreign equities, foreign buying of Treasuries, foreign purchases of U.S. corporate bonds, foreign buying of U.S. agency bonds and foreign purchases of U.S. stocks.  The biggest sources of lessening dollar support involved reduced foreign net purchases of U.S. Treasuries, greater U.S. direct investment overseas, and a better U.S. appetite for foreign equities.  Note that the sum of the figures in the right-most column is identical, except for a minuscule rounding error, to the $89.6 billion adverse swing in direct and portfolio investment from a $48.1 billion inflow in 4Q11 to a $41.5 billion outflow in 1Q12.

Blns of Dollars 4Q11 1Q12 Change
U.S. DI Abroad +111.2 +110.9 +0.3
Fgn DI in U.S. +76.1 +28.7 -47.4
U.S. + Foreign Bonds -27.4 -18.5 -8.9
U.S. + Fgn Stocks -8.6 +14.9 -23.5
Fgn + Treasuries +82.5 +34.0 -48.5
Fgn + U.S. Corporates -31.3 -15.1 +16.2
Fgn + U.S. Agencies +13.1 -0.4 -13.5
Fgn + U.S. Equities -17.1 +18.7 +35.8


The dollar does not appear to face any substantial downward pressure in the short term.  The question is whether it will continue to score progressive gains and in the case of EUR/USD make a run soon at the June 2010 high of $1.1878.  At the Memorial Day break, this was looking to me like a reasonable summertime prospect.  The bet has suffered lately, and the statement week between the end of trading on June 7 and today has been a disappointing one for dollar bulls.  Those Thursday-to-Thursday movements showed varying dollar losses of 1.7% against the kiwi, 1.2% relative to the Australian dollar, 0.4% versus the euro, Swiss franc, yen and loonie, and 0.1% against sterling. 

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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