Currency Paradox

March 21, 2013

  The dollar and euro are natural rivals. The dollar and euro are the two most influential currencies in the world, a fact reflected in their one and two standings in reserve asset portfolios.  In the arena of foreign exchange, one currency’s rise in a bilateral relationship is tautologically the other’s decline. Worsening general sentiment for either the dollar or euro usually augments demand for the other. 

A paradox of 2013 so far is that both the dollar and euro have performed comparatively well.  The euro since end-2012 has risen 7.3% against the yen, 4.5% versus  sterling, and 1.3% relative to the Swiss franc.  The dollar has climbed 9.3% against the yen, 3.1% versus its northern “loonie” neighbor, and 2.1% vis-a-vis the euro.  Net changes in the value of the dollar against the Aussie dollar, New Zealand dollar, and Chinese yuan have been minuscule.

The United States enjoys a number of fundamental economic advantages compared to the euro area.  The U.S. recovery is approaching its fourth anniversary and seemingly becoming deeper and broader.  Several reported indicators of U.S. demand and activity have exceeded expectations this past month.  Euroland and most surrounding economies not participating in the common currency are struggling.  Today’s preliminary purchasing manager survey results for March provide the most convincing evidence to date that the euro area’s recession will extend well past midyear, now just three months away.  U.S. long-term sovereign debt is more appropriately priced than their Ezone counterparts.  U.S. Treasury yields offer a more appealing yield than German bunds, which helps support the dollar.  The U.S. and Ezone have similar inflation.

The superlatives are too long to list in a single paragraph.  The United States has fewer labor market rigidities and other regulatory drags.  The U.S. is more competitive, more inventive, and enjoys healthier demographics.  U.S. banks are much better positioned than five years ago, while Europe’s banking system remains very fragile and shock-prone.  Much of that fragility is self-imposed by the ill-advised straitjacket of the euro.  The purported stability of a currency union hasn’t delivered economies of scale because of the dysfunctional condition of political structures.  The U.S. political system is equally paralyzed, but the dollar’s currency links are with developing countries, are informal in nature, and not managed by Washington.  The political fault lines in both economies run east to west, dividing north from south.  Conservative thought is concentrated in Europe’s North and controls the thrust of an ill-conceived fiscal policy for the whole area.  In the U.S., the geographic divide is the mirror image of Europe.  More eclectic thinking from the North has acted like a brake on the conservative South, so while fiscal policy has been inappropriately tight since 2010, much less damage has resulted than in Europe. 

The dollar should be much stronger against the euro, notwithstanding some Ezone advantages like a current account surplus to set against America’s deficit and a smaller aggregated fiscal deficit in Euroland than the United States.  The dollar is protected from excessive appreciation by different policy priorities. High unemployment is attracting more attention than the goal of price stability to a greater extent at the Fed than the ECB.  In a disinflationary world, moreover, officials at the Federal Reserve and U.S. Treasury are most content if the dollar is stable to weaker.  ECB officials, on the other hand, have a stronger stake in avoiding currency depreciation given the region’s debt crisis that fuels doubts that the euro will hold together.

If Euroland is to escape its zombie state, either politicians from the north and south will need to see the light and get along, or a significant depreciation of the euro will be required.  Having both conditions would be better yet, but having either does not seem like a probable near-term outcome.  In the meantime, it’s a great opportunity for the yen to complete its run to 100 per dollar and perhaps beyond.  Japan’s fundamentals have eroded, yet the yen, even at 100, would be far stronger than its average value since the U.S. currency floated forty years ago this month, which is 158 per dollar.  Japan had a strong current account surplus most of that time and prior to 1990 considered sub-3% economic growth to be a recession since such occurred so rarely.  The new Bank of Japan Kuroda is declaring war on deflation and will employ whatever monetary policy tool he must to achieve 2% inflation by early 2015.  He candidly conceded that yen depreciation, though not the objective, will be a plausible by-product of that effort.  While the dollar and euro embrace in stalemate and as Japanese monetary policy now goes to a new intensity of stimulus, the time for crossing the 100 per dollar threshold could be near.  The one counter-argument comes from Cyprus.  Yen strength thrived during Europe’s crisis prior until last autumn.  If Europe’s new mess puts upward pressure on the yen, there will be a pro-active Japan central bank prepared to take counter-action of its own.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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