The Fall and Fall of the Euro

Has the euro bottomed? Is it likely to rally any time soon? Will it survive in its current form? For those who wish to skip the following 1500 words of opinion and analysis the short answers to these questions are no, yes and no. For the long answers, please read on.

Exchange rates are based on the ever-changing assessments (subjective and objective) of millions of people throughout the world and are, by definition, relative. We plan to add our own opinion to the reams that have already been written on why the euro's exchange value has fallen as far as it has and what the future holds for the euro-dollar exchange rate. We will also look at the euro's fundamental basis, or its reason/justification for being, as a separate issue. A currency either has a valid reason to exist or it doesn't – there is no relativity involved.

The Euro's Relative Value

From the time of its introduction in January 1999, the euro has declined relentlessly versus the dollar. As far as we can tell, euro weakness is due to a combination of the following:

1. Substantial European direct investment in the US. Simply put, European companies have spent a lot more money buying US companies over the past 2 years than US companies have spent buying European companies.
2. US corporations seeking to reduce their interest expense by borrowing in euros (euro interest rates have been lower than dollar interest rates). Most of the borrowed euros are exchanged for US dollars, thus putting downward pressure on the euro versus the dollar.
3. The euro carry trade (speculators take advantage of low euro interest rates and the downward trend in the euro-dollar exchange rate by borrowing euros, selling the euros to obtain dollars, and then investing the dollars in higher-yielding assets or debt).
4. The perception that the US debt and equity markets would provide better risk-adjusted returns than their European counterparts.
5. A deliberate policy to devalue the euro, on the part of European governments and the ECB, in an attempt to boost European exports and, therefore, economic growth.
6. Surging energy prices. Rising energy prices in parallel with an already declining euro exacerbated the existing currency trend due to Europe's heavy reliance on imported oil.
7. The trend. Once a major trend is in place it is self-reinforcing in that a decline in a currency's exchange rate leads to a further exodus of capital and heightens the feasibility of any financing/speculative strategies that involve the borrowing or short-selling of the currency. The euro will be considered as a cheap source of funds as long as its trend is perceived to be down.

Many of the above factors are, however, either no longer applicable or are dwindling in their influence. Firstly, with large European telecommunications companies having spent huge sums to secure 3G spectrum licenses and now facing enormous financial commitments to build the associated infra-structure, further expansion through the acquisition of US companies seems highly improbable. Also, the ability or willingness of European financial institutions to make further US-based acquisitions is in doubt given the fall in US stock markets and the large (and growing) credit problems on both sides of the Atlantic. The amount of foreign direct investment in the US is therefore likely to fall quite substantially. Secondly, many of the US corporations that have taken advantage of lower euro interest rates are now 'up to their eyeballs' in debt and are in no position to take-on additional obligations. In fact, this contributor to trans-Atlantic capital flows may even reverse direction as payments of interest begin to exceed the value of new loans. Thirdly, the performances of the US equity and corporate-debt markets throughout much of this year must be causing many Europeans to reconsider their US investments. Fourthly, European governments and the ECB have apparently begun to recognise the dark side of a falling exchange rate, namely higher prices for imports, reduced investment, higher interest rates and, eventually, slower economic growth. Continued intervention to support the euro is therefore almost a certainty.

For the reasons cited above, the rate at which capital exits Europe for the US is likely to fall. Since these capital flows have offset the US current account deficit and brought about the euro's downward trend, a significant reduction in these flows should change the trend. Once the trend in the euro-dollar exchange rate is perceived to have reversed then those strategies that are only feasible in a declining euro environment, such as the euro carry trade, will cease.

The Euro's Reason for Being

The euro is a fiat currency and thus suffers from the usual fiat currency ailments such as having no objective limits on its supply. However, the euro also has its own special set of problems, chief among these being the impossibility of finding a monetary policy that matches the needs of all the politically and fiscally disparate nations participating in European Monetary Union (EMU). With differing rates of economic growth, inflation, and unemployment throughout the member nations, as well as diverse taxation and regulatory environments, any 'one size fits all' monetary policy is eventually going to hit an enormous snag.

Other euro-specific problems include the absence of any physical presence (the euro doesn't exist outside the memory-banks of computers) and the general lack of popular support for the currency. The absence of a physical presence will possibly be resolved at the beginning of 2002 when euro notes and coins will become available. We say "possibly" because having a purely-electronic currency helps fulfill the dream of all modern-day governments to be able to monitor every financial transaction. Therefore, if a way can be found to make Europe 'cashless', without precipitating a complete loss of confidence, the euro might never have any physical form.

The lack of popular support for the euro stems from the fact that a fiat currency's value is based purely on confidence and governments, no matter how hard they try, are not able to mandate confidence. In the case of Germany, the largest euro-using nation, confidence in its previous currency (the Dmark) had been built over several decades via the highly disciplined approach of the Bundesbank. It doesn't seem unreasonable that many Germans would be uneasy about replacing a currency with a track record of strength and stability with an unknown quantity.

Aside from the impossibility of constructing a single monetary policy that fits the needs of all member countries, the other euro-specific issues are not insurmountable. The euro's 'confidence problem' would likely be resolved in the long-term if the ECB was able to operate independently (from politics) and to focus its efforts on protecting the currency's purchasing power. The 'lack of confidence' issue could even be addressed in the short-term by substantially increasing the euro's gold backing, thus 'de-politicising' the currency. However, there is no getting around the big issue – monetary union cannot work without fiscal union and fiscal union cannot work without political union. So this begs the question – assuming those who brought the euro into existence were/are not stupid and were thus able to recognise the fundamental flaw in the whole EMU concept, why did they still proceed?

The only answer that makes sense to us is that the ultimate goal was never EMU, it was and is EPU (European Political Union). In other words, the euro's 'raison d'être' is to be the first step in a path that leads to EPU. This is clearly not how the euro has been 'sold' to the people of Europe.

Conclusion

The forces driving capital out of Europe and into the US are likely to abate over the next few months and a rally in the euro-dollar exchange rate should therefore unfold. The longer-term issue, however, is that problems will arise due to differing economic, social and political circumstances across the member countries. For example, what happens when one member-country desperately needs a cut in interest rates due to plummeting economic growth whilst a second is crying out for higher interest rates due to surging consumer prices? Will the government of a low-growth euro-using nation continue to accept the monetary policy dictated by the ECB when such policy removes any hope of that government's re-election?

The euro's fundamental defect ensures that it cannot survive in its current form and suggests, to us, that a broadening in the power wielded by a central governing body will gradually occur. This will be done, of course, in the name of something beneficial such as greater economic growth or lower unemployment.

In summary, the euro is a political concoction designed to further a hidden (from public view) political agenda. There is no legitimate basis for its existence. With regard to its value vis-à-vis the dollar, there is some cause for optimism over the medium-term as the forces that have driven the euro-dollar exchange rate to its current level look set to experience a partial reversal. However, we seriously doubt that the euro has seen its ultimate lows. We have yet to see the exchange rate respond to a 'confidence crisis' brought-on when at least one government attempts to break away from the monetary union in an act of self-preservation.

As we've said several times before, there is no viable alternative to the dollar in the 'fiat currency world', least of all the euro. In order to find a viable alternative One must look outside the fiat currency world.

Steve Saville
Hong Kong
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