The Euro has been falling recently versus the Dollar. Why? There have been many theories proposed, but I want to offer my own theory this evening. Fiat currencies are political creatures, and are only as strong as the political entity issuing the fiat currency (fiat — it’s currency because we say that it is).
The intersection of politics and economics is tricky. Currencies, and confidence in currencies are ephemeral. I look at the Eurozone and ask a simple question: who stands behind the Euro? Who will lay out tax revenues to support it in a crisis? Who will be the lender of last resort?
Much as I did not like the bailout plan because I think there were many better plans to pursue, nonetheless, the US has the benefit that the US Treasury and Federal Reserve are acting like one unit. In the Eurozone, there is no central taxation, regulatory banking, or police authority; there is no lender of last resort. Individual governments or “coalitions of the willing” may bail out financial companies, but there are no guarantees because the ECB and European Parliament are toothless. If the same conditions existed in the US, regional Federal Reserve Banks would do the bailouts, and not the Central Bank.
When I was on “The Ron Smith Show” two weeks ago (sorry, no podcast), I commented that the credit crisis was a global phenomenon, and the European banks were more levered than US banks, though with less credit stress as a percentage of assets. I pointed out that there is no lender of last resort, and that many countries have different goals for currency policy, and bank regulation. I also noted that the criticisms of American finance were valid, but applied to Continental Europe as well.
At present, those Europeans that dissed Anglo-American finance have egg on their faces (including the lady who shares my surname). With the competitive rush in Europe to guarantee bank deposits, even Germany switched its policy and guaranteed deposits. That hasn’t happened in the US yet, but I wouldn’t rule it out.
It is possible that the current crisis could destroy the Euro, and possibly the EU. I think of the Confederation, where the economic pressure became so great that an extra-constitutional coup took place to create the Constitution, and implicitly, the fiat Dollar that we live with to this day. WIthout political unity, fiat currencies have short shelf-lives. Alternatively, the crisis could create a Federal Europe where the central government has significant powers to the degree that France in the Eurozone would be similar to Texas in the US. I don’t see that as likely; there is not the same degree of trust across the Eurozone as there is in the US.
What’s my upshot here? Extreme volatility does not favor the Euro; it calls their system into question. Better to be in the Dollar, or better yet, the Yen, Swiss Franc, or Norwegian Kronor. Carry trades are play on low volatility; when volatility rises, the low interest rate currencies tend to do well because the ability to hedge bad currency outcomes is diminished, and carry trades collapse.
That’s where we are now. Neither the US nor Europe should gloat over the other’s bad providence. They have their own unique weaknesses.