You’re Owed Euros
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.
October 7th, 20085:58 am at
By coincidence, I was clicking channels over the weekend and saw a conference at which Milton Friedman was speaking–in 1997! Someone asked him about the creation of the brand newfangled Euro.
He said it wouldn’t work and it would collapse. Why? Because a currency backed by disparate political forces would ultimately fail.
He was wrong for 10 years, but maybe just early?
regards
October 7th, 20086:34 am at
I don’t understand your view: when the EUR first reached the 1.35 levels against the USD, a lot of people thought it couldn’t go any higher.
The lack of confidence in the US currency and the various economic ailments of the US pushed it as far up as almost 1.6, now, seeing as the Euro zone is also exposed to the credit crisis, it seems to correct dramatically. However, it’s still at these levels that many people thought already extraordinarily high a couple of years ago. Remember the Euro was introduced at roughly 1USD and went as low as 0.8USD in the first couple of years.
So can you explain how it’s “collapsing” right now to the degree where you seem to consider that it’s even reasonable to question its very existence?
I’m no expert, there may be a lot of good reasons for your statements, but they don’t seem obvious in the light of the pure USD/EUR relationship (even if you throw the JPY into the mix).
Thanks in advance.
October 7th, 20087:58 am at
Concerning currencies, I’ve been drawn to the Swedish Krona. They’ve already had a banking crisis and come through it for the better. There is an ETF, FXS. Their interest rates are a little over 3%, paying you while you wait.
That being said, I haven’t pulled the trigger. I was ready to a couple times, but didn’t get to it and the price ran up where I wasn’t interested anymore. Lately I’ve come to the opinion that the dollar is going to run up in a flight to safety, but long term, these combined trillion dollar bailouts are going to cost us.
One thing I am not sure about, is whether there are long-term risks to owning the FXS. If anyone is able to comment to that I’d be appreciative.
October 7th, 200810:33 am at
You might enjoy Paul Kedrosky’s Infectious Greed post on how the bailout of AIG saved the European banks (temporarily, at least). They wrote 300 Billion in swaps to enable regulatory arbitrage in order to evade capital requirements. Some of the ratios he calculates are rather astounding. The fear of damage from this, as well as the unwinding of the dollar carry trade (with the dollar in the role formerly played by the yen) have probably contributed to
the theme of the post.
October 7th, 200810:45 am at
David,
Thanks for your blog.
Pls add some color to your “….similar to Texas in the US.” comment. I have trouble following
October 7th, 200811:44 am at
It seems to me the EUR is in some ways a modern gold standard.
While it may very well eventually break down in a crisis, as did all the various metallic standards, it’s also possible it survives for a while yet. It’s possible, for example, that one or two members choose to revert to a national fiat currency in order to devalue their way out of trouble, and provide an example of what happens when you go down that road.
October 7th, 200812:41 pm at
VT — it was fun to think of France as a state in the country of the EU, as Texas is in the US. Equating France and Texas should make both blink.
RK — saw that, another good post from Paul.
Jay — yes, he may have been early, as Steve Hanke was to the Baltimore Security Analysts Society back in 2002. And, Euromoney predicted much the same at the Euro’s inception.
vfwh — this isn’t the first time I have said this, and no, it is not off of the currency moves, but out of the disarray of EU policymakers, who are pursuing national, not EU interests.
October 8th, 200811:38 am at
Texas was also French once, although nobody in France knows that, strangely enough. French people think “French Louisiana” had the same borders as the current state of Louisiana.
I agree with your comments about the worrying state of the EU financial policy making and see what you mean.
I seem to be the only poster here not working or hobbying in finance or accounting, so sorry if I bore everybody, but I’m still not convinced of the structural soundess of this post’s argument, summarized thus:
- Why is the EUR falling against the dollar?
- Because the EUR is a fiat currency (somehow not rooted in real economic activity)
- Because there is no real EUR lender of last resort
- Because each of the EUR states is pulling the cover to themselves and not acting in concert for the EUR economic zone.
- Therefore the current crisis could mean the end of the EUR.
The problem, and I guess the misguidedness of my initial question stemmed from that, is that the question that you start your post with is “Why is the EUR falling against the dollar?” And it is in answering this question that you bring these arguments to the table, which, though valid, cannot answer the question you asked, because precisely the EUR is still at very high levels against the dollar.
If all your points about EUR support are true, and they are, then the real question is not “why is the Euro falling against the dollar?”, it should be “Why is the Euro still so strong against the dollar?”
Though, again, no expert, I would venture that it probably has to do with the fact that the Euro is a national currency in all the Euro countries, hundreds of millions of people use it to buy milk, iPhones or theater tickets, businesses use it to buy services and materials, investors use it to purchase stocks, other currencies or financial products, salaries and pensions are paid with it, etc., all in the second largest economy in the world, that is supported by a broad agreement on, and enforcement of, various economic indicators relative to, surprise, debt in particular.
So the EUR has its issues with policy and providing a last resort phone number, but that’s not the be all and end all of a currency.
Moreover, if the EUR leaders, such as your namesake, have egg on their faces, it’s not because of the lack of coordination of a EUR response, it’s because of the about-fa
October 8th, 200811:54 am at
Texas was also French once, although nobody in France knows that, strangely enough. French people think “French Louisiana” had the same borders as the current state of Louisiana.
I agree with your comments about the worrying state of the EU financial policy making and understand what you mean in your response.
I seem to be the only poster here not working or hobbying in finance or accounting, so sorry if I bore everybody, but I’m still not convinced of the structural soundess of this post’s argument, summarized thus:
- Why is the EUR falling against the dollar?
- Because the EUR is a fiat currency (somehow not rooted in real economic activity)
- Because there is no real EUR lender of last resort
- Because each of the EUR states is pulling the cover to themselves and not acting in concert for the EUR economic zone.
- Therefore the current crisis could mean the end of the EUR.
The problem, and I guess the misguidedness of my initial question stemmed from that, is that the question that you start your post with is “Why is the EUR falling against the dollar?” And it is in answering this question that you bring these arguments to the table, which, though valid, cannot answer the question you asked, because precisely the EUR is still at very high levels against the dollar.
If all your points about EUR support are true, and they are, then the real question is not “why is the Euro falling against the dollar?”, it should be “Why is the Euro still so strong against the dollar?”
Though, again, no expert, I would venture that it probably has to do with the fact that the Euro is a national currency in all the Euro countries, hundreds of millions of people use it to buy milk, iPhones or theater tickets, businesses use it to buy services and materials, investors use it to purchase stocks, other currencies or financial products, insurers insure value with it, salaries and pensions are paid with it, etc., all forming the second largest economy in the world, that is supported by a broad agreement on, and enforcement of, various economic indicators relative to, surprise, debt in particular and account balancing in general.
So the EUR has its issues with policy and providing a last resort phone number, but that’s not the be all and end all of a currency.
Moreover, if the EUR leaders, such as your namesake, have egg on their faces, it’s not because of the lack of coordination of a EUR-wide response, it’s because of the about-face that she had to make, just as Paulson/Bernanke had to make after Lehmans. It’s the same egg.
The EUR zone is highly integrated economically, and although politicians will indeed flail around and gnaw their teeth at each other, they all face the same crisis, the major institutions, especially banking ones, are cross-border (see the Fortis/Amro/BNP saga, the Dexia bailout), and they will each bail out their banks and insititutions with tax-payer money, like Paulson/Bernanke.
There are many other considerations, such as the mandate of the ECB and the principles of the European Commission policy-making (which has remained ostensibly silent) that we can talk about in terms of the ability of the EU and/or EUR zone to respond to crisis, and much to agree on. I just think that reports of the death of the EUR are highly exagerated.
October 8th, 200811:55 am at
Sorry, fat fingers posted the commentary in mid-flight, apologies.
October 22nd, 200812:17 pm at
vfwh — I said that the demise of the Euro was a possibility, not a likelihood. The powers that be in Europe will do all they can to preserve their experiment. But if the crisis gets larger, it could lead to nations dropping the Euro, or it could lead to political integration.