Wednesday, June 1, 2011
There is much apprehension about the future of the Euro, especially in light of the current debt crisis that is sweeping Europe. The concern is valid. Greece is floundering, Ireland is a mess, Portugal needs assistance and empirical evidence suggests that Spain and Italy are next.
There is much to be said about the sustainability of the Euro, something that I have questioned for several years. With little doubt, the most poignant incongruency of the Euro Zone, is its lack of ability to align fiscal with monetary policy. Even with the ECB's attempt to influence fiscal policy, through its doctrine of imposed austerity on needy nations, its inadequacy of being able to govern spending at the appropriate level is obvious. The riots and demonstrations that show their colors in the streets of Greece, Spain and Portugal are indicative of the ineffectiveness with which local governments have been able to address their respective electorate. Things are bound to become much worse, until ultimately, weaker countries will be compelled to abandon the Euro and revert to their local currencies. (See Paul Krugman's "The Road to Economic Crisis is Paved with Euros")
What does this mean for the Euro? Not much. Should the financially weaker countries of the Euro Zone bail from the Euro, the Euro will effectively come to represent a more stronger set of countries, essentially composed of Germany and France.
Secondly and of equal importance is the fact that interest rates in Europe as governed by the ECB are expected to remain firm. There has been an expressed willingness to "combat" inflation through interest rates, irrespective of the inadequacy of the methodology that is being applied to measure inflation. As I have mentioned previously (see "Fool's Trap: Measuring Inflation"), interest rate determination in Europe is going to have little impact on a drought that may prevail on the wheat belt, causing grain prices to firm; or on instability in the Middle East that would result in a spike of crude, consequently feeding "inflation".
Irrespective of the effectiveness of Europe's interest policy in constraining inflation, firmer interest rates in Europe relative to the U.S. will maintain a strong Euro, if not as a sole consequence of traders taking advantage of the "carry trade".
Another corollary of a firmer Euro is that manufacturers in Europe will struggle to provide goods outside the Euro Zone, at competitive prices. The robust growth that Germany has experienced in recent months is quite deceptive, if you bear in mind that Germany's main trading partners are France, the Netherlands (both part of the Euro Zone) and Iran.
In summary, probabilities are weighted towards a firm Euro, relative to the dollar, especially if weaker Euro Zone countries capitulate.
Also see: Future of Euro's Sustainability is Vulnerable