For the better part of 2009 the U.S. dollar was the world’s most hated currency. But it’s looking increasingly likely the tables could turn in 2010. And the euro could take over that unenviable title.
In recent weeks we’ve seen a surge in scrutiny over sovereign debt. First, it was announced that Dubai would be “restructuring” its debt (i.e. default). And then the focus quickly turned toward the Eurozone’s weakest link — namely Greece.
This type of scrutiny can snowball quickly. Now other weak spots in the Eurozone, such as Spain, Italy, Ireland and Portugal are getting more attention. All of these countries are running massive budget deficits, many have huge debt burdens and all have muted prospects for growth.
That’s a recipe of trouble. Consequently, yields on government bonds in these countries have surged in recent weeks, reflecting the rising uncertainty surrounding their ability to meet debt obligations.
Investors are concerned about a spillover of debt defaults that could escalate into in a sovereign debt crisis. That is, debt defaults that spread throughout emerging market countries, perhaps even the industrialized world.
These problems aren’t new. And they’re occurring in the same European countries that have been vulnerable from the outset of the global financial crisis.
But the attention for much of 2009 has been squarely on the U.S. And because of that, these weak countries have gotten a free pass for quite a while.
Flaws of the Euro …
Countries that have joined the euro currency have unique challenges when economic times are tough. And we’ll likely find that the range of problems within the Eurozone will present a major threat to the euro’s lifespan.
The monetary union in Europe consists of a common currency and a common monetary policy. But fiscal policy is determined by each individual country. And to patrol those fiscal decisions, the European Union established its Growth and Stability Pact that, among other things, sets two criteria for member countries:
1) Deficit spending by its member countries cannot exceed three percent of GDP, and
2) Total government debt cannot exceed 60 percent of GDP.
As you can see in my table below, those limitations have been completely ignored by the countries that are having the biggest financial problems, exposing the structural flaws of the monetary union …
In short, the euro member countries are in trouble for all of the reasons Milton Friedman, one of the most influential economists of the 20th century, cited prior to the euro’s inception 10 years ago.
I’ll paraphrase four of Friedman’s statements and follow each with how it’s playing out:
A one-size fits all monetary policy doesn’t give the member countries the flexibility needed to stimulate their economies.
The European Central Bank’s mandate is inflation targeting, not growth. A premature exit from easy money policies could drive weaker European countries further into recession.
A fractured fiscal policy forced to adhere to rigid EU rules doesn’t enable member governments to navigate their country-specific problems, such as deficit spending and public works projects.
A majority of the sixteen countries in the monetary union have completely disregarded the EU’s Stability and Growth Pact by running excessive deficits.
Nationalism will emerge. Healthier countries will not see fit to spend their hard earned money to bail out their less responsible neighbors.
The cornerstone of the euro, Germany, has rejected the notion of big spending to bail-out troubled countries. And German citizens are in a protectionist mode.
A common currency can act as handcuffs in perilous times. Exchange rates can be used as a tool to revalue debt and improve competitiveness of one’s economy.
Under the euro, weak member countries are helpless. Italy has a history of competitive devaluations of the lira during sour times. Now, in the euro regime, its economy is left flapping in the wind.
Today, the most challenging issue facing the euro might be addressed in this statement by Friedman:
“Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.”
Milton Friedman saw the vulnerability of this single currency concept coming and predicted the euro’s demise within a decade. While the euro has outlasted that prediction, if a sovereign debt crisis defines 2010, look for the viability of the euro to come under attack again.
Bryan Rich is an accomplished currency specialist with more than 12-years of experience in trading, research, and consulting in the global foreign exchange markets. He is President of Logic Fund Management, a currency management and consulting firm.
Bryan began his career as a trader for a $600 million family office hedge fund in London. The macro-oriented fund managed assets for a prominent European family, and was one of the largest players in global currency markets in the 1990s. Later, he was a senior trader for a $750 million leading global macro hedge fund located in South Florida. There, he helped manage and trade a multi-billion dollar foreign exchange options portfolio.
His consulting resume includes work for a boutique currency fund in New York, where he developed trading models and strategy for the core investment program of the company. He later joined the company as a partner, based in their Wall Street office.
Bryan has also served for several years in a management and consulting role for the Weiss Group, performing in a variety of analytical areas across its economic research, money management, ratings, and institutional research divisions.
He has a BA from the University of North Florida and an MBA from Rollins College.
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