Monday, May 17, 2010

The Beleaguered Euro

To say that the euro is experiencing its most serious existential crisis since its inception is a pretty salient statement by now, given the barrage of media coverage in the last two months in the midst of the eurozone's intensifying fiscal debt crisis.

In that environment, talk of a possible break-up of the euro bloc's common currency is gathering steam, and the resulting strong downward pressures exerted on the currency pushed it briefly today to a 4-year low against the dollar. While a euro break-up is no longer in the realm of fiction and is gaining increasing legitimacy as a possible outcome, it is always helpful to put the entire issue and its implications into some context.

Four points need to be highlighted:

1) If the eurozone member countries prove ultimately unable to regain the credibility demanded by markets that they will manage to enforce a true convergence of fiscal policies among all member-countries moving forward, then a real risk exists that the euro may disintegrate as a currency. However, the stakes for all countries involved are much too high for such an outcome to occur without all other measures to rescue the common currency have been exhausted first. Already loud voices have been raised from the powers-that-be (Germany and France) in support of a more centralized mechanism of coordinating fiscal policies for all member countries of the bloc.

In other words, any breakup of the euro is unlikely to be the result of panic and disarray within the eurozone in the midst of a crisis, but rather the product of a very deliberate and time-consuming process by the member-countries involved. The issues that need to be sorted out by each country in any decision to revert to their original national currencies are complex and multidimensional (setting new exchange rates, sorting out the payments on existing debt denominated in euros, handling of outstanding international trade transactions and contracts, and so on) and they can not be made in a rush. So, any suggestion that a euro break-up is a plausible outcome in the next few months is totally unrealistic (as Goldman Sach's Chief Global Economist, Jim O'Neil, has also pointed out; see link

2) Perhaps, a more likely, but considerably less disruptive, outcome of the current crisis in the euro zone would be that, at some point, some of the weaker member-countries of the bloc are forced, via some indirect process that will need to be put in place, to abandon the euro. Still, this is not a likely solution in the midst of the current intense phase of the bloc's fiscal crisis, as it would tend to add fuel to the already raging fire. First, the bloc will need to put out the fire (that is, stabilize the dismal debt picture of many of its member countries) and, then, at a later point, deal with potentially more radical measures that might involve the expulsion of some countries.

3) Despite its precipitous decline in the last three months or so, the euro is not remotely close to its lowest level reached against the U.S. dollar since its inception. Such a level was reached in 2000-01 at approximately 0.82, while the euro today stands around 1.23 (but with an admittedly downward momentum in place). So, the current levels of the euro against the dollar are not alarming per se; it is simply the persistence and intensity of the sell off that bear close monitoring in the weeks ahead.

Source: ECB

4) Much has already been made about the likely adverse effect that the slower pace of economic growth in the eurozone ahead will have on the U.S. economy (as the direct result of more fiscal austerity measures adopted by most member countries for this year and next ). While it is true that more than $15 billion a month of U.S exports have as their destination a eurozone country and that such exports will suffer somewhat, it is important to remember the following:

a) The main driving engine of the U.S recovery in this phase remain the consumer, capital spending, and the inventory cycle. Net exports, which represent a relatively modest amount of overall GDP (about 12%) to begin with, are unlikely to constitute a major risk of derailing the U.S economic recovery. The slower pace of GDP growth in the eurozone may represent an additional moderate headwind for the U.S economy but, most probably, not a defining factor. b) Although most of the focus so far has been on the contractionary effect of fiscal austerity on growth in the eurozone countries, it is often unrecognized that a portion of that will be offset by stronger exports from the bloc- the direct benefit of a weaker currency.

Anthony Karydakis

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