Saturday, October 25, 2008

Does the Euro have a future?

The current financial crisis rocking the world economies has cast a rather unfavorable shadow on the perception of the euro as a viable, strong currency. 

European financial stocks, and hence stock markets, were hit hard in recent months by the growing problems with mortgage-backed debt. There is a perception that European banks’ exposure to bad mortgage debt (both US and European) is much worse systemically than US banks’ exposure, which is rather ironic since the sub-prime mess originated in the US. So European investors aggressively liquidated European bonds and stocks and sought a temporary refuge to weather this storm. And that safe haven was sought in US treasury bonds.

Globally, short-term US Treasury bonds are considered the safest debt investment. The US has long had the largest, strongest economy in the world. And because Washington can use the Fed to create endless US dollars out of thin air, the US Treasury can never default (unless the US government is overthrown in a civil rebellion or conquered in an invasion, neither likely scenarios). 

Since the US is a single sovereign nation, as opposed to the often-fragile federation of competing sovereignties that is the European Union, foreign investors still have more confidence in US Treasuries than other government bonds.

Now, the US dollar, like most currencies, exists as a result of nation-building, while the Euro exists as a step towards nation-building.  The European Union is not yet a state in the full sense of the word.  The member states control their own fiscal policies.  More importantly, they see themselves as distinct nations.  And different member states are growing at varying paces which creates uneasiness and discontentment. Especially the southern four member states, namely Greece, Italy, Portugal and Spain are feeling the strain of the high-priced German-centric Euro on their national economies. 

The governors of the European Central Bank have been following the traditions of the German Central Bank. Fighting inflation is their primary goal.  That works for a strong, stable economy like Germany.  But such economic policies during a downturn might prove too much for the Southern states to bear, presenting them with a Cornellian Dilemma.  Leaving or staying in the European Monetary Union, both with ugly consequences.

The Euro was floated in 1999. In its short history so far, it has remained a viable currency but that was during good times. How it fares during the current recession will decide its future. With widening divergences between the EMU’s member states, the pressure on it could become intolerable during a recession. And ultimately this could lead to its breakup. Two possibilities, every nation charting its individual course, or perhaps a Nordic Euro, with the Southern four breaking away.

I wonder if China has already begun formulating a strategy on how to deal with and perhaps take advantage of this possibility. 

1 comment:

Vinod_Sharma said...

Time to get back to the gold standard, or platinum or whatever; something more real than what is happening now for all the wrong reasons in a badly configured system?