When the euro hit a low of $1.1917 against the US dollar on June 7th, 2010, the airwaves crackled with assertions that the European common currency, beset by Greek debt problems and intra-union discord, was destined to trade at parity with the greenback. They were wrong. Since then, the euro has risen over 17% against the dollar, hitting $1.3961 today. The current upswing, delivered courtesy of the Fed, has at least temporarily silenced the euro’s critics. It should also serve to impugn the notion that the US dollar holds a permanent position as the world's reserve currency.
To be clear, I have always felt that the euro is just another flawed fiat currency. However, since its inception in the 1990s, it has earned my begrudging respect. Most analysts have reservations about the euro, but I see cause for some confidence.
Together, the 27 countries that comprise the European Union represent the largest single market in the world. Its GDP on a purchasing power parity (PPP) basis was $16.5 trillion in 2009, which is greater than the $14.2 trillion US economy in that year. The economies of the 16 countries in which the euro is legal tender produced a GDP of about $10.5 trillion on a PPP basis. That is equivalent to 74% of US total output in ‘09. Therefore, the economy of Europe, however measured, is similar in size and scope to that of the US and should be viewed with the same gravitas.
Rather than the comparative size of the two massive markets, the primary issue is that the US dollar accounts for 62% of global central bank reserves, even though it represents less than 25% of global GDP. In comparison, the euro represents just 26% of FX reserves. Why does the US economy deserve such a tremendous over-weighting of central bank reserves, and is this a net benefit to dollar investors? I argue that since their currency holdings are so vastly concentrated, global central banks are in a tenuous and vulnerable position. Should they ever need to reduce their dollar holdings – especially in concert – it would place tremendous downward pressure on the US currency. Meanwhile, no such over-owned condition (along with concomitant pent-up selling pressure) exists for any other currency.
Currently, the gross national debt of the US stands at 93% of GDP. The European Commission projects that their gross national debt will reach 84% of output this year and 88.2% in 2011. The Congressional Budget Office projects our national debt to reach over 100% of GDP in 2012, whereas the national debt of the EU will not reach 100% of output until 2014, according to the European Commission. Finally, US interest rates are much lower than those of the eurozone. From the looks of it, it’s not the euro analysts should distrust, but the dollar.
But What Happens the Next Time Down?
Investors the world over have traditionally flocked to the US dollar for safety. Many well remember the fall of non-dollar currencies in 2008, when the Dollar Index surged 27% and crushed most commodity prices, including gold. How do we know that the next international crisis won’t cause the same global flight into the “safety” of US dollars and out of secondary currencies like the euro? The answer can be found in comparing the Fed’s current approach with the strategy it employed two years ago.
Ben Bernanke’s initial response to the credit crisis of 2008 was fairly muted. Given today’s era of accommodation, it may surprise investors to be reminded that the Fed left interest rates unchanged throughout the entire panic period from April 30th thru October 8th, 2008, despite the fact that the S&P 500 dropped 37% during that time. And Bernanke only slightly increased the monetary base by $160 billion during that drubbing in equities. So, given the uncertainty and confusion that reigned and the Fed’s promises of stability, global investors flocked to the dollar, as they have done in Pavlovian fashion ever since the Bretton Woods Agreement was signed more than 65 years ago.
However, since the initial crash, the Fed has abused the dollar so disastrously that the remaining well of confidence has dried up. Ben sent out a fleet of helicopters to demonstrate to the world that he would not tolerate the appreciation of the USD or allow price levels to contract. While other central banks are beginning to tighten policy, the Fed has only promised more “quantitative easing.”
On the fiscal side, lawmakers in Washington have diverged from their counterparts in Berlin and London by refusing to consider any measures that would address growing debts. While austerity takes hold around the world, profligacy still runs rampant in the US.
In short, we are sending a loud and clear message to global investors: “You will be severely punished for seeking shelter in our currency and bond market!” The monetary base has doubled since the crisis, to $2 trillion, and the announcement of another dramatic increase is expected at the conclusion of the next FOMC meeting on November 3rd. The Fed has engineered robust “growth” rates in all the monetary aggregates, but yet has gone on record for the first time in its history saying that the rate of inflation is too low. All this has resulted in the US dollar losing nearly 13% of its value since June.
I went on record last summer saying that selling euros (or most any other currency) to buy US dollars is sort of like exchanging your ticket on the Titanic for a ride on the Hindenburg. The only safe forms of money are those that act as a store of wealth, preferably because their value will not be recklessly diluted by fiat. The Fed has put the world on notice that the dollar can no longer be viewed as a safe-haven currency. No such notice has been posted by the European Central Bank. And although no fiat currency is really safe, it is clear some are abused much less than others.
During the next phase of the crisis, it is likely that investors will be more cognizant of these facts than they were in 2008. As a result, I would expect them to seek shelter outside the dollar, perhaps in other currencies but also in commodities and precious metals. The days of panic dollar spikes may finally be over.