Given its history, why is the Euro now top dog amongst the world's monetary mutts...?
THE EURO just hit a fresh lifetime high against both the Dollar and Yen.
It's pushed the Pound Sterling – darling of central-bank reserve managers in 2006 – down more than 4% since the start of this year.
Versus the Swiss Franc, one of its least volatile pairings, the Euro has climbed 13% since 2002.
Why have the world's currency traders picked the Euro as top dog amongst the world's top five monetary mutts? What's kept the coat on this monetary mongrel so glossy and thick?
"[Currency traders] are treating the Euro as if it was the old German D-Mark, but it's not," says Bernard Connolly, global strategist at Banque AIG. "Germany has regained competitiveness. It has a whopping current surplus and can withstand a higher Euro. France, Italy, Spain, Greece, and Ireland cannot."
Not even the Germans are grateful for the Euro fort, however. More than half of them think it's had a "negative impact" on their economy, according to a recent poll for the Financial Times. More than two-thirds of French, Italian and Spanish voters agree.
"The full effect of currency rises peaks after 18 months," says Connolly, "so the strong Euro is going to hit these countries just as their domestic demand booms are turning to busts. They're facing a double whammy in late 2008."
Spain's now running a current account deficit worth 9% of GDP. Ireland's central bank warned last week that the Celtic Tiger can't bear any further interest-rate hikes. Italy, as ever, is a basket case; how Rome got to share interest rates with Frankfurt remains one of history's greatest financial comedies.
There's nothing new here, however. Economists warned there would be trouble right from the start – even before the start, in fact. As early as 1998, Hal S. Scott of the Harvard Law School warned that "there [was] a significant chance – over one in ten – that EMU may break up in whole or in part."
Ravi Bulchandani, then of Morgan Stanley and now at Barclays in London, also wondered aloud in print whether a speculative attack would blow Europe's monetary union apart before it got started. Speculators had, after all, driven the Pound Sterling and Lira out of EMU in Sept. '92.
Italy crept back into the club, crimping its government deficits to meet the pre-Euro requirements. But on launch, the new pan-European currency came under attack exactly as forecast. By March 1999, just nine weeks after the Euro began trading on the foreign exchanges, it had dropped to $1.05 – down more than one tenth to the Dollar.
Far from proving "strong as a bear", warned Wilhelm Nölling – a former member of the Bundesbank in Germany – the single currency was seen as "weak as butter" by the financial markets. Traders kept selling, and the Euro kept falling.
One year later, it slipped below $1.00 per Euro – and along with parity, public opinion was shot. A poll in April 2000 showed less than half of Germans supported the Euro. Justifying the mood with economic analysis, Franz Christoph Zeitler, president of the Bavarian division of Germany's Bundesbank, warned that "without fundamental reform, the Euro will weaken further."
Zeitler was right; Greece and Italy continued to run budget deficits way above the Eurozone's agreed ceiling of 3% – and the Euro continued to slide. It kept sinking until Oct. 2000, when it finally hit rock-bottom.
The poor citizenry of Europe, however, weren't to know that $0.8252 marked the low. By the time the Euro became flesh – on 1st Jan. 2002 – the new currency had spent twice as long beneath parity with the Dollar as it had above it. And when shopkeepers across the ECB's empire switch their price-tags from Francs, Lira, Gilders and Deutschmarks into Euros that day, two-thirds of people felt ripped off by a stealthy inflation.
The professional money in Frankfurt, Milan, Paris and London still couldn't grasp why the Euro should work, either.
"While the economic benefits from participating are sufficiently large to make such an event unlikely," said Morgan Stanley in April 2003, "we simply cannot neglect the possibility of fraction and secession.
"Markets will have to attach a higher probability to a break-up of EMU and/or the EU at some future date."
In other words, the Euro should either trade lower...or it should pay higher interest rates. Both amount to much the same thing. For in the lingo of investment bank analysts, "higher probability of break-up" meant "higher rewards for taking a risk."
But thanks to the new economics of the early 20th century, attracting investors to take a risk on the Euro hasn't required lower prices – nor significantly higher interest rates. April 2003 might not seem so very long ago. But it's a lifetime away in the history of money and credit...back in those ancient days before the Fed took US rates to an "emergency" low of 1%.
The Reflation Rally had barely got started. Ukrainian chicken factories had yet to raise $40 million in bonds sold to Frankfurt fund managers. Floating on London's AIM exchange was only a pipe-dream for China's orange grove farmers. No one was paying $400,000 for sketches that Francis Bacon tossed out with his garbage.
And the Euro, not long out of nappies, was back trading at "parity" with the US Dollar. The uptrend was well under way. The currency markets had finally stopped mocking les petits Charlemagnes in Brussels. If they wanted to play at making history, let them have their pan-continental funny money – plugged Euros, obscure bridges, waxy paper and all.
Currencies – when viewed solely as tradable assets – can either pay you a yield or give you a capital gain. Just like their rivals on the equity desks in the early 21st century, currency traders would rather have both, of course. Hence the grinding demise of the Japanese Yen. No yield, no capital growth. Witness the New Zealand Dollar, the Icelandic Krona...even the Pound Sterling...by way of comparison.
The Euro, however, proved an exception. Paying less than the Dollar, but more than the Yen, it broke $1.3600 by the start of 2005 – a startling gain of two-thirds from the turn of the century. The effect across Europe, besides making the Eurocrats smug, was to deliver on the Bundesbank's promise. Now known as the European Central Bank, strict German monetarism had delivered low inflation for all – and the low interest rates that low inflation allows.
So what if Irish back-office staff couldn't afford German engineering in their cars? They could buy all the BMWs they wanted on tick thanks to German-style financial stability.
But fresh Nay-Sayers squared up to take aim at the Euro. France and the Netherlands, both mired in recession, voted "non" and "nee" to the new EU constitution. Italy suffered its third downturn in six years. The welfare minister in Rome called the Euro a "disaster" and demanded the return of the Lira. A story in Stern, the sober German weekly, claimed that even the Bundesbank boss had discussed leaving the Euro!
Who wanted to stay? Cheap money rewards those who spend more than they have – for the short-term, at least. Spain, Ireland and Greece couldn't believe their good fortune. The Celtic Tiger along with its Iberian and Hellenic cousins had been gorging on low interest rates...sucking in real-estate traders and joining the club of grown-up economies in record-quick time.
"When we entered the euro, our mortgage rates went down from 12% to 2 or 3%," notes Juan José Dolado, a Madrid-based professor at the Centre for European Policy Research. Athens ran a government deficit worth nearly 8% of GDP, well over twice the agreed Eurozone ceiling. Dublin real estate became the most pricey in Europe – twice as pricey per square foot as Berlin according to the Economist Intelligence Unit.
And now today...three hundred years after Scotland and England united under one crown...the union of 13 nations under the same sovereign currency that lacks a sovereign government is at issue again. Only now, Germany is recovering; the ECB in Frankfurt wants to raise base rates further once more. Even the French might vote this weekend for commerce over protectionism. The whingers, for a change, are those countries that once enjoyed the "first win" of currency convergence.
"The reason Ireland and Spain have seen such credit growth is that interest rates have been too low," says Richard Fox, a senior director at Fitch Ratings. Ambrose Evans-Pritchard reports in The Telegraph that Ireland's bank lending grew 30% last year; house prices have risen 16% every year over the last decade! Another hike in Eurozone rates, warn the policy wonks in Dublin, and Ireland's feel-good bubble won't feel much good any more.
"There are downside risks," wailed the Central Bank of Ireland last week. "In addition to the dampening effect influence of fiscal tightening...and the lagged impact of earlier interest rate rises, the global economic environment is becoming less supportive."
Less supportive of what - a bubble in money and the fastest real-estate boom in history...?
"The single monetary policy has meant that excessively loose conditions for our economy have been almost continuous," confessed the Bank of Spain's governor, Miguel Fernandez Ordonez last week. "A less relaxed tone would have been better for our needs."
Now Germany's recovering thanks to the "relaxed tone" of previous ECB policy, the fundamental differences between north-western Europe and her neighbors in "Club Med" are threatening to rip the Euro wide open once more.
"Berlin gave up the D-Mark under an implicit contract that the Euro would never fuel German inflation," says Ambrose Evans-Pritchard in today's Telegraph. "This contract will be enforced. If not, German citizens will pull the plug on EMU."
Just like the ongoing demise of the Dollar, however, don't rely on it happening too soon. The Eurozone treaty makes no provision for a member state leaving the currency. None whatsoever.
That will only make breaking up so hard to do. Expect a bull market in trouble.