A doomed currency

[EJ]

A doomed currency
December 13, 2006 (Telegraph.uk)

The achievement of economic and monetary union by 11 European countries in 1999 was based on a deal: Germany, the strongest member, gave up the Deutschemark on the understanding that the others would not debauch the new common currency, the euro. Nearly eight years on, that inherently doomed project is coming apart at the seams.

The fundamental problem is that the economies of the "Germanic" members have diverged so far from those of the "Latin" bloc that the single interest rate set by the European Central Bank (ECB) is becoming a huge political liability.

The threat to the cohesion of the eurozone is best illustrated by comparing France and Germany. The second, having established a competitive advantage over the southern bloc of about 30 per cent over the past decade, is facing incipient inflation and favours a tight monetary policy. The first, devastated by the strength of the euro against the yen, dollar and renminbi, would like a halt to interest-rate rises. While the French political establishment has already turned against present policy, its abandonment would undermine support for the EU in Germany. The two "motors" of Europe are pulling in opposite directions.

AntiSpin: We recall in 1998 when iTulip first went on the air, before the euro was adopted by the EU, one commentator said, "Europe is about to lock themselves in a cage and throw away the key. They'll be at each other's throats within ten years. Don't they ever learn?"

While we have been euro bulls short term, longer term we are very bearish on the euro. Buying euro denominated bonds at US0.75 in 2001 and selling today at US$1.32 is not a bad trade. The question is, what might cause the euro to continue to appreciate relative to the dollar in spite of the structural political issues?

Consider the latest from Crooks on Currencies' John Ross Crooks III:

Thursday 14 December 2006 5:00 AM EST
Key News
• The Swiss central bank raised interest rates for the fifth time in a year. (Bloomberg)
• The Nihon Keizai newspaper reported the Bank of Japan will probably leave interest rates unchanged at its next meeting. (Bloomberg)
• The yen hit record lows against the euro.
• European Central Bank council member Axel Weber signaled support for increasing interest rates again,
saying forecasts on inflation by the bank’s staff don’t signal an all clear for policy makers.

• Key Reports (WSJ):
8:30a.m. Initial Jobless Claims. For Dec 9 Wk. Expected: -4K. Previous: -34K.
8:30a.m. Nov Import Prices. Expected: -0.1%. Previous: -2.0%.
10:00a.m. DJ-BTMU Business Barometer. For Dec 2 Wk. Previous: -0.1%.

FX Trading – A surprise!
Stronger-than-expected retail sales data was a big surprise yesterday—it gave the greenback a major shot-in-the-arm, changes the dynamics near-term, and sets the table for a decent $ correction.

Holiday infused retail sales rose 1.0 percent in November -- the first gain since July -- and left traders questioning whether U.S. economic growth is slowing.

These numbers followed Tuesday’s inflation-themed FOMC meeting. Those betting on inevitable rate cuts (and we’re in that camp) were disappointed when growth concerns played second fiddle to inflation concerns yet again.

The way we look at it the Fed is throwing investors a serious head-fake here. That’s because it’s in the U.S. Central Bank’s best interest to maintain the upper hand on the outlook for the U.S. economy. So many new bears are jawboning away at the U.S. dollar that it makes sense to keep them back on their heels with some heavy inflation rhetoric. more...

My take is that the Fed is praying for data that shows that economic slowing is starting to moderate the global inflation that has resulted from the coordinated global central bank reflation since 2001. The ongoing stimulus continues to create the perverse situation of a high correlation among all asset classes–all asset prices up. Apparently, the Fed has to acknowledge a growing stagflation problem as the U.S. economy slows (housing with lag effects) and all goods prices continue to rise (reflation with lag effects).

For more on the economic slowing, see John Serrapere's December Portfilio A update.

For more on inflation, see Aaron Krowne's report today on the announcement by the U.S. mint that melting pennies and nickels is now a crime punishable by $10,000 fine and/or five years in prison. The key phrase in the press release:

"In all essential respects, these regulations are patterned after the Department of the Treasury's regulations prohibiting the exportation, melting, or treatment of silver coins between 1967 and 1969, and the regulations prohibiting the exportation, melting, or treatment of one-cent coins between 1974 and 1978."

Begs the question, what happened between 1967 and 1969 to require silver dimes, quarters and half dollars to be taken out of circulation and replaced with clad coins? What happened between 1974 and 1978 to require copper pennies to be taken out of circulation and replaced with clad coins? These were episodes in a stagflationary period of rising inflation and slowing economic growth, like the one we appear to be headed into now.

[bart]

Re: A doomed currency

One item I've noticed lately about the Euro area that no one has mentioned; the yield curve there.

I track the 3 month and 10 year rates via the Swedish Riksbank site, and we're about .1% away from going into a yield curve inversion.

[jk]

Re: A doomed currency

the irony is that as [some] people become more aware of the strains within the eurozone, the rest of the globe is busily "diversifying" into [mostly] euros. the rising euro will surely add to intra-eurozone tensions as the more export dependent industries get squeezed.

fiat currencies are truly presenting us with an "ugly contest." which makes pms look all the prettier.

[akrowne]

Re: A doomed currency

Great post, Eric.

The Euro stuff is worrisome. Without a solid alternative to the dollar, I think we're in for considerably more global economic chaos than we'd see otherwise.

This strengthens the case for gold (and other PMs and commodities) fantastically.

And, of course, hoarding those pennies and nickels.

[Mish]

Re: A doomed currency

Pennies, Nickels, and Dollars
http://globaleconomicanalysis.blogsp...d-dollars.html
Mish

Right now, a nickel is the closest thing to "Honest Money" we have. We are in the ironic situation where the value of the dollar is falling but the value of a nickel is rising. In what time frame will the current (and probably soon to be confiscated) nickel be worth more than a dollar?

[Jim Nickerson]

Re: A doomed currency

And, of course, hoarding those pennies and nickels.

Right now, a nickel is the closest thing to "Honest Money" we have. We are in the ironic situation where the value of the dollar is falling but the value of a nickel is rising. In what time frame will the current (and probably soon to be confiscated) nickel be worth more than a dollar?

So what is the value of hoarding pennies and nickels, if they may be ultimately confiscated?

[jk]

Re: A doomed currency

So what is the value of hoarding pennies and nickels, if they may be ultimately confiscated?

i still have some silver quarters. they have some intrinsic value. it's like a $20 gold piece- worth a bit more than 20 dollars.

[EJ]

Re: A doomed currency

So what is the value of hoarding pennies and nickels, if they may be ultimately confiscated?

No one's talking about confiscation. I have a fair number of silver US coins I bought in 2001 when silver was trading under $5 to prove that the U.S. Mint is not interested in confiscation. I can even use them as legal tender if you want to, but why would I? All the mint is saying is that it's no longer economical to use zinc and nickel in U.S. currency. As an interim measure, before they can get the new cheap-o coins on line in place of zinc and nickel coins, but while they still have to mint them using zinc and nickel, they are fulfilling their responsibility to tax payers by discouraging the theft of these coins. Later, when they are able to mint them out of–what, aluminum?–you will be able do whatever you want with the old zinc and nickel U.S. coins, just as you can with silver and copper coins. Melt 'em, spend 'em, hoard 'em... knock yourself out.

Most interesting to me is the inflation that is causing this to happen at this particular moment in time, and it raises an interesting question. Clearly the mint did not foresee the day when the value of zinc and nickel in coins would exceed their face value. Even if the mint starts to use aluminum, at US$1.30/lb it's still only slightly less than half the price of copper by weight, but not by volume. If the dollar falls another 80% or so they've got the same problem again. Plastic coins... that's the ticket.

[WDCRob]

Re: A doomed currency

They'll eventually just do away with small coins altogether, I'd think. Pennies are more trouble than they're worth now.

[metalman]

Re: A doomed currency

They'll eventually just do away with small coins altogether, I'd think. Pennies are more trouble than they're worth now.

it's troubling when a base 10 currency doesn't work anymore. why is 100th of a dollar useless? it should not be. maybe we should switch to a base 12 currency. that'll mess up everyone's head big time, have pence and sovereigns and kind of arcane stuff. everyone will be so busy trying to make change they'll never notice that the purchasing power of their income is gone.

[0tr]

Re: A doomed currency

.... Even if the mint starts to use aluminum, at US$1.30/lb it's still only slightly less than half the price of copper by weight, but not by volume. If the dollar falls another 80% or so they've got the same problem again. Plastic coins... that's the ticket.

Problem with all currency is wear and tear. I'd go for porcelain or some ceramic. Very durable, lots of raw materials. problem with all coinage is also energy input for various processes (including ceramics of course). Aluminum is poor wear-wise. Any engineers out there?

Surprising that no Gauls have objected to being called Latin in the Telegraph article.

[Jim Nickerson]

Re: A doomed currency

No doubt I will not survive long enough to see it occur, but assuming the US is not largely wiped out by some nuclear or biological terroristic event or natural biological event, someday currency will be replaced with some sort of money cards, only assumption is there is enough energy to continue to make electricity. That will solve so many problems in a society which at the moment seems primed to unendingly increase its population and some of the useless, detrimental problems that go along will massive societies, i.e. financial crimes, robbery and murder for money and stuff, drug trafficing, etc. Anything that physically occurs with currencies 'tween now and then is simply spitting into the wind.

[Eurofan]

Re: A doomed currency

EJ, and indeed everyone else, if you'd care to elaborate on your sense of the Euro problems i'd be very interested in your perspectives.

(Disclaimer; I've been following iTulip for some months now with increasing interest and must admit my eyes have been opened however i'm very much a novice with regard to some of the more in-depth theories and concepts here )

From an Irish perspective (I live in Dublin) we would appear to be in the worst position of all. Everything i read on iTulip with regard to the U.S. property bubble can be safely doubled here. We are today in a position where the average property price is 10x average industrial wage. One of the contributing problems has been an ecb-set interest rate that was entirely inappropriate for our level of growth. It should have been considerably higher 5 years ago as the speculative boom took off and would ideally be beginning to lower now as the initial stages (finally) of concern are setting into the market.

However Ireland (and Spain to a lesser degree) aside, Italy is the one nation in the Eurozone that is having real difficulties from it's own productivity issues in comparison with Germany and some other members.

The ecb seems (by it's own statements) not concerned so much with inflation alone but with M3 growth and is on a mission to tame that. While domestic concerns are an issue i see political complaints from every quarter, including the French, as realistically being little more than the 'expected' pomp and ceremony politically speaking. Otherwise there is very strong support for both the Eurozone concept and the implimentation thus far.

Bear in mind too Euro exports would not be hurt as much as might be assumed by a weakening dollar. I'll try to find the figures again but overall the growth in the area is within the Eurozone and not as dependent on ex-euro exports.

To be frank i found much in the telegraph article to be extremely overstated. The divergence in euro economies is far from dramatic and to be expected as some are slower to come to terms with their own productivity issues than others. This is the crux of the 'political liability' and not interest rates but is something that would exist in a free-trade zone regardless of currency issues. The notion that France, or other 'latin' :rolleyes: nations are somehow "devastated by the strength of the euro against the yen, dollar and renminbi" is really nonsense. France has domestic issues to deal with (in particular thorny labour union and welfare issues) and pointing the finger elsewhere is nothing more than convenient politically.

I'm entirely open to understanding how the future of the Euro will play out but i've seen very little so far to suggest the currency is, or will be, in trouble.

To be honest the one nation i could forsee pulling out at some point would be my own - Ireland. The ramifications of the property bubble bursting here with nigh-on 30% of employment reliant directly or indirectly on construction will be terrible but we no longer even have control over our own monetary policy. However things would have to get incredibly bad for the positives of abandoning the Euro to outweigh the negatives (and penalties).

[jk]

Re: A doomed currency

EJ, and indeed everyone else, if you'd care to elaborate on your sense of the Euro problems i'd be very interested in your perspectives.

(Disclaimer; I've been following iTulip for some months now with increasing interest and must admit my eyes have been opened however i'm very much a novice with regard to some of the more in-depth theories and concepts here )

From an Irish perspective (I live in Dublin) we would appear to be in the worst position of all. Everything i read on iTulip with regard to the U.S. property bubble can be safely doubled here. We are today in a position where the average property price is 10x average industrial wage. One of the contributing problems has been an ecb-set interest rate that was entirely inappropriate for our level of growth. It should have been considerably higher 5 years ago as the speculative boom took off and would ideally be beginning to lower now as the initial stages (finally) of concern are setting into the market.

However Ireland (and Spain to a lesser degree) aside, Italy is the one nation in the Eurozone that is having real difficulties from it's own productivity issues in comparison with Germany and some other members.

The ecb seems (by it's own statements) not concerned so much with inflation alone but with M3 growth and is on a mission to tame that. While domestic concerns are an issue i see political complaints from every quarter, including the French, as realistically being little more than the 'expected' pomp and ceremony politically speaking. Otherwise there is very strong support for both the Eurozone concept and the implimentation thus far.

Bear in mind too Euro exports would not be hurt as much as might be assumed by a weakening dollar. I'll try to find the figures again but overall the growth in the area is within the Eurozone and not as dependent on ex-euro exports.

To be frank i found much in the telegraph article to be extremely overstated. The divergence in euro economies is far from dramatic and to be expected as some are slower to come to terms with their own productivity issues than others. This is the crux of the 'political liability' and not interest rates but is something that would exist in a free-trade zone regardless of currency issues. The notion that France, or other 'latin' :rolleyes: nations are somehow "devastated by the strength of the euro against the yen, dollar and renminbi" is really nonsense. France has domestic issues to deal with (in particular thorny labour union and welfare issues) and pointing the finger elsewhere is nothing more than convenient politically.

I'm entirely open to understanding how the future of the Euro will play out but i've seen very little so far to suggest the currency is, or will be, in trouble.

To be honest the one nation i could forsee pulling out at some point would be my own - Ireland. The ramifications of the property bubble bursting here with nigh-on 30% of employment reliant directly or indirectly on construction will be terrible but we no longer even have control over our own monetary policy. However things would have to get incredibly bad for the positives of abandoning the Euro to outweigh the negatives (and penalties).

as you point out, ecb-set rates have been too low for ireland, and likely too high for, e.g. germany. italy would love to devalue, but can't. meanwhile, germany and france are running deficits well above that allowed via the stability pact, but suffer no consequences. you have unified interest rates, i.e. unified monetary policy, but disparate fiscal policies. the real difficulty is that there is little mobility of labor and population.

viewing the u.s. as a currency union, it is important to note that the fiscal policy of the federal government as the same effects everywhere. the redistributional effects of federal taxation and spending, and the mobiliy of capital and labor tends to moderate regional differences, though such differences certainly exist.

the euro is subject to strains right now, in the midst of global expansion. what will happen during the next global recession? intra-european differences can be expected to remain significant. some countries will be hit much harder than others.

let us assume, for the sake of argument, that france is particularly hard hit. the e.u. and the eurozone were initially french enthusiasms because the french saw them as a platform for french leadership. the germans, humbled by wwii, followed the french lead, and the two dominated the continental organizations. the e.u. became a modern expression of gaullist policy.

with e.u. expansion, and especially the incorporation of east european former soviet satellites, the organization has taken on a decidedly atlanticist tone. and the political tone of the e.u. continues to move away from the french "social model."

over the period from now until 2013, payments from the common agricultural policy will shift substantially, to the detriment of france. and internal tensions with resident muslim populations, along with the fear of "polish plumbers," is contributing to a an increase in nationalism, while the e.u. prevents france from regulating who can cross its borders. both france and italy have made moves to "protect" "national champions" in important industries from cross-border acquisition.

the surprise that killed the proposed e.u. constitution was rejection by french voters. i think it is possible, not certain but certainly possible, that the surprise that kills the euro will be withdrawal by france.

[FRED]

Re: A doomed currency

as you point out, ecb-set rates have been too low for ireland, and likely too high for, e.g. germany. italy would love to devalue, but can't. meanwhile, germany and france are running deficits well above that allowed via the stability pact, but suffer no consequences. you have unified interest rates, i.e. unified monetary policy, but disparate fiscal policies. the real difficulty is that there is little mobility of labor and population.

viewing the u.s. as a currency union, it is important to note that the fiscal policy of the federal government as the same effects everywhere. the redistributional effects of federal taxation and spending, and the mobiliy of capital and labor tends to moderate regional differences, though such differences certainly exist.

the euro is subject to strains right now, in the midst of global expansion. what will happen during the next global recession? intra-european differences can be expected to remain significant. some countries will be hit much harder than others.

let us assume, for the sake of argument, that france is particularly hard hit. the e.u. and the eurozone were initially french enthusiasms because the french saw them as a platform for french leadership. the germans, humbled by wwii, followed the french lead, and the two dominated the continental organizations. the e.u. became a modern expression of gaullist policy.

with e.u. expansion, and especially the incorporation of east european former soviet satellites, the organization has taken on a decidedly atlanticist tone. and the political tone of the e.u. continues to move away from the french "social model."

over the period from now until 2013, payments from the common agricultural policy will shift substantially, to the detriment of france. and internal tensions with resident muslim populations, along with the fear of "polish plumbers," is contributing to a an increase in nationalism, while the e.u. prevents france from regulating who can cross its borders. both france and italy have made moves to "protect" "national champions" in important industries from cross-border acquisition.

the surprise that killed the proposed e.u. constitution was rejection by french voters. i think it is possible, not certain but certainly possible, that the surprise that kills the euro will be withdrawal by france.

Welcome, Eurofan. Very impressive first post from someone who claims to be a novice. As usual, an enlightening response from jk.

The major long term risk to the euro is that it is a multi-national currency versus a national one. So far that's been a good thing, as the discipline of the euro policies compared to the striking lack of policy discipline, especially with respect to trade and fiscal deficits, has recently been the greatest weakness in the U.S. dollar. As long as all members of the EU are doing relatively well, the euro will do well. However, if several member nations go into recession and stay there long, while other members are faring better, that's when weaknesses in the system will be put to the test.

Nationalistic interests always trump the interests of a Union of nation states. Now the benefits of Union are higher than the costs, but one doesn't have to go too far back in time to find circumstances which, of repeated, might change that calculation.

The animation below is of the 50 U.S. states. It shows unemployment by state from 1978 to 1999.

Source: economagic.com

Bright green is good (low unemployment)
Yellow is not good (around 5%)
Red is bad (high unemployment, around 10%)
Purple is worst (20% and above)

The recessions of 1980, 1981 and 1990/91 show up clearly as broad expanses of red/black covering the nation.

Population movements within the U.S. mitigates some of the negative political impact on U.S. states of regional recessions. Labor motility is a major political safety valve. If California goes into recession while Texas and Georgia keep growing and adding jobs, residents can easily move from California to Texas and Georgia.Such population movements can translate into tricky political immigration issues in the EU under similar circumstances.

Imagine instead of a map of the U.S. a map of Europe's nation states. What happens if (when?) in the future, say, France and The Netherlands go into recession while Germany does not? Can residents of France and The Netherlands easily move to Germany where the jobs are? What if most of those leaving France and The Netherlands are part of a politically troublesome Muslim community, and both countries "encourage" them to leave? Will Germany be eager to allow them in? The background political tensions in this case will make continued adherence to EU rules very difficult, and if the rules are not adhered to, the euro will be worse off than even the dollar, as adherence to the rules is the whole value proposition today for using the euro as a reserve currency.

China, by the way, has it even better than the U.S. The CCP controls population flows between the country and the city to control wage rates, employment levels. Then, of course, there's the matter of facing prison for dissent.