Related positions: Long Germany via EWG; Short France via EWQ; Long Gold via GLD
While a common currency in Europe has been contemplated as far back as the League of Nations in the 1930s, it wasn’t until the Maastricht Treaty of 1992 that established a framework that led to the Euro’s official launch on January 1, 1999 and general circulation via notes and currency in 2002. Importantly, it’s worth emphasizing that the Euro is just over a decade old.
In that time period, the Euro has quickly become the world’s second largest reserve currency after the U.S. dollar. In fact, the Euro has taken consistent reserve share from the U.S dollar over the past decade, going from roughly 18% of global currency reserves in 1999 to just over 28% in 2009. Currently, roughly 330 million Europeans use the currency on a daily basis and almost 175 million additional people use currencies that are pegged to the Euro.
This strength and scale of the Euro led former Federal Reserve Chairman Alan Greenspan to opine in 2007 that it was “absolutely conceivable that the euro will replace the dollar as the reserve currency, or will be traded as an equally important reserve currency.” Not surprisingly, Greenspan’s statement is, in hindsight, at best a contrary indicator.
The current sovereign debt crisis in Europe is creating some rightful questions about the future of the Euro and whether its structure is fundamentally flawed. While the recently approved €750 billion plan to backstop European debt by the European Central Bank seems to signal that the Eurozone will protect its common currency at all costs, this action also highlights the key structural flaws associated with the Euro.
As stipulated by the Stability and Growth Pact, which grew out of the Maastricht Treaty, certain monetary and budgetary requirements were mandated for Euro adoption, including that each nation has a budget deficit as a percentage of GDP below 3%, debt as a percentage of GDP of less than 60%, and inflation over the trailing twelve months of less than 3.2%.
Interestingly, and as outlined in the table below, many of the most prominent nations in the Eurozone currently far exceed the stipulations outlined in the Stability and Growth Pack. This obviously shines the light on the lack of fiscal discipline of the European Union as whole, and presents two main questions: 1.) What are appropriate targets for fiscal imbalance reduction?, and 2.) Should these parameters be adhered to at all?
In addition to the specific fiscal requirements for entrance into the European Union, the Maastricht Treaty also mandated that no country would ever be bailed out. The intention of this was, it seems, to protect the broader fiscal order of the Eurozone and to ensure that there were consequences for bad fiscal policy. Obviously, with the recent ECB sovereign debt bailout, this tenet of this Maastricht Treaty has been willfully ignored.
In ignoring this key tenet of the Maastricht Treaty, the Eurozone is revealing one of the key risks to the Euro -- interconnectedness. Most nations within Europe borrow from, and lend to, each other. So, while in theory, the Eurozone should likely let Greece restructure based on the Maastricht Treaty, most major banks within the Eurozone hold Greek debt, and would feel the pain of a Greek debt restructuring.
And this interconnectedness goes well beyond Greece: one-third of Portugal’s debt is held by Spain; Italy owes France more than $500 billion; Spain owes Germany $238 billion and so forth. Therefore a restructuring or writing down of the debt of any nation will impact the banks and economies of many other Eurozone nations.
The primary structural flaw that is being revealed with the Euro is that because of the disparate economies in Europe, a one-size-fits-all monetary policy is ineffective. As an example, while Spain may require a monetary policy that attempts to combat its 20% unemployment, Germany may require monetary policy that ensures its economy doesn’t begin to heat up. In essence, without a political union that can manage the disparate economic goals of each member nation, the monetary union is destined to be weak, which is what we are seeing evidenced by it not adhering to the Maastricht Treaty.
In summary, the issue is not really whether the Euro will fail or disband, because the European sovereign debt bailout package suggests the Euro will endure for the longer term. The issue, rather, is that the ongoing illumination of these structural flaws will create a growing lack of confidence in the Euro and reverse any perception that one day the Euro would surpass the U.S. dollar as the world’s reserve currency. And with this change in perception, it is likely that Euro is revalued and continues its slide towards its all-time lows versus the U.S. dollar and beyond.
Daryl G. Jones