Man Without Qualities

Thursday, June 09, 2005

Stories From The Edge Of The Precipice

"Draw your chair up close to the edge of the precipice and I will tell you a story."
-F. Scott Fitzgerald, The Crack-Up (1945)

The euro fell near its nine-month low against the dollar today. For the moment that should help calm down European politicians who see the "strong" euro as a major economic burden in their export-led economies. The fact is that the recent rise of the euro against the dollar has been a political disaster across much of Europe, especially Germany and Italy. But the cause of that rise suggests that much worse may lie ahead for Europe if the euro survives and prospers relative to the dollar:
Asian central bank buying of euro-denominated assets ... has been a significant factor in the currency's 56 per cent rally against the dollar in little more than three years. With banks worried about the long-term health of the US dollar amid rocketing deficits, central banks cut the proportion of their forex reserves held in dollars from 67 per cent at the start of the millennium to 64 per cent at the end of 2003, according to the International Monetary Fund, with Russia and the Organisation of the Petroleum Exporting Countries leading the way.

Conversely, the proportion held in euros has risen from 13.5 per cent at the end of 1999 to 19.7 per cent in December 2003, and is almost certainly above 20 per cent now.

"The relative outperformance of the euro has been largely driven by increased interest in diversifying reserves," says Simon Derrick, head of currency research at Bank of New York.
In the short run, the euro's fall against the dollar will harm US exporters and those, such as Warren Buffett, who have bet large against the dollar.

Although there has recently been some talk of the possible end of the euro, Bob Mundell, the Nobel Prize-winning economist and originator of the concept of an optimal currency area believes "There is less chance that Emu will be disbanded than there is of a collapse of the dollar."

A good deal of media ink and ingrams have been spent describing the consequences (often in silly, lurid and unlikely detail) of a "collapse of the dollar" to the United States. Paul Krugman, for example, is fond of such imagery.

But what would a real, protracted swoon of the dollar against the euro do to Europe? As the above quoted article indicates, the possibility of such a swoon is from a practical standpoint in the hands of Asian central bankers. The dollar will swoon against the euro if and only if those bankers choose to "diversify" out of the dollar into the euro - in the limit refusing to accept the dollar as a "reserve currency" at all and refusing to buy dollar denominated assets. In the case of such a "diversification away from the dollar" there are essentially two practical possibilities: either (1) Europe gives a lot of euros to Asia in exchange for Asian goods or (2) Europe does not do that.

This is where one gets a good picture of the differences between the European and American economies. Possibility (2) is what has been happening during the limited anti-dollar diversification that Asian central bankers have engaged in so far. For example, the eurozone accounts for only 12 per cent of Japanese exports. The current near-crisis in much of Europe suggests that even this limited diversification has pushed up the euro substantially thereby suppressing the export sector of many European economies. Those export sectors are large and European economies are much more rigid than the US economy. Suppression of the European export sector is causing long-term structural unemployment in Europe, which is largely the cause of the gathering political crisis. If the euro has a much bigger "victory" of this variety, Europe would probably find itself in political and economic chaos with unemployment rates at or near levels seen in the depression*.

What about possibility (1)? This is what the US is doing: running a very big trade deficit while flooding the earth with dollars that the Asian central bankers hold as "reserves." For example, the South Korean central bank holds about $100 Billion. What happens if Europe does the same thing?

Well, in that case the euro will not soar (or, in the New York Times' bizarre universe, claim "victory"). But the EU countries trade among themselves. It is likely that a big EU trade deficit with Asia would correspondingly suppress the EU export sector to some extent. But, even more, such a big trade deficit would suppress the domestic sector of the EU as a whole - by displacing sales of EU-created goods in the EU itself. That is what has happened in the US as a result of its big Asian trade deficits. But, again, the US compensates with its internal economic flexibility - and US unemployment has not soared. The same flexible response to major trade deficits would almost certainly not happen in Europe. European workers displaced from their jobs as a result of Asian imports would mostly just stay unemployed, essentially forever. Once again, Europe would probably find itself in political and economic chaos with unemployment rates at or near levels seen in the depression.

Of course, a strong swoon of the dollar against the euro would also have consequences in the US. Interest rates would rise for a time. The federal budget would have to be trimmed (Democrats and some Republicans would say taxes must be raised). A recession, perhaps. Then it would all be over and the US would probably re-equilibrate by shifting manufacturing back to this country, etc.

But not Europe - at least that is my opinion and prediction. The rigid European system would probably enter serious, long term crisis.

But then, they're heading there anyway.
* The European Central Bank could, of course, just print and sell euros as the Asian central banks are buying euros. But, aside from undermining world confidence in the ECB, the Asian banks would then be buying those euros from the ECB with dollars, so this pretty much nets out as the European Central Bank buying the dollars that the Asians are turning down in their posited "diversification" effort. The prospect of the European Central Bank purchasing for "reserve" perhaps hundreds of billions of American dollars that the Asian central banks have refused - thereby financing the American life style and "twin deficits" in order to save the sacred European "system" from the turmoil of mass structural unemployment - is just too exquisite to accept as a practical, realistic possibility. I suppose stranger things have happened. I can't think of any at the moment, but I'm sure they're out there.

... Aren't they?

Comments: Post a Comment