The Euro and How it Will Affect Us All

The Euro and How it Will Affect Us All

On 1st January 1999, 11 of 15 member states relinquished their local currencies and their central banks for a new single currency called the Euro, under the control of the single European Central Bank. On the surface, no problems so far, this will aid the movement of goods and services, and trading conditions in general, amongst the member states and nations within the region. But on closer inspection there is the potential for profound ramifications particularly for those in the US.

Anyone involved in the currency markets would agree that these markets have given the participants a wildly volatile ride in the last 18 or so months. With the introduction of the Euro and the resulting displacement of the US dollar internationally, this volatility is likely to heat up dramatically in the months ahead.

It is ironic that the tracks were laid for this wild ride back in the closing days of the war in Europe in the summer of 1944. The smell of an allied victory was in the air, and as if to divide the inevitable economic spoils of the war, a relatively small group of the western world’s notable economic, social and political minds met in a small town in New Hampshire called Bretton Woods.

John Maynard Keynes and his plans to rebuild the world were to feature prominently in the Bretton Woods Conference and its resulting agreements. He was about to become the principal architect of what has become known as “post World War II reconstruction”.

At the time of the Bretton Woods Conference, the United States, Canada, Switzerland, Australia and New Zealand alone stood as the only industrialized nations to have their treasuries, economies and banking system fully intact.

Keynes proposed that a new international monetary system be established, headed by a strong international banking system and a common world currency, not tied to the strong discipline of a gold standard.

If the world was to recover from its economic devastation, with so much of its means of production being seriously crippled, its trade economies destroyed, and so many nations so deeply in debt, it needed to expand. This expansion, he argued, would be limited if paper currency was still anchored to gold. In short Keynes reasoned that the industrial nations could re-equip and rebuild through a process of interest bearing money supply, deficit spending, deeper debt and increased consumption, even at the expense of future generations.

The outcome of the conference was several agreements, which included the establishment of the IMF, World Bank and the US Dollar as the world’s reserve currency in place of the British Pound.

The stage was set for the United States and its now unrivalled currency, the dollar, to feature prominently in all global trade, politics and economics. From those post war boom years to today every international transaction, in other words all the trade between all the countries, has been settled in US dollars. The exception to that would of course be the free unregulated marketplace where gold has continued to feature.

Today vast quantities of US dollar reserves exist around the world, in the form of cash and treasury debt certificates like bills and bonds, on the books of central banks, financial and investment institutions and in the hands of private investors.

In the 50 years since Bretton Woods, the US dollar has undergone drastic change, including the removal of all gold backing and massive inflation. The crippling effects of this progressive debasement, to a large part have been exported around the whole world, particularly to Europe, sheltering to a degree those back at home in the United States.

In 1957, the European Economic Community was founded. Now, some four decades later, the once illusive dream of a united Europe has finally arrived.

On December 11 1998, in the San Jose Mercury News, an article by Lori Montgomery in Berlin said “After a thousand years of strife and war, the nations of Europe will close the bloodiest century in their history by binding themselves more tightly together into a United States of Europe”.

“On New Year’s Day, Germany, France, Italy and eight other countries will merge their economies, abandon their marks, francs and lire and introduce the Euro, a new currency that will immediately become the world’s second- largest, and may one day challenge the supremacy of the dollar” (emphasis mine).

The creation of EUROLAND and the launch of its currency has been called “the most important aspect of the new environment in Europe”. It has been said to “present historic opportunities for European business and global investors”. It is without doubt, the financial event of the 20th century.

The 11 countries, which will be initially participating in the Euro, are Belgium, Germany, Finland, France, Ireland, Italy, Luxembourg, The Netherlands, Austria, Portugal and Spain. These 11 countries have met the strict criteria set for participation in the Euro.

Euroland will be one of the most powerful economic forces on Earth, with an economy second in size only to that of the United States and with slightly more people.

All analysts and commentators agree there are no end of challenges and trouble facing the currency and the participating nations. On the surface some simple but deep-rooted problems exist.

The participating nations have tough domestic problems, for example an average 10% unemployment rate.

In most member states, chasms exist between leftist political leaders and the more conservative bankers and financial heavy weights. For instance recently German voters installed a left wing, social-democratic coalition led by Gerhard Schroeder in place of Helmut Kohl, a euro champion. Schroeder’s finance minister, quickly initiated a bitter debate between the conservative central bankers, who are dedicated to maintaining a stable currency, and politicians who want bankers to lower interest rates in the hope of spurring job growth.

In early December, member nations took the unprecedented step of jointly slashing interest rates, uniformly setting rates at 3% in every member nation except Italy. This was seen as a positive step to spurring economic growth. But it further fueled fears that the major players, France and Germany, are already pushing the new currency toward instability.

January 1999 began the start of a 3-year implementation strategy. During this transition period, existing national currencies will coexist with the Euro.

This means participants within the economies of member states will need to carry 2 prices for their goods and services. For instance groceries will be priced in Euro’s and also in the price of the local currency. Employees will be able to be paid in the currency of their choice.

Banks will have to run two sets of transactions, reports and accounts, in Euros and the local currency.

The drain and expense on infrastructure is immeasurable. The burden of preparing for the Euro has been placed squarely at the feet of corporate and private enterprise.

Despite all the obvious problems associated with the introduction of the new currency, earlier scenarios of a failure in the new currency seem to have dissipated.

Virtually no-one now predicts the euro will fail. Quite the opposite, commentators are becoming increasingly optimistic about the potential of the new monetary union, and are instead talking about the opportunities it offers the investor.

The strict criteria the participating member nations had to meet to join the union are expected to improve the performance of their internal economies.

Healthy trade figures have emerged from the 11 countries taking part in monetary union. The countries are expected to record a trade surplus of $100 billion for last year. By comparison the U.S. is expected to post a trade deficit of about $140 billion.

Norbert Walter, chief economist of Germany’s Deutsche Bank recently said “The euro will be to the dollar what Airbus is to Boeing,”

This is a fitting statement ; you see it is the displacement of the US dollar and the effects of that displacement on the international markets that will effect us in the future, and particularly those living within the US.

The day the single currency was launched, its combined economies represented nearly 300 million people. This united trade zone contains the equivalent of US$27 trillion in combined financial assets. This compares to the US total estimated at US$24 trillion.

The remaining 4 EU countries are welcome to join at any time that they meet the criteria and choose to participate. At the moment the combined Gross Domestic Product of the 11 member EU is second only to the US. If and when the remaining nations join the 11, Euroland’s GDP will exceed that of the U.S.

While still not official the Euro is to have gold backing of at least 15%. This will be the first time since 1971 that a major currency has had any gold backing.

Vast quantities of US dollars are held as reserves, trade and investment currency, circulating cash and so on around the world. The mighty US dollar accounts for nearly half of the world’s foreign-held bank deposits and two thirds of official foreign reserves. Over half of world trade is invoiced in dollars.

Of all the US Treasury bonds ever issued, the vast majority are held by overseas investors, institutions or central banks.

As of January this year, the second largest trading block in the world will no longer use US dollars to settle their accounts. In simple terms that is about 1/3 of the total US dollars held overseas to facilitate International trade. These US dollar reserves will start to enter the market.

Likewise, other nations, corporations, banks and financial institutions within the region are free to buy, sell, hold and exchange Euros, just as they currently do with US dollars. A portion of the US dollars they currently hold will also start to enter the market

But it doesn’t stop there. Globally nations are looking to the Euro dollar with interest. As I said earlier much of the damaging effects, the inflation and boom bust cycles caused by the debasement of the US dollar have been exported around the world. The people who understand this process have long memories and don’t forget.

China currently holds around US$140 billion in foreign exchange reserves. In October last year China’s Central Bank governor announced that over time China would switch a substantial portion of it foreign exchange reserves from US bonds to Euro’s.

When China starts to switch its foreign exchange reserves from US dollars to Euro dollars, it is only fair to presume that other Asian economies would follow suit.

When every-one wants a beachfront condo, demand drives their prices up. Then a hurricane comes through and changes every-ones mind  no-one wants them any more, and so invariably their prices plummet.

Just like any sought after or highly regarded asset that suddenly goes out of vogue, its value falls to the point where the sellers meet the buyers. The more sellers and less buyers you have in a given market, the lower the prices will fall.

This deposition of an international currency has happened before this century. One need only look at the plight of the British pound on the international scene and within the British Empire after WW2, to see the inescapable effects on an economy where this has happened.

Its worth remembering that before Bretton Woods officially dethroned the Pound, the British Treasury did not have the same degree of debt the US carries today. Nor did they have the balance of trade deficit with the rest of the world that the US has today.

And by comparison there was nowhere near the level of foreign held reserves in pounds as there is in US dollars today. Prior to Bretton Woods, the pound had been used along with gold and the US dollar in international trade. There had been no clear international monopoly on currency.

But despite all of this, for over three decades the British economy struggled with the harsh effects of this international displacement of their once great pound. The British economy missed much of the post war boom, experienced by most of the west. Devaluation in the Pound reeked havoc domestically in Briton, culminating eventually in an IMF bailout in 1975.

In November 1998 CNNfn reported a survey by the Deutsche Bank. It took the views of about 200 global fund managers responsible for US$7.5 trillion. Many central banks were represented in the survey. Three-quarters of fund managers, including a majority of U.S. fund managers, said the euro would rival the dollar as the preferred currency for debt issuance within five years. With central banks among the main investors in bonds, this suggests the euro could rival the U.S. dollar as a reserve currency by 2003.

The analysts and fund managers that predict the new currency will present a serious challenge to the dollar, are right.

This displacement of the US $ globally may take some time but it will happen – it is inevitable.

The future plight of the US dollar becomes even more important when one considers for many years now, investors the world over have been fed the same prevailing wisdom – “if the investor really wants a safe haven for his wealth, free from the storms of the stock market and real estate booms and busts, there is only one place to go – dubbed “the flight to quality” has not been gold and silver in the physical possession of the holder, but – AAA rated US treasury bonds”.

Could it be that prevailing wisdom of the day is again about to be found wanting?

Throughout August and September last year, it would have appeared to the observer that the US economy was in a deathly tailspin. Triggered by the Russian debt default, losses in the US stock market were approaching 20% from mid July highs. With crashing confidence and plunging markets in the US, the Asian and Russian crisis threatened to become a global economic and financial crisis.

Every 1000 points lost on the Dow Jones is equivalent to around $1 trillion in lost equity. $100’s of billions had been stripped from mutual funds, share portfolios and the hip-pockets, of average American’s.

To ward-off plummeting markets and deflation in the US and a worsening global crisis, on 3 separate occasions between late September and mid November 1998, the Fed lowered official US interest rates, from 5.5% to 4.75%.

In January 1999 the effects of this monetary intervention by the Federal Reserve is evident. Markets have temporarily settled. For now, talk of global crisis has ended. Investors with notoriously short memories have again driven stock markets back to record highs (buoyed by small cap, high tech stocks).

Back in Europe 10 of the 11 participating nations have set interest rates at 3%. At the moment US rates are at 4.75%. In other words holding US dollar reserves attracts a 1.75% premium over the Euro – the US dollar is a higher yielding investment.

The higher premium the US now pays should slow the displacement of the dollar internationally, but in the long run, can’t stop it. As US dollar reserves are dumped on the open market at an ever-increasing rate, pressure will mount on US monetary authorities to increase the premium or lift US interest rates.

Deflation in the US (and Australia) is waiting just around the corner. Stock markets are the highest they have ever been in history. Any increase in the official rate will re-ignite deflation and slam markets through the floor.

Domestically within the US throughout 1999, pressures will again swell toward lowering US rates, to combat a slowing economy and intensifying deflation.

The problem with an unsustainable system ; its only a matter of time before you are in a no-win situation. In the months ahead these opposing pressures on US rates are going to escalate dramatically. US monetary authorities will continue walking the razors edge.

Europe is a vast patchwork of differing political ideologies, economic theories, painful memories and cultural habits. It may be that mixing all these elements behind a central currency and bank would be like mixing iron with clay – but time will tell.

The launch of the Euro and the inevitable displacement of the US dollar is not the end of the world. On the other hand, it is sure to add to the turmoil in the months ahead.

I am reminded of Larry Burkett’s closing words captured on the documentary “Millennium Money” when he said “ultimately God is our security, not gold, not silver, not any assets at all”.

by Philip Judge