``Inflation is not the result of a curse or a tragic fate but of a frivolous or perhaps even criminal policy.” -Ludwig Wilhelm Erhard
Lady Luck seems to smile at us, given that our forecasts of last week appear to have been serendipitously realized. The Euro surged by 2.4% over the week and risk assets turned materially positive, exactly as we spelled out[1].
But of course, we hardly ever talk about ONE week, we allude to near to medium term which may cover the outcome for the rest of the year. Perhaps the Euro may recover to the 1.30 to 1.32 level by the yearend?
There are three more reasons why the Euro should persist to rally and why risk asset markets are likely to gain momentum.
First of all, emerging markets continue to lead the way in terms of economic growth[2], whereby EM economies may do some heavy weightlifting to buttress developed economies.
And the cyclical broad based EM led global economic recovery, as a result of the expansive monetary policies and from globalization friendly policies, will likely expand global trade.
By cyclical recovery we allude to the bubble cycle.
Yet considering what mainstream calls as ‘global imbalances’, seen in many ways as ‘savings glut’, ‘dearth of investments’ or ‘Bretton Woods II’, instead we see this in terms of the Triffin Dilemma, where an international reserve currency, particularly the US dollar, would need to run large deficits in order to finance this burgeoning global trade from the cyclical recovery.
The Triffin Dilemma, according to Wikipedia[3], ``was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency, to fulfill world demand for foreign exchange reserves.”
``The use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: to maintain all desired goals, dollars must both overall flow out of the United States, but dollars must at the same time flow in to the United States. Currency inflows and outflows of equal magnitudes cannot both happen at once.”
This is one explanation mainstream can’t accept because it puts into the light or magnifies the inherent flaws of the current monetary standard, which the theory projects as unsustainable. Of course, homemade or national policies exacerbate such conditions.
But the point is, mainstream sees that the de facto currency reserve standard as an entitlement that must never be compromised, hence espouse theories even where water, in its natural state, can move upstream.
For instance, some see monetary policies will be engineered to promote exports.
Figure 7 BCA Research: Bearish On US Dollar
According to BCA Research[4], ``The U.S. also needs strong exports and an improving trade balance to add to GDP growth. Last week’s news on the U.S. trade front was not encouraging, with the deficit widening again in April. Furthermore, cyclical and structural factors are pointing to even wider trade and current account deficits ahead. In turn, with the unemployment rate still near 10%, U.S. policymakers are also unlikely to tolerate significant strength in the dollar and the consequent drag on growth.”
This outlook sees the application of monetary policies as a ‘one way street’ or where the policy actions of the other pair (or the other nation which is represented by the opposite currency) may not offset those of the US. This is pretty much one sided because monetary policies are not only relatively dynamic but also has relative impacts from perpetually evolving policy actions.
Secondly, the implication is that export growth can only be achieved by devaluation. Hence the kernel of this mercantilist leaning view is that every nation will try to out-export each other by competitive devaluation, or the race to devalue via inflationism which presumptively leads to prosperity.
Yet this outlook could lead to fatal results, as Ludwig von Mises warned[5], (bold emphasis added)
``they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies. If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively. A general acceptance of the principles of the flexible standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations' monetary systems.”
In other words, nations don’t trade people do. Yet people don’t trade to generate economic growth, people trade to have a need fulfilled and or to obtain profits. Nations only account for the cumulative actions of individuals. Hence inflationism isn’t an optimum way to meet such goals.
Besides, merchandise trade (exports and imports) for the US is only about one-fourth of the economy, such that the call to devalue in order to support the export industry, which is only 12% of the economy at the expense of the 88%, would seem absurd. Moreover, US unemployment from the 2008 crisis has been less related to the export industry as most of the job losses has emanated from the bubble areas (e.g. mortgage, construction etc...).
For me, the Triffin Dilemma has played the biggest role in shaping the underlying trend of the US dollar. And a global recovery translates to a weaker US dollar.
Next, the credit risks seem tilted towards US states than from the Eurozone economies (see figure 8)
Figure 8: The Economist: American states' finances are worse than those of some euro zone countries
According to the Economist[6], (bold emphasis mine)
``RECENT comparisons made between some American states' finances and those of Greece are exaggerated. But credit-default-swap (CDS) spreads, which measure investors’ expectations of default, are wider for some American states than for some of the euro zone’s other peripheral economies. On June 17th the cost of insuring Illinois’ bonds against default hit a record high, rising above that of California, America’s largest municipal borrower. Both considered riskier than Portugal’s debt. New York and Michigan are higher than Ireland’s. Like euro-zone members, American states may not declare bankruptcy and cannot be sued by creditors. And like many European governments, legislators are reluctant to impose the pain necessary to close budget deficits.”
As we pointed out last week, the downtrodden state of the Euro has emanated mostly from overly depressed sentiment. This has constrained demand for the Euro and has been more than the problem of relative structural issues, which seem to lean against the US. Thus, when finical sentiment shifts, structural issues will come into play.
Importantly as the Economist explains, fiscal discipline may not be stringently observed by both the affected parties in the Eurozone and in the US states. That’s because this may not be politically palatable for politicians. This serves as euphemism more inflationism.
Lastly, if the Euro is soon destined towards disintegration, as alleged by some, then she is probably looking towards the inclusion of more nations to join her death leap.
That’s because the Eurozone has enlisted Estonia as her newest member. Estonia will be the 17th country to carry the Euro by January 1, 2011.
Earlier we dealt with Estonia’s free market leaning approach even towards dealing with the recent crisis[7]. And perhaps such accomplishment has been recognized by the Euro bureaucracy.
According to the New York Times[8], ``Meeting in Brussels, Europe’s 27 governments hailed the “sound economic and financial policies” that had been achieved by Estonia in recent years. They said Estonia would shift from the kroon to the euro on Jan. 1, 2011.”
And unlike Greece who fudged their data to foist herself into the EU membership, Estonia seems more qualified.
Or perhaps could it be that Euro officials have been desperately looking for an agitprop to buttress their position? This from the same New York Times articles[9],
“The door to euro membership is not closed because we are going through a sovereign debt crisis,” said Amadeu Altafaj, a spokesman for Olli Rehn, Europe’s commissioner for economic and monetary affairs. “Estonia’s admission is a sign to other countries that our aim is to continue enlarging economic and monetary union through the euro.”
“Continue enlarging economic and monetary union through the euro” even when the Euro is in the death throes? Hmmm.
In my view, these three factors, specifically, growing global trade which should expand US trade deficits and amplify the effects of the Triffin dilemma, the credit risks slanted towards US states more than the EU and Estonia’s as the Euro’s newest member should all add up to boost the Euro vis-a-vis the US dollar.
Of course, a better bet in place of the Euro should be Asian currencies, including the Philippine Peso.
[1] See Buy The Peso And The Phisix On Prospects Of A Euro Rally
[2] See Another Reason Not To Bet On A 2010 'Double Dip Recession’
[3] Wikipedia.org, Triffin Dilemma
[4] BCA Research Currencies: Still Broad U.S. Dollar Bears
[5] Mises, Ludwig von The Objectives of Currency Devaluation, Human Action, Chapter 31 Section 4
[6] The Economist, Risky business, June 18, 2010
[7] See Estonia’s Free Market Model And The US 1920-1921 Depression
[8] New York Times, What Crisis? The Euro Zone Adds Estonia, June 17, 2010
[9] Ibid
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