The Euro - a viable alternative? No way!

The following is an extract from commentary that was posted at www.speculative-investor.com on 27th January 2002. 

With the euro having taken a beating on the foreign exchange market last week it seems like an appropriate time to reiterate our medium- and long-term views on the new European currency. But first, let's review a couple of related extracts from our recent commentaries.

From our 2nd December 2001 commentary (we were explaining why we thought the Dollar would remain strong during the first quarter of 2002): "Thirdly and perhaps most importantly, the conversion of all the European national currencies into euro notes and coins begins on 1st January 2002 and must be complete by 28th February 2002. Euro-bulls no doubt believe that once the euro has a physical presence its value relative to the Dollar will rise, but that is not how these things usually go. Not everyone who owns German Marks and French Francs will be happy to exchange them for euros. In fact, some of the existing holders of Marks and Francs will prefer the perceived safety of an international currency that has been around for longer than 15 minutes. The forced conversion to euros may therefore give the demand for US Dollars a substantial boost during the first quarter of next year. Note that this is potentially one time when a weak euro will not go hand-in-hand with a weak gold price since a flight from the euro would probably boost Dollar demand and gold demand."

And, from our 2nd January 2002 commentary: "The conversion of the existing European currencies into euro notes/coins has been cited by some analysts as a reason to be bullish on the euro and bearish on the Dollar. The fact that the conversion seems to be proceeding quite smoothly has certainly generated some enthusiasm for the euro in the foreign exchange market, but we think this enthusiasm will be short-lived. We are medium-term bearish on the Dollar, not because of the euro but in spite of the euro."

The introduction of euro notes and coins was not a reason to be short-term bullish on the euro. How could it be? How could the fact that the people of Germany and France were being forced to exchange their Marks and Francs for an unknown quantity be anything other than a short-term negative?

A lot of spurious justifications for being bullish on the euro have been put forward over the years. One of the most popular is that the euro will be the equal of, or even superior to, the US dollar because the euro will be used throughout a region that has a higher GDP and a higher population than the US. But does size really matter? After all, for much of the past 30 years the Swiss Franc has been considered to be superior to the US Dollar, yet compared to the US the Swiss have a small economy and a small population. Would the euro become a stronger currency if, for example, the size of the 'euro zone' was increased via the additions of Bosnia, Belarus, and Estonia?

We've been bearish on the euro since early-1998, one year before its introduction. Perhaps we lack vision, but we just couldn't see how the euro could ever be appreciably stronger than its weakest link/component. The best case for the euro, in terms of its standing in the foreign exchange market, might be that it becomes an average of its components - weaker than the German Mark but stronger than the Italian Lira. Another concern of ours has been that the entire basis for the euro is wrong. Monetary union in Europe appears to be the first step in a plan to bring-about political union, with the plan being carried out in a deceptive way (the euro certainly hasn't been sold to the people of Europe as if it were a means to a political end). 

We've mentioned on a number of occasions over the past 3 years that the euro has been, is, and will continue to be, a boon for the US Dollar, because rather than create a viable alternative to the Dollar the introduction of the euro has eliminated viable alternatives. The DMark was a viable alternative for decades, but it has now disappeared. The Swiss Franc was, for a long time, an excellent alternative to the Dollar, but the Swiss have made it painfully clear that they want the SF to trade in synch with the euro. The Pound still remains as an independent currency, but not for much longer if Tony Blair has his way.

Getting back to our question as to whether size matters when it comes to a currency, the answer is obviously no. A fiat currency is not backed by the economic output of the country or region in which it is used. US GDP was far greater than that of any other country during the 1970s, yet the US Dollar slid relentlessly lower during that period. A fiat currency - any fiat currency - is backed by only one thing: confidence. A country that can somehow maintain a high level of confidence in its currency and its financial institutions while, at the same time, expanding the supply of credit at a rapid rate, will become a magnet for foreign investment. The US has been able to do just this over the past few years.

Although we have our reasons for disliking the euro in principle and not considering it to be a viable long-term alternative to the US Dollar, we think that 2002 will turn out to be an UP year for the euro's foreign exchange value (relative to the Dollar). This is because, with 2002 likely to be the third consecutive DOWN year for US stocks and also a DOWN year for US Government bonds, the US will be unable to attract investment at a fast enough pace to offset its current account deficit. Despite its recent strength the US$ has done little more than tread water over the past 16 months (the euro is still well above its October-2000 low), which points to capital out-flows approximately matching capital in-flows over this period. Any drop-off in the amount of investment flowing into the US, something we certainly expect to see over the course of this year, should therefore lead to a Dollar decline.

Taking a 12-month view there are plenty of reasons to be bearish on the Dollar, but one of those reasons isn't the euro. For those looking for a viable long-term alternative currency to the Dollar there is only one that we know of and that is gold. Even in the medium-term we consider gold to be a much better option than the euro (or any other fiat currency) for those wishing to diversify away from the US$. This is because a fall in the Dollar's exchange value will create a bull market in gold (or, it could be argued, amplify the existing bull market). In a gold bull market the price of gold rises in terms of all fiat currencies. 

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