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Which is Safer, the Dollar or the Euro?
06/30/2011 7:30 am EST
With the Greek austerity plan up for a vote, and Greeks in the streets, it's a good time to look at what this Eurozone turmoil means for the euro and the US dollar, writes Axel Merk of Merk Insights.
Is the euro or the US dollar safer? Before jumping to a conclusion one way or the other, let’s look at different sides of their respective coins.
We have been warning for years that there may be no such thing as a safe asset anymore, and that investors may want to take a diversified approach to something as mundane as cash.
We believe Greece has rather serious issues, but concerned investors may want to take a closer look at their dollar holdings for potential “contagion” risks. Let us explain…
Each Has Risks…
The dollar risk hiding in plain sight are US money-market funds. Just like all investors, money-market funds have been scrambling for yields.
With yields on three-month Treasuries at a rock-bottom annualized 0.02% as of this writing, money-market funds have had to look for riskier investments to make ends meet.
The point here is: investors have a choice and should be conscious about the risks they are taking on. In practice, many investors embrace US money market funds, but may shy away from the euro.
Our argument continues to be that the issues in the Eurozone are serious, but that they should be expressed in the spreads in the bond markets. Meaning, it is perfectly compatible to have a strong euro with Greek debt selling off.
It is precisely because less money is spent and printed in the Eurozone that the euro has been able to rally.
Bernanke has testified that going off the gold standard during the Great Depression helped the US recover faster from the Great Depression than other countries. While such a policy is not compatible with the Fed’s mandate of price stability, such a policy may indeed spur nominal growth (subject to various risks).
What many don’t realize is that someone is on the other side of the trade. Currencies of countries—or the Eurozone in this case—that don’t actively debase their currency may end up with a lot of pain, and less economic growth, but potentially a very strong currency.
You may not want to hold Greek debt, but how about the euro through German Treasuries? There are other choices, such as the Swiss franc or gold, to name but two.
What makes the euro different amongst these choices is that the euro appears out of favor with many investors. The euro may present a good value opportunity for those who believe the currency can thrive even with all the challenges going on in the Eurozone.
NEXT: Contagion Risk…|pagebreak|
So what about contagion risk? We tend to disagree with both camps: those that say that all will be fine don’t respect the markets—an attitude that may be hazardous to one’s wealth.
On the other end of the spectrum, we have policy makers such as Jean-Claude Juncker, the prime minister of Luxembourg and “President of the Euro Group” (the head of Eurozone finance ministers), who warn of apocalyptic consequences.
First, it’s not in Greece’s interest to default at this stage. If Greece were to default now, the country may not be able to get financing at palatable terms, thus forcing an overnight adjustment of its primary deficit.
Greece’s problem is not one of a strong currency (by being part of the euro), but an inability to collect taxes—combined with too many promises made to its people, many if not all of which will inevitably be broken.
Similarly, it’s not prudent for the stronger Eurozone countries to cut their aid at this stage. German exports are booming, among others, because of the weaker euro caused by Greek debt worries.
In the Eurozone, the current account is roughly in balance, making it possible to have lackluster economic growth combined with a strong currency.
Ireland appears to be following through in imposing losses on unsecured debt holders of Irish banks. But because the country’s entire business model is based on serving the Eurozone, an exit from the euro is (in our view) most unlikely.
Indeed, we are more concerned about potential fallout to the pound sterling stemming from any Irish crisis, because of exposure of the British banking system to Ireland.
Portugal is a small country that rose to the challenge rather late. Its banking system is in decent shape. We won’t speculate about Portugal’s fate here, shall note that we believe any shock stemming from the country can be absorbed.
Spain is a different story: it’s a big country with a big economy that went through a housing bust. Spain’s total debt-to-GDP ratio is low for advanced economies, even if the budget deficit and unemployment are currently high.
Spain started to address issues in its banking system well before stress tests became fashionable, and is moving about as fast as possible given Spain’s history and culture.
Italy survived the financial crisis well, and did not substantially ramp up expenditures due to the crisis.
Italy’s Achilles' heel is its total debt-to-GDP ratio, not to mention an ailing government. Still, most of Italy’s debt is domestically owned, and the market places Italy—rightfully so, in our opinion—in a more stable category than the small peripheral countries.
Finally, note that we believe an exit of, say, Germany from the Eurozone is not in the cards. A "new Deutsche Mark" would kill Germany’s export-driven economy.
The departure of a strong country would suck money out from the Eurozone financial system, causing a collapse. And if Germany were to leave its obligations denominated in euros, as some have suggested, it would be considered a partial default—causing irreparable damage to Germany’s cost of capital.
There is no silver bullet to resolve the Greek debt crisis. Indeed, it’s not merely a Greek or “PIIGS” crisis—it’s a global sovereign-debt crisis, where the debt-to-GDP ratio in developed countries is exceeding 100%.
Rather, it will be a drawn-out process. In our assessment, it may be a painful process, but one in which the euro may substantially outperform the US dollar in the medium to long term.
Is the euro safe? No, but in our opinion, it’s odds look better than those of the US dollar.
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