Comment 74: The Euro Crisis, the Cause and the Impacts (June 9, 2010)

The cause of the Euro crisis is Euro itself since Euro is an unstable currency due to the intrinsic shortcomings in its very concept. When a country joins Euro, it yields the sovereign power of creating its own currency to The Euro Central Bank and adopts Euro as its currency. The exchange rate of the local currency to Euro is determined by the relative economic strengths among the Euro members at the time of the application to join Euro. Euro region encompasses many different economic entities at various stages, ranging from high value added producers like Germany to low cost producers like Greece, Ireland, Portugal, Spain and so on. However, the global economic environment changes continuously and the impacts on each Euro member differ widely. This means that the actual relative exchange rates among local currencies should change according to the global economic environment, but cannot due to the rigidity of Euro. Thus distortions and stresses build up within Euro region and eventually explode to create mass chaos. That is what the Euro crisis is all about. Apparently the crisis cannot be papered over by no matter how large a rescue fund is created. Let us see the concrete series of events that make the above argument the reality.

Since the onset of "globalization" in early 1980s, The United States has been the lone country with its enormous trade deficit single handedly matching the aggregate of trade surpluses of crude oil producers and Asian exporters. This implies that trade surplus countries are getting U. S. dollars for their trade surpluses. Then come the inception of Euro at the beginning of 1999. Many trade surplus countries have mistakenly viewed the intrinsically unstable Euro as a new super currency rivaling U. S. Dollar so they have sold dollars at hand for Euro to diversify their foreign currency reserves. However, Euro region as a whole has not been running significant trade deficit so there is no big free floating Euro pool to tap into. As the consequence the governmental buying of Euro had pushed Euro higher and higher against U. S. Dollar. At January 2, 2002 when the U. S. economy emerged from the 2000-2001 recession and the trade deficit had started to expand anew, Euro was trading at the rate of $0.9/Euro. By April 22, 2008 Euro hit $1.6/Euro. With the high flying Euro low cost producers in Euro region lost quickly their competitive power to their Asian rivals that pegged their currencies to U. S. Dollar. Those low cost producers in Euro region issued Euro denominated sovereign bonds to cover their trade shortfalls, used the borrowed money for domestic spending and infrastructure and real estate constructions, and led good life unaware of the coming financial and economic crisis just like policy makers, most economists and analysts in other countries all over the globe. As the crisis hit, again just like all other countries, those low cost producers in Euro region are forced to give large governmental stimuli to keep their economy from collapse, and further exasperated their sovereign debts. Another onslaught of Asian imports since 2009 weakened those low cost producers in Euro region more, financial markets lost confidence on those countries and refuse to refinance their sovereign debts, and have forced them to the brink of default. Thus comes the Euro crisis. How does the latest onslaught of imports from Asia come about? To understand the situation we need to rewind the time scale back to the pre crisis years.

When dollar rich Asian exporters and crude oil producers sold dollars for euros during the go-go years of Euro, those sold dollars went into Eurodollar market to be borrowed. European speculators, just like their American peers, borrowed those dollars in short-term and loaded up toxic debts related to American mortgages. As the climax of the financial meltdown hit in the fall of 2008, short-term dollar loan market disappeared, and those European speculators, just like their American peers, faced the risk of imminent default since they could not roll over their dollar loans. On the American side The Federal Reserve injected unlimited amount of dollar liquidity and saved those American speculators from ruin. On European front, The Euro Central Bank cannot issue dollars so it injected large amount of Euro liquidity. European speculators borrowed those Euro liquidity, dumped them for dollars and repaid their dollar loans. Thus Euro tumbled against Dollar. By the spring of 2009, Euro had fallen to $1.25/Euro level. As the liquidity squeeze eased due to the massive creation of money by central banks, Euro staged a natural rebound vs. Dollar to certain degree. Then Asian exporters piled in to push Euro higher and higher until reached $1.5/Euro level by the spring of 2010. Why do Asian exporters want to push Euro higher? The recession of 2007-2009 was triggered by the default of U. S. consumers. Since then U. S. banks have become very cautious in making consumer loans. Without the large influx of money from consumer loans, U. S. consumers were not able to buy massive amount of foreign made goods like in the go-go years, so U. S. trade deficit has plunged. Asian exporters were hit hard, and want to find new patrons for their exports. They naturally set their eyes on rich Euro region countries like Germany. To open the flood gate of mass exports to Europe, Euro must rises vs. Dollar since Asian exporters, except Japan, have pegged their own currencies to Dollar. Ironically the torrent of exports from Asia into Europe have become the last straw that broke the back of low cost Euro producers and triggered the crisis of Euro. What are the impacts of the Euro crisis on the global economy? Some analysts and politicians suggest that the Euro crisis has nothing to do with U. S. and Asian economy, and the markets are behaving irrationally. We strongly disagree with those Pollyanna like opinions. Let us trace out the impacts of the Euro crisis next.

On the face of the rising risk of sovereign defaults of those low cost producers in Euro region, rich Euro members, with the assistance of IMF and The Euro Central Bank, assembled a huge rescue package. However, the root cause of the problem is the loss of competitiveness of those low cost producers to their Asian rivals, and the problem cannot be solved by the rescue package. Structural reforms, even doable, takes many years to be effective. The urgently needed remedy is the devaluation of the currencies of those low cost producers against U. S. Dollar until they have a level playing field with their Asian rivals. Of course, with the rigid structure of Euro, the devaluation needs to take down the whole Euro versus Dollar. That is what the market is mandating by pushing Euro steadily down against U. S. Dollar. For a major currency movement to be translated into the movement of trades, six months to a few years of time delay is required according to the level of products involved in the trade. As time goes on, Asian exports to Europe will wane, causing the growth of Asian exporters to slow down. The noticeable bright spot in this economic rebound is the surge of capital goods manufacturers. The export of capital goods from U. S. to Asia exporters underlie to a large degree this rebound of manufacturers. As Asian exporters slow down, so will U. S. manufacturers. Furthermore, the falling Euro gives capital goods manufacturers in Germany a windfall advantage. U. S. manufacturers will face a stiff competition from Germany at the time when the demand from Asian exporters is shrinking. As the result U. S. economic recovery will also slow down, and The Federal Reserve needs to keep the near-zero interest rate policy much longer than the case of without the Euro crisis. As for the stock market, it always stages strong rallies near the end of a recession as has been pointed out in Comment 64. The recent rally from March of 2009 is not an exception. However, as has been pointed out in Comment 70, the rally at the end of 2000-2001 recession eventually fizzled and made lower lows compared to the bottom reached at the peak of the recession even without any double dip; only a lackluster recovery was enough to create the debacle. If the current U. S. recovery slows down substantially, like down to 2% annual growth in GDP, the possibility of revisiting the March, 2009 low cannot be excluded. That is why we need to monitor the evolution of the Euro crisis continuously.