As fears of a US dollar meltdown have loomed ever larger in recent years, major
investors, including central banks, have moved significant portions of their
cash reserves into the euro, the currency of the European Union (EU). And while
it is true that the euro offers some shelter from the American economic
catastrophe, the currency does come with baggage that investors should not
ignore.
Introduced as an accounting medium in 1990, the euro became an actual currency
in 1992. It is at present issued by 16 of the 27 EU member countries,
representing some 329 million people.
With the equivalent of almost US$1 trillion in circulation, it is the world's
largest physical currency.
The birth of the euro was a stunning example of putting the cart before the
horse. When it was first issued as a physical currency in 1999, the major
states that participated were not yet united. Many believe that this premature
introduction was done to hasten the political union. In hindsight, the strategy
was successful. The single currency removed a key psychological barrier towards
unification.
As soon as it made its debut, the euro quickly became the second-largest
currency held in the official foreign reserves of central banks. Major
corporations and investors followed suit. By September 2007, former Federal
Reserve chairman Alan Greenspan said it would be "absolutely conceivable that
the euro will replace the dollar as the dominant foreign reserve currency, or
will be traded as an equally important reserve currency".
However, the structural problems that were so heavily debated at the birth of
the EU remain unresolved. These uncertainties may undermine the euro as a
viable dollar-alternative. Should recent economic strains continue unchecked,
investors, institutions, and central banks may move heavily into gold as an
ultimate "safe haven".
In the US, monetary union depends upon political union. When California faces a
crushing debt burden, it can neither print its own highly inflationary currency
to ease the pressure (though its "IOU's" are a haphazard attempt) nor leave the
union to avoid this constraint. Thus, crises in US states tend to push states
toward the central government as they seek assistance from Uncle Sam. EU member
states similarly lack their own printing presses and are therefore unable to
monetize their problems. But in Europe, the emergency exit is always open -
states can leave if they believe their interests are not being considered.
The EU does not have a common fiscal policy, so countries are free to bankrupt
themselves according to their own decree. But when they do, there is no formal
option of seeking a bailout from the pan-European government. Even if such a
road were available under the EU treaties, the European Central Bank, modeled
on the famously inflation-wary German Bundesbank, would be unwilling to
monetize the additional spending.
Partially because of this stringent monetary policy, the euro has risen by some
40% against the dollar since its launch. This has severely hurt eurozone export
economies like Spain, Portugal and Italy, who have long relied on currency
devaluation to subsidize their manufacturers.
While countries like Germany, the world's largest exporter, have been
successful in utilizing the benefits of a strong currency to continue selling
products at a real profit, others have failed. Indeed, both Italy and Greece
now have government debts in excess of gross domestic product (GDP) - 115% and
113%, respectively. Furthermore, Greece, with a budget deficit of some 12.7% of
GDP, is now threatened with default.
Although the EU, by and large, currently spurns talk of a bailout for Greece,
the debate will intensify if the economy deteriorates further. If, in order to
preserve union, the EU does decide to bail out an individual member state, what
precedent would that set?
Germany, the strongest EU economy, found it a Herculean task to bail out just
17 million people in the former East Germany. Could it even contemplate bailing
out not one but several other EU member states, without attendant political
control?
There seems little room to move forward under the status quo. Though the Lisbon
Treaty (read, EU constitution) has just come into effect, it was passed without
the mandate of citizen referenda. The member states remain culturally distinct,
the citizens have little allegiance to the behemoth in Brussels, and,
therefore, it seems far-fetched that the EU would go to war to compel one of
its members to remain in the club. With little to glue it together, investors
are questioning whether the eurozone is strong enough to withstand the shocks
that would accompany a dollar collapse.
As the credibility of the US dollar has eroded and that of the euro is now
suspect, it is likely that investors will continue their quiet rush into gold.
If so, silver is likely to become a store of value for smaller investors and
the small change of the rich. In such a world, the price of silver could rise
even faster than that of gold.
John Browne is senior market strategist, Euro Pacific Capital. Euro
Pacific Capital commentary and market news is available at
http://www.europac.net. It has a free on-line investment newsletter.
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