Why the Alps will Tower the Rockies

or, Wagering on the Euro


Euro-bashing has become the favourite sport of many an economic commentator. Unaddressed structural problems and bureaucratic inertia in the Euro-zone has provided valuable ammunition for the critics of the common currency, and the combination of weak confidence and self-fulfilling expectations has exacted a heavy toll on its exchange rate. In defiance of the grain, I believe that it is possible for the Euro to reassert itself in foreign exchange markets, and fortunately, my convictions are neither premised on the risky and unpredictable nature of unsterilised interventions nor on the sound, albeit slow, policy of microeconomic reform.

There have been a plethora of reasons advanced for the weakness of the common currency, ranging from microeconomic problems - best illustrated by the distortionary spectre of the much-maligned Common Agricultural Policy - to macroeconomic influences, such as the apparent ambivalence of the European Central Bank to adopt a firm stand on its purpose and direction. Yet, the changing economic landscape is the best testimony to the fact that the Euro will rise from its doldrums and enter into a higher level, the best efforts of speculative currency traders notwithstanding.

Featuring most importantly is the weakening US economy. Although the sole engine driving the world economy for the past few years as Europe, Japan and Asia stuttered, recent indicators from the world's largest economy have shown ominous signs. The soft landing sought after by Federal Reserve Chairman Alan Greenspan has threatened to stall the economy into a recession, and even if recent disheartening data from consumer confidence measure, GDP growth rates and the battered stock market improve, it seems unlikely that the US will steer itself back into the dominance it enjoyed for almost a decade.

This translates directly into the possibility of a Euro recovery. In the recent past, the globalisation of capital flows has dominated home bias effect, as European liquidity flowed into US markets to exploit the superior returns in the red-hot economy. As the US slows, these funds will increasingly look back towards home, where economic data is beginning to look increasingly favourable vis--vis the US. Compound this by attractive returns in Asia and Latin America, the double whammy of capital outflows from the US and capital inflow from European funds back into Europe might prove to be an important force in re-energising the Euro.

As liquidity returns, the Euro-zone will inevitably be boosted, and this would drive a self-perpetuating virtuous cycle that would lift the currency and keep it there. Further, a Euro which more closely reflected the economic fundamentals of the zone would allow the ECB to concentrate on its primary task of sustained growth with low inflation, instead of being torn by multiple objectives. This can only prove to be good for the countries in the zone and hence further enhance the attractiveness of Europe as a destination for investment.

Finally, political economy factors add fuel to the kindling flame. ECB officials seem to finally have gotten their act together, and the frustrating and confusing habit of their issuing conflicting policy statements seems to be something of the past. The attempt by governments and officials to talk up the Euro seems to have abated as well, and their reconciliation of the fact that market valuations were possibly justified has freed them to (finally) concentrate on pushing through real reforms rather than blaming the Soroses of the world. An unexpected - but certainly welcome - development would be Britain's firm commitment to the currency; although its absence should not be too large a mitigating factor against it.

In the longer run, as the Euro gains the respectability and confidence that a common currency of a zone worth more than EUR 1600 billion, the rest of the world will increasingly diversify portfolio holdings to include the Euro and Euro-denominated assets, sealing the role of the currency and ensuring that the unfortunate episodes in the early years of the fledgling currency will remain a memory.

This article is unpublished.