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Is The Euro Kaputt?

May 22, 2000

The relentless erosion of Europe's new currency is deeply troubling -- the more so because no one seems to understand what is causing the decline, much less why it is all but guaranteed to continue until the euro goes bust.

A bottomless euro threatens to unhinge Europe's economy and destabilize global currency and financial markets. It would also price a growing list of imports beyond the easy reach of European consumers, feeding a downward economic spiral on both sides of the Atlantic.

Relative to the dollar, the euro has shed 25 percent of its value since being introduced in early 1999, falling from $1.18 to a recent low of $0.89. Though not a full-blown collapse, the decline has been steep enough to warn that something is seriously amiss.

Yet the central bankers and policy works remain in denial, to judge by their ruminations on the op-ed pages. There they've admonished euroland to get its financial house in order, presumably by tweaking the relevant monetary and fiscal controls just a tad.

But the diagnosis is wrong, and so is the prescription. Even the usually astute Robert L. Bartley, editor of The Wall Street Journal, seems to have no clue about what is going on.

The problem is one of excess liquidity, he asserted in a recent op-ed piece titled "The Mystery of the Vanishing Euro." Specifically, the euro, with its lower transaction costs and universal acceptance throughout Europe, is simply more efficient -- which is to say, more liquid -- than the 11 smaller currencies it is intended gradually to replace, says Bartley.

Consequently, when euros are substituted in a one-to-one ratio for the national currencies, he says, "liquidity will be increased just as if there had been a sudden increase in the European money supply." To mop up the excess, Bartley suggests monetary tightening, regardless of whether it might dampen Europe's economy.

Even if that were politically feasible in a region that currently supports 10% unemployment, the theory behind it is flawed. For if oversupply were the problem, the ubiquitous dollar would be falling like a stone. In fact, it has been rising steadily against most other currencies for years.

Would anyone argue that dollars are in tight supply? To the contrary, the world is knee-deep in them, notwithstanding the Federal Reserve's supposed efforts to choke off the supply of credit.

"Stoke the supply" of credit would be more accurate. In the final months of 1999, the broadest measurement of money grew at its fastest face of the decade, ballooning at an annualized rate of 18.5 percent. And in the three months that followed, Federal Reserve credit rose at a yearly rate of 63.7%, while the amount of currency in circulation increased 58.6% and the U.S. Monetary Base rose 27%.

To compete with that kind of profligacy, Europe needs to tighten ? Give them a break! It would be like downing a Mickey Finn to cure impotence.

So why does a promiscuously available dollar continue to trounce the euro in global currency markets? Simply because it has become the currency of choice during these boom times for deal-makers and financiers around the world.

As I wrote here a while back, it is a matter of opportunity moving to size: Create a theoretically unlimited supply of credit -- which is precisely what the world has done, using the dollar -- and the shakers and movers will find limitless ways to borrow from it and put it to work.

Moreover, if they are confident that the dollar and all assets priced in dollars will continue to rise, they will wheel and deal in dollars obsessively and to the greatest extent possible, shunning such monetary also-rans as the German D-mark, the French franc, the British pound -- and of course, the euro.

That is the mass psychology that has been driving the dollar ever higher in recent years, and it has become much too deeply ingrained by now to be reversed by the kinds of piddling changes the words would suggest.

But that won't stop them from trying. Over the next 6-12 months, to keep the euro from going brain-dead, and to save face, the central banks will raise interest rates, intervene in currency markets and jawbone, jawbone, jawbone.

But the euro will continue to fall. Eventually, I predict, Europe will be forced to throw in the towel, returning to its old system of national currencies.

The euro hit record lows last week approaching 88 cents, but I expect it to plunge to around 75 cents later in the year or early next, following a brief rally from the current abyss.

When the euro sinks below 80 cents, there will be some wild days in the trading pits. The dollar will be soaring to record heights, creating price spikes on the charts that will likely stand for many years to come.

At the same time, gold priced in dollars will plunge to mark the absolute low of a 20-year bear market. But the swoon will be brief, lasting perhaps just a day or two, just like the dollar's fleeting peak. Then, bullion will begin a long climb that will eventually carry it above its 1970s high of $850 an ounce.

All of which has little practical significance. What matters most is that the bullish psychology of the dollar will have been broken, and that many of the deals that have been leveraged with dollars over the boom years will begin to unravel.

When this happens, we should not expect the central banks to have much success with countermeasures, for the fiscal and monetary nostrums they would administer are throwbacks to a bygone era when currency values were driven by global trade in goods and services.

It is financial transactions that drive currency values now, and the amounts involved are said to exceed $100 trillion, dwarfing a global GDP that amounts to no more than half that.

Any attempt to prop up the euro is therefore destined to fail. It is weak not because Europe has pursued flawed policies, but because it is part of a global money system that long ago decoupled from anything whose value can be measured.

The Federal Reserve Bank of New York holds the world's largest accumulation of monetary gold.
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