There are well known and documented disadvantages to the common currency of the Eurozone – the Euro. ¬†All the monetary architects and creators of the Euro knew what the risks were. ¬†But they felt that they could overcome them and develop mechanisms to reduce the disadvantages.
Well what are the disadvantages you may ask?
Lack of Strong Federal Government
Each country within the eurozone has it’s own federal government that decides it’s own budget and passes its own laws. ¬†Of course the eurozone countries have treaties that they sign and agreements that apply to all member states, but there is a lack of a strong federal government. ¬†They can share a common currency, but there can be large disparities between taxes, regulation, and laws in various eurozone countries. ¬†Each country within the eurozone has it’s own inflation rate, growth rate, productivity, budget deficit, etc.
Now in the U.S. there are many different states, each with different economic growth rates, unemployment rates, etc, but they are all united under a strong federal government with the congress and executive branch. ¬†Federal laws on taxes, regulation, etc can be applied across all fifty states. ¬†There is a federal government backed by federal tax revenue that can deploy that money without having to go through a lot of hassles like the people in Eurozone go through when they try to structure a support or bailout mechanism for another country.
If a country in the eurozone runs into problems, for example the PIGS – Portugal, Ireland, Greece, and Spain, then this poses a problem for the eurozone because there is a risk that the country or countries become a weak link in the system. ¬†If they are a weak link in the system and run a huge budget deficit, then this poses a problem because a lot of the European banks have exposure to the debt of many other European countries. ¬†And then if they want to structure a support or bailout package, all the countries leaders need to get together to agree on how much money to fund and then they need to overcome their own domestic political opposition.
If the United States wants to structure something similar for its own states, then it just needs to convince congress and the President to do that. ¬†No need to involve the domestic politics of fifteen different countries that each may have their own nationalistic tendencies on money matters.
It doesn’t mean one system is better than the other. ¬†I don’t care about that. ¬†I just explain what is and how it can impact the market and form potential global macro scenarios to profit from.
Two Speed Economies
Due to the disparities in inflation, economic growth, productivity, laws, it was inevitable that a two speed¬†European¬†economy formed. ¬†Certain countries like Germany have an efficiency, productivity and thus competitive advantage over many other countries in Europe, especially Greece. ¬†So you have a situation where the German economy is performing much better than that of Greece or Spain for example. ¬†This poses serious problems to the European Central Bank, because when they set interest rates, they set them for the entire eurozone. ¬†This poses an interest rate¬†dilemma.
To Raise Or Lower Interest Rates?
Normal central banking¬†policies¬†state that if an economy is performing well, then there may be some inflation forming and that would require an interest rate hike in order to contain the inflation. ¬†And the Germans are known for their tough inflation fighting.
But normal central banking also states that if an economy is shrinking, unemployment rising, demand is falling, such as in Greece, then that may require an interest rate cut, in order to stimulate demand in the economy.
However, with the eurozone, you have a two speed economy where there are strong economies and weak economies mixed in together. ¬†So the ECB is faced with a dillema. ¬†Germany requires an interest rate hike, but other countries such as Spain and Greece require an interest rate cut. ¬†What does it do? ¬†Well currently it has decided to embark on a rate hike process. ¬†It deems the inflation threat greater. ¬†Also the ECB only has a price stability mandate, unlike the FED which was a dual mandate of both price stability and full employment.
So the ECB starts hiking interest rates even though the peripheral¬†Mediterranean¬†economies may require an interest rate cut. ¬†The inflation in Germany is tamed, but the interest rate hikes can tank the economies in Spain, Greece, etc. ¬†They can exacerbate the debt crisis as if the economies tank, economic growth goes negative, or further negative, and good luck paying off debts when economic growth is negative.
Thus the formulation of the Euro, abolished¬†independent¬†monetary policies. ¬†Back in the days when each country had their own currency, if an economy ran into trouble, that country could slash interest rates. ¬†That country could also devalue it’s currency. ¬†The central bank would devalue the currency, or the market would do it itself as it saw lower interest rates and recession brewing in that economy.
Being able to slash interest rates and devaluing a currency are very powerful recession fighting tools that the economies of Europe have lost out on. ¬†Although Britain has still made a good choice in keeping their pound sterling.
Of course there are advantages to the Euro, otherwise they wouldn’t of created it.
Disadvantages Remain Concealed Until…
Now when the times are rosy, and the global economy is growing like it was back in the middle of the 2000’s, these issues do not concern the market. ¬†For the countries can borrow money at reasonable interest rates and spend as much as they want.
When the problems crop up is when a crisis comes. ¬†When a recession comes. ¬†When a global financial crisis comes. ¬†And that finally came in 2008. ¬†The euro dropped precipitously in the second half of the year from 1.60 down to 1.25. ¬†A lot of it was from the dollar safe haven bid.
Then the problems cropped up again in the first six months of 2010. ¬†Now the problems are creeping up again in the summer of 2011.
So how does this play out in the global macro world?
Well, there are two conflicting order flow generators. ¬†On the one hand you have a situation where the European Central Bank (ECB) is raising interest rates. ¬†Thus there is a bullish order flow component to this as there are players in the currency market chasing the higher interest rates.
But there is a potential bearish order flow component that can creep up at some point in the future. ¬†If the market realizes that the interest rate hikes are starting to kill growth in some of the weaker eurozone countries and exacerbating the debt crisis, then that can generate bearish order flow.
The market likes interest rate hikes if they are backed by a strong and growing economy. ¬†But if the market participants believe that the interest rate hikes will cause growth to crater, or cause a crisis to come, then macro sellers will come in to start hammering EUR/USD lower. ¬†High interest rates are nice, but holding the currency when the economy around you is going into recession is not the best of ideas either.
Don’t try to use this knowledge for day trading. ¬†This is probably too long term for that. ¬†But look out for the market changing sentiment and sensitivity about interest rate hikes to see if you can spot the shift over the coming months. ¬†It may happen, or it may not. ¬†I just take it day by day.
Of course there is also the possibility of a successful resolution to the debt crisis. ¬†That is always a¬†possibility.
Then there is always the other component of the currency pair. ¬†The USD component. ¬†After all there is a reason it is called a “currency pair.” ¬†Gotta watch out for the potential macro factors coming out of the United States too, which can effect the price of EUR/USD.
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