A Way Out (?)

The following is a post by Marc Chandler, head of Brown Brother Harriman’s Currency Strategy Team. For more of BBH’s currency views, visit the website here.

We have argued that the EU faces a horrible dilemma.  One horn is the moral hazard inherent in support for a profligate agent, while not necessarily putting a firewall around the other weaker credits in Europe.  The other horn is to do nothing, risking the rout turns into a capital strike.                    
What is needed is not only a solution for this particular crisis, but a new mechanism.  A European bond has much to recommend it.

Recall that during the late 1950s, the Soviet Union removed its dollar holdings from the US, ostensibly fearing they could be frozen or confiscated, and brought them to merchant banks in the UK.  At the same time, there was a cap on US interest rates and there were some forces that were looking to circumvent the mandated ceiling.  The net result was the creation of an offshore market for US dollars–now affectionately known as the eurodollar market.

Europe may be best served by using this crisis as an opportunity to develop a true European bond market.  Now there is a German bond market.  A French bond market.  An Italian bond market.  But not really a European bond market.

The absence of a homogenous bond market in Europe is also arguably one of the reasons that the euro’s share of world reserves is very close to the share commanded by the ecu, the Deutsche mark and French franc previously.
A European bond could serve as a benchmark for the region.  It could be used as a mechanism to ensure financing for countries like Greece, with conditions that EC enforces.   The bonds could be guaranteed by a number of triple-A names, like the Germany, France, the European Bank for Reconstruction and Development, and the European Investment Bank.

A European bond would avoid pitfalls of the Catch-22 under which Greece may only get assistance if it implements its austerity program, but if it does successfully implement its austerity program it won’t need assistance.  A European bond also may minimize the moral hazard issues.                            
However, none of this–European bond, EU or bilateral financial support, or IMF technical support–address an underlying but fundamental issue which is really about competitiveness.

Germany has kept an iron fist on unit labor costs.  No one in the euro zone has been able to match that.   Prior to the advent of the euro, countries would devalue to recoup, at least momentarily (before inflation ate it away) some competitiveness.  That road is blocked by EMU.   Fiscal policy appeared to offer a way to evade the competitive issue, but at a steep price.

Indeed, out of this crisis, the euro-zone is likely to create the mechanisms that prevent a repeat of the fiscal laxity.  Rather than the disintegration of the euro zone or the EU that some prophets (profits?) of doom and gloom are arguing is likely, the more likely result is that there will be more integration (not less) and that means a further surrender of sovereignty.

The implication of this European credit crisis is broadly dollar supportive, insofar as the crisis calls into question the desire to diversify reserves into euros.  Indeed, given the euro’s depreciation, it is reasonable to assume that valuation adjustments alone favor an increased share of dollar reserves and a decline in the value of euro reserves.

These developments in Europe also offer stark contrast to Fed Chairman Bernanke’s indication that the Fed is preparing to taken additional steps "before long" to normalize monetary policy, including raising the discount rate.  This would suggest that the US dollar may be underpinned by structural and increasingly cyclical considerations.