The European currency has depreciated dramatically against the US dollar in the past few months, falling from over $1.50 on December 1st to $1.35 today. The move has caused many investors to question the viability of the European Union and its currency, while also serving to reinforce the notion of the USD’s position as the world’s reserve currency.
To be clear, there has never been any question in my mind that the euro is just another flawed fiat currency. It could never serve as a real place holder for investor’s wealth or become a viable alternative to owning precious metals. However, it deserves to maintain its status as an excellent diversification- currency for those who hold excess dollars. But we currently find the question being asked more today than ever before if the USD can act as a safe haven from the troubles over in Euro land? The answer to that question can be found in the data and the data clearly shows that it cannot.
The 27 countries comprising the European Union’s economy is the largest in the world. It’s GDP on a purchasing power parity basis was $16.5 trillion in 2009, which is greater than the $14.2 trillion US economy. The economies of the 16 countries in the Euro zone that use the Euro currency produced GDP of about $10.5 trillion on a PPP basis according to the CIA 2009 world fact book. That is equivalent to 74% of US total output. Therefore, the economies of the EU (27) or Euro Zone (16) are similar in size and scope to those of the US and should be viewed with the same gravitas. The size of the European economy is not an issue.
U.S. GDP contracted 2.7% in 2009 compared with a contraction of 4.2% in the Euro (16). However, the annual change in prices in the Euro Zone was just .9%, which is lower than the 2.7% Year over Year increase in the U.S. Consumer Price Index. Therefore, while both nations suffered from a loss of total output--with the Euro Zone contracting at a slightly greater pace than that of the U.S.--the U.S. also suffered from a greater rate of inflation. The data on growth and inflation is a wash and does not argue for a much stronger dollar.
Yet according to the IMF, the US dollar accounted for 64% of global central bank reserves. In comparison, the Euro currency represented just 26%. Why is it that the U.S. economy deserves to represent such a tremendous over-weighting of central bank reserves? Since their currency holdings are so vastly concentrated, it places global central banks in a tenuous and vulnerable position. Should they ever need to reduce their dollar holdings—especially in concert--it would place tremendous downward pressure on the US currency. But unlike the greenback no such over-owned condition along with its concomitant pent-up selling pressure exists for the Euro.
There has also been much distress over the current state of Greek debt and justifiably so. The European Commission has projected the Greek deficit will reach 12.2 percent of GDP and have gross debt of 124.9 percent as a percentage of GDP in 2010. However, taken in aggregate the average deficit in the Euro zone will reach 6.9% of GDP in 2010. Yet the deficit in the same year for the United States is projected to reach a far greater 10.6% of GDP.
Not only is the annual shortfall of red ink greater for those of us who use the greenback but from a gross national debt standpoint it looks equally unfavorable as well. Currently the gross national debt of the US stands at 87% of GDP. The European Commission projects that their gross national debt will reach 84% of output this year and 88.2% in 2011. And In contrast, the Congressional Budget Office projects our national debt to reach over 100% of GDP in 2012, whereas the national debt of the EU will not reach 100% of output until 2014 according to the European Commission.
While many investors are flocking to the USD for safety because of debt downgrades in Greece, they are overlooking the risks associated with our own fiscal imbalances. Steven Hess (senior credit officer in the sovereign risk group of Moody’s Investors Service) said this about the US sovereign credit rating in a Reuters interview a few weeks ago, “…at some point, we don’t know when, there would be downward pressure on the US credit rating.
Therefore, not only is our debt situation worse than Europe’s but our interest expense may increase significantly if or when our sovereign credit rating is cut. Our debt service would then rise dramatically causing GDP to contract. The Fed may be forced to step up their monetization of government debt, which would send inflation rates rising dramatically. The result would be an even higher debt to GDP ratio and may cause a massive global rush out of dollars.
How then can the USD be seen as a safe haven from the Euro? The two currencies have similar sized economies and there is no trenchant difference in their health when viewing GDP and inflation data. Yet the debt situation in the US is worse than in Europe and the USD is the most over-owned currency on the planet.
Selling Euros to buy dollars is sort of like exchanging your ticket on the Titanic for a ride on the Hindenburg. The answer is not to sell one sinking currency and jump on another one that is drowning as well. The only truly safe currencies are those that can act as a store of wealth, that cannot be diluted by fiat and whose purchasing power cannot be corrupted by a government. Investors the world over should seek the safer harbor that is derived from owning commodities and precious metals rather than to believe the USD can offer any real protection.
Senior Market Strategist
Delta Global Advisors