WASHINGTON, May 27 (UPI) -- The euro was trading midday Tuesday above $1.19, higher than the level at its optimistic launch date of Jan. 1, 1999, and more than 30 percent above its nadir. Yet it can go much further -- the deutsche mark was at 1.42 to $1 in December 1995, implying a euro value of about $1.37. So where are we headed?
Currency swings can be huge, in both directions. Ten years before the dollar's nadir in early 1995, the dollar peaked during the Reagan years at an average of 3.17 deutsche mark = $1 in 1985, equivalent to a euro value of little more than $0.61 (the calculation cannot be done exactly without great effort, because the European currency upheaval of 1992 altered the euro's component currency values against each other -- since the deutsche mark was the strongest currency in Europe, the euro would have been worth rather more in deutsche marks in 1985 than the 1.95 deutsche marks at which it was fixed in 1999.)
Differential inflation also needs to be taken into account. Not in the 1990s, during which U.S. inflation averaged 3.23 percent per annum, not much above Germany's 2.32 percent, or even in 1985-2000 as a whole, where the differential is only a little wider (3.20 percent vs. 2.01 percent) and would be countered by higher inflation rates in other countries of the euro zone. But earlier, in 1970-85, the differential is significantly wider -- 7 percent vs. 4.60 percent, with large annual variations.
Clearly inflation cannot account for currency swings of this size. Whatever the "purchasing power parity" between the United States and the eurozone, it allowed the imaginary (at that period) euro to rise from about $0.65 to $1.37 over a 10-year period, thus transforming itself from an "undervalued" to an "overvalued" currency. Starting at the level of $0.82 at which it bottomed out in 2001-02, a similar move in the euro would lead it to $1.73, by late 2011 or early 2012.
Still a long way to go, in other words!
Against the yen, things are a little different. Like the euro, the yen topped out against the dollar in 1995, with an average exchange rate during that year of 100 yen to the dollar. It has fallen back much less than the euro, bottoming out in 2002 at 132 yen = $1. It has also recovered less, trading Tuesday at 117 yen = $1, albeit with huge intervention by the Bank of Japan in recent weeks to keep the yen down. In addition, there is an inflation differential here; Japanese inflation in 1990-2000 was only 1 percent, and may now be negative.
Precisely how all this will pan out over the next few years is uncertain -- undoubtedly there will from time to time be secondary counter-trends against the major trend. However, with the U.S. balance-of-payments deficit having topped $500 billion in 2002, and the federal budget deficit rising towards that level in 2004, the overall picture is clear. The dollar is due to be very weak, much weaker than people have been expecting. And that trend can be expected to continue for several years.
2012 may seem a huge distance in the future, but the precedent of 1985-95 suggests that the bearish trend in the dollar's value may continue as long as that, and that by the end of the trend, the euro may well be trading above $1.70. Of course, that too will be an extreme; the dollar can be expected to bounce back fairly quickly from that level. Nevertheless, if asked what I expected the average dollar/euro exchange rate over the 2005-2010 period to be, I would have to say 1 euro = $1.45-1.50.
This has huge implications for the U.S. economy, the world economy, and the stock and bond markets.
-- If you need a home mortgage, get it now; with the federal budget deficit running at $500 billion per annum, and foreign investors licking their wounds from currency losses, there is NO chance that today's low long-term interest rates will persist for more than the next few months.
-- If you're thinking of buying a European car, do so now -- they won't be as cheap again in relative terms until 2015 or so. Just remember that by 2012, you may be in the position of driving the only Hispano-Suiza on U.S. roads -- and paying accordingly for spares and service!
-- Forget about the vacation in Paris, which is already expensive; your next 15 vacation trips will be to Florida's Disney World, where you will be mobbed by big-spending European tourists, most of them employed by their governments.
-- If you're Boeing, it's about time to spend some money on new model development; your competitive advantage against Airbus is about to be massively increased. Interestingly, the European Union authorities seem to recognize this, since they have just ordered from Airbus no less than 160 jumbo air transports for the embryonic European army -- presumably they know something about Airbus' order book and financial prospects that we don't.
-- Although you may think to make money on European stocks because of the exchange rate advantage, don't bet on it. The Europeans who poured money into the United States in 1995-2000 may have financed a lot of dud Internet startups, and made the stock market massively overvalued, but they will pay for their sins. The deflationary recession that the United States is currently very slowly working its way through may indeed turn into full deflation, with prices dropping -- in Europe. In particular, if the pound gets linked to the euro in the next couple of years, London house prices may be about the easiest short trade in existence -- were there any way to sell them short.
-- Even with the declining dollar and the consequent softening of the U.S. recession, the U.S. stock market will still perform poorly -- don't forget the "wall of money" now heading away from Wall Street.
-- Expect the euro-sclerosis and high unemployment of the early 1990s to return, redoubled, with jobs migrating en masse from the appallingly overpriced countries of Western Europe to their high skilled, relatively low cost neighbors to the east. Provided the country remains approximately capitalist and only moderately kleptocratic, Russia can expect to be a big winner from this trend.
-- Willis Hawley and Reed Smoot, authors of the infamous 1930 tariff, will appear Cobdenite free traders compared with the barriers that the EU will put up against U.S. and Third World imports once it becomes clear that this currency realignment is a long-term trend. The United States and the European Union, taken as a combined grouping, run a huge trade deficit with the rest of the world. Following the currency realignment, most of this deficit will be located in the EU, with the union's major exporters particularly badly hurt. The EU as a body has no real commitment to free trade, and an absolute commitment to preserving its traditional social structure, increasingly economically suicidal though its cost is. Import controls, and probably exchange controls (present in all major EU countries except Germany before 1980) will be the inevitable response. If you're European, get your money out now -- but not to the United States.
-- Japan can be a winner out of this, but it needs to keep its dollar exchange rate under control, and shrink its government sector. Only by reflating its economy can it prevent bank after bank succumbing to bailouts (there is almost no such thing as a platonically bad loan, but huge portions of most loan portfolios would turn bad if subjected to 13 years of deflationary recession such as Japan has suffered.) Japan no longer has stock market or real estate excesses, and its export industries may well be able to take market share from European exporters in the U.S. market. Only Japan's excessive infrastructure spending, as difficult a problem as Europe's pension systems, has the potential to prevent a fairly strong Japanese resurgence.
-- China is right to try to hold its currency down against the U.S. dollar, thus increasing its export surplus, but it must use the money to restructure its appallingly inefficient state sector and its banking system whose problems make Japan's seem minor. If it does not do so, preferring to continue producing false output statistics, bailing out state companies with loans and pretending that all is well, then it will suffer a harsh protectionist backlash, particularly in the European Union. Once that has happened, the option of using its export success to solve its economic problems will no longer remain.
-- Latin America will see some improvement in export potential, as its currencies remain tied to the declining U.S. dollar, but it is far less well set up than East Asia to take advantage of its expansion opportunities -- in an era of deflation, commodities and primary goods will suffer as they did in the 1930s.
-- Middle Eastern oligarchs will suffer, as the purchasing power of their oil in terms of European luxury goods will be badly hit. The Arab street will also suffer, as the remittances from families in the European Union will be hit by EU unemployment and tighter immigration controls.
-- Africa will find foreign aid budgets cut still further, as the United States battles its budget deficit and the EU battles the costs of its unemployment. Those countries that use this period to wean themselves from foreign aid, and strengthen their feeble export industries, will benefit in the long run.
-- Finally, the one winner, India. The rupee will strengthen against the dollar, yet India will still be competitive in cost terms both in the United States and in the EU. The competitiveness of its outsourcing and software services in the EU will increase, yet EU protectionism will find these imports more difficult to block than conventional imports of goods. As a largely self-sufficient economy, India will be damaged less than most by the hiccups in world trade that the next decade will inevitably bring. And its stock market, undervalued by Western standards yet now largely open to foreign investment, should perform quite well against competitors hampered by capital outflows (the United States) or deep recession (the EU.)
Aggressive and savvy traders will figure out away to go long Indian software developers and short London housing. The rest of us may not be able to profit from the impending unpleasantness, but can at least avoid the more obvious losers.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
