Re: [TNF] The Euro is Not Our Problem

["Gary Santos" <evs@xxxxxxxxxxxx>]

I was surprised that my reply went into the length of an article. That being
so, I decided to title the reply.

"No, Warren, the Euro is No One's Problem"
(A reaction to The Euro Is Not Our Problem)

ON THE EURO

Hmmm, I don't know whether the primary purpose of the Euro's introduction
was
to free Europe from American domination. Maybe, primary in the mind of its
framers, was the integration of the European economies into one monetary
regime. The purpose was to stabilize the prices of those commodities
"domestically" produced within the Euro Area, past volatility due to dollar
cross rate fluctuations avoided completely. Freedom from domination is but a
natural consequence of the desire for price stability of domestic
production.

THE EURO AS A RESERVE CURRENCY: WHY THE ECB SHOULD BUY DOLLARS

On the issue of whether the Euro will become a reserve currency, I look at
it from a "market" point of view and, viewed as such, the "reserve currency
issue" is a totally separate thing from its initial price stability
objectives. The Euro is the tool for price stability and its survival is
paramount since the Euro IS the European Union.

If it proves *stable* against or stronger than the US$ *and* if the Euro/$
market remains *liquid*, it will gain acceptance as a reserve currency. As
it is a new currency with no one holding it, Euro interest rates should be
initially higher than that of the US to enhance its attractiveness.

The need for liquidity can not be overemphasized. And, because of this the
ECB must ensure that its reserves are perceived to be "stores of value". So
that when someone, anyone, in the future goes into the market to sell Euro
for Dollars, that person will be confident that the closing price after his
selling will not be significantly lower than the closing price yesterday.
Put another way, an investment is defined by two essential elements: it has
a return and, second, it must have liquidity. I buy 100,000 shares of a new
tech company at 1.00 but when I want to switch to another stock I find that
the market maker only has the minimum, 1,000 shares, bid at each
fluctuation. It will take me 100 transactions to get out in a trading day or
100 days at 1,000 sold each day to get out of the position. Now that's a
market without "liquidity" and I would not want to own that stock.

Since the ECB is the buyer of last resort, its reserves must be perceived
"as easily convertible" in to other assets especially the dollar. Which is
why, from a "market" point of view, it is in the ECB's interest to buy
dollars by issuing Euro, to accumulate enough dollars so that it will gain
the perceived ability to take on all sellers. As the amount of dollars held
by the ECB increase, the confidence of  dollar holders to hold Euro,
hopefully indefinitely due to its higher rates, increases.

The Euro and the ECB needs work, therefore. It needs to beef up its two
sources
of dollars: *first*, dollars obtained from Euro exporters who convert back
into Euro and, *second*, Euro bonds whose proceeds will be used to buy
dollars
in the Euro/$ market (which it also market makes). It must source Euro using
*long term* liabilities rather than *current* liabilities since it from its
current liabilities that Euro selling pressure can come from. An image of
two balance sheets with equal dollar reserves but one with 90% in current
liabilities and the other with 90% in long term liabilities will help. But,
because bond issuances have limits, the Euro Area has to, as a strategic
move, encourage its
export to the US so as to give the ECB a long term, stable, long term source
of dollars.

THE BENEFITS OF A EURO FALL

In fact, one can even look upon the slide of the Euro from its introduction
to end 2000 as part of this strategy. It was the intent to gain market share
in the international market especially in the US market. The external
position of the US and the bilateral trade position gave them confidence
that market support will eventually come. And, now we are back from where we
started in 1999 -- at 1.15 Dollar per Euro. Nothing lost on the ECB balance
sheet. But, its exporters gained market share over the last 4 years. They
will have to contend, however, with the price rise in dollar terms and the
possibility of losing market share.

Since 2001, I believed that the Euro, the Swiss Franc and Gold would
eventually appreciate against the US dollar -- beginning with the 1999
article of Catherine Mann on the unsustainability of US current account and
fiscal deficits; to the fact of a supply hole -- gold driven so low in price
due to central bank selling prior to 1999; to speculations on the gold
shorts, the GATA story of huge paper shorts in the gold market to the Howe
civil case in Boston; and, with worldwide policies of fiscal deficits.

ON GOLD AND RESERVES

Which brings us to gold. After reading a few central bank issued policy
statements and some email from Henry, I've come to the conclusion that gold,
as far as central banking is concerned, is really a less desired form of
reserve. They would rather have fiat money than gold. Not that gold will not
form part of their currency reserves as it, in fact, does to a significant
extent (I attach the Swiss CB position on gold.) but the *gold market is
illiquid* for a big holder in this era of floating rates. A central bank
wanting to unload its gold for Dollars will find it can not do so without
significantly affecting prices. The price will drop -- fast. The mere
mention of another central bank selling would stop any rally in the past in
its tracks. Hence, the insight that without a market maker like the US was
before 1971, the gold market is not as liquid as it generally assumed to be.
Just look at the slide in gold starting 1995 when the dollar started to gain
strength. I believe central bank gold was being sold then. The slide only
stopped in 1999 when the Washington Agreement (limiting more gold sales) was
signed. Gold, also, has an added disadvantage: it does not earn much
interest in aggregate holdings. Hard currencies do. With hard currency
reserves, the whole amount held as reserves earn interest. With gold, only a
portion will be leased out and at lower rates.

Why is gold still a part of central bank reserves? Well, I figure, even
central bankers know that what they are issuing is only "paper" as they can
create it by debiting a clearing account just as their new asset in hard
currency is created by a contra debit to a clearing account. With more
"current" paper issued, the risk of losing one's reserves is pronounced
during a shock or when the fiscal side undertakes to deficit spend at high
levels. So, just in case of the worst and given the public's understanding
of what value is, rightly or wrongly, some gold is held as part of reserves.

With this central banking thinking, gold will remain a commodity and will be
subject to commodity demand and supply. As of 1999, there was a supply gap
as mines closed with prices so low. I believe the balance will be restored
at about the $400 to $500 area.

ON DEFICIT SPENDING AND THE DOLLAR

On the issue of deficit spending, the US is indeed lucky that its currency
is the standard reserve form. For unlike the ECB, when the US goes into
deficit spending, the current liabilities it creates are really like a
perpetual bond issuance as they are never redeemed. The dollars people hold
are redeemed in the currency markets and there is no need to perform market
making activities. Japan, Korea, Taiwan, China and all other exporters are
doing the market making for the Fed.

In contrast, deficit spending could create balance of payment problems in
countries like the Philippines and finish off central bank reserves. The US
can sustain a higher level of deficit spending since the value of the dollar
will be supported by all the exporting countries containing imported
inflation. Well, that thinking was true until late 2002 as the dollar
started to slide.

The lucky(?) thing is inflation is still low in the US because of one
country, China, who is dollar pegged. The United States must remember though
that there is a level of danger in having to depend on someone else for
one's economic well being.

CONCLUSION

So, is the Euro anyone's problem? Not to the US. Not for Japan, Korea,
Taiwan as all their currencies are appreciating simultaneously (more or
less as Taiwan is pegging), freeing disposable income and competition is
stable. Not for China as it allows them to continue their chosen
developmental goals as it needs FDI and technology more than anything else.
Not to the Euro area as the domestic economy can be revitalized. In fact,
it's no one's problem in the short term. It's a matter of priorities.

*end *