What Is the Future of the Euro?

Recent financial turmoil in Greece and other European countries has raised doubts about the stability of the European monetary union and its currency, the euro.

From the start, many European countries bent the rules to adhere to EU requirements, while the EU turned a blind eye:

  • Greece allegedly cooked its books in order to meet European Union fiscal requirements, with the help of Goldman Sachs (NYSE: GS  ) and other banks.
  • When France wanted to join in 1997, it lowered its budget gap by negotiating a deal with the soon-to-be-privatized France Telecom (NYSE: FTE  ) -- receiving a lump-sum payment of 5 billion euros in exchange for assuming the company's pension liabilities.
  • Portugal underreported its deficit in 2001, because of the misclassified accounting of subsidies for state enterprises.

In the following interview, Scott Mather, sovereign debt expert and head of global portfolio management at Pacific Investment Management Company (PIMCO), told this Fool that on many levels, the European monetary union was simply an illusion. Here is an edited transcript of our conversation about the euro's future.

Jennifer Schonberger: If we extend Greece's situation out to the EU as a whole, we recently learned that member countries were able to engage in investments in derivatives in order to adhere to eurozone requirements -- and in some cases, they took many actions without disclosure. We're also seeing now, in this time of crisis, that countries like Greece cannot devalue their currency to assist with their situation. Does this demonstrate that the European monetary union was simply an illusion?

Scott Mather: On many levels, yes. Of course, there were some rules imposed, but they were never enforced. So everybody ignored the master criteria almost from day one. By ignoring the debt limit -- and everybody found an excuse to do that at their own convenience -- [these countries] allowed debt to be piled up in peripheral Europe. Instead of heading in the direction it needed to go, it went in exactly the opposite direction.

Schonberger: What is the future of the euro?

Mather: The EU is going to have to undergo some severe changes. Ultimately, it's probably going to look quite different. Certainly it looked different over the last 10 years, in that there have been some new entrants in the eurozone. The assumption of many people was that the zone will just get bigger, and there will be more countries that keep entering it. It was never conceived that there might be countries that need to leave. Now people are beginning to think about that -- that's probably the reality. Unless there can be some stronger fiscal union, it's probably a reality that some countries won't be able to stay inside.

The other thing that doesn't get talked about, in terms of the EU promises that weren't fulfilled, was that there was supposed to be a lot of labor mobility. That's virtually nil -- even within countries, much less across borders in Europe. [European Central Bank President Jean-Claude] Trichet and other European policy makers like to compare the eurozone with the U.S. There are very large fundamental differences. One being that the fiscal transfers between countries are relatively small, compared with the U.S. So there's no ability to balance out when specific states have a problem. There's not broadly the same harmonization in tax policy, regulatory policy. The economy is different across regions in the EU [compared to] the U.S.

Then, without having labor mobility and the same language and cultural identity, it's very difficult to make the economies keep up with the political will. So what you saw was, the political will kept advancing, but there were lots of economic fantasies that were part of that promise, and people are waking up to the reality.

Schonberger: What is your outlook for the euro this year?

Mather: The rising tensions within the eurozone would portend for a weaker currency. The euro is still overvalued relative to the rest of the world. Most valuation models, which rely on purchasing power of parity, put the value of the euro between 10%-15% lower than where it is today...

Schonberger: Because of the recent sovereign debt issues, there is a lot of speculation about nearly every major currency in the world. Which currencies do you see as the winners and losers going forward?

Mather: In many ways, it's like, "What's the cleanest dirty shirt?" It gets passed around. There's no constant currency that looks good, and that goes back to the level of sovereign indebtedness. We've never seen a regime like this. So much of the developed world has an unstable debt dynamic -- far too much debt far too quickly. So that's why this risk will be with us for many years, and perhaps the baton will get passed around in terms of "Who's the worst for today."

In general, over the next several years, we think you'll see a revaluation of countries that don't have this unstable debt dynamic -- the countries with better growth and with low levels of debt. In general, that's true of most emerging markets ... most emerging-market currencies will be winners.

So, in the developed world, look for countries that can benefit from the growth in emerging markets, [and which] have better debt dynamics. Countries like Australia and Canada come to mind. Each has commodity exposure and a much better debt dynamic. Those should be currency winners in the old developed world.

Schonberger: Do you have any thoughts on the currency dance China and the U.S. are engaging in ... both short-term and long-term?

Mather: If we're right about our growth outlook -- we think there's going to be stubbornly high unemployment and lower growth than normal in the U.S. in years to come -- that is going to result in an increasing amount of tension with countries such as China, where the U.S. runs a large deficit, and where there's a perception that many jobs are slowly being lost to trade competition from China. The focus on the currency is there front and center.

Short term, we think it's likely China begins to move [on its currency]. One, to defuse the pressure; two, they can afford to. Their economy is growing by all measures above potential now. So in many cases, it's in their own self-interest. We don't think China will be moving outside of self-interest. Certainly, having a trade war is not in their interest, and probably not in the U.S.'s interest.

They can defuse some of the tension by allowing their currency to slowly appreciate within a band. That's most likely what they'll decide to do in the next few weeks.

What do you think about the future of the euro? Which currencies do you think will be the winners? Weigh in below!

Read more from Mather on Greece's situation and the debt crisis.

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. France Telecom is a Motley Fool Income Investor pick. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 14, 2010, at 9:12 PM, xetn wrote:

    I believe the future of the Euro is complete failure as the EU is not really a united group but many countries with much different cultures and goals. At the same time, all countries are relying on massive currency inflation in order to "solve" the financial crisis. At some point, the laws of economics will prevail and the result will be default by many countries of their sovereign debt (including the US).

    The current rift between China and the US over exchange rates is kind of silly because the US is creating money out of thin air driving down the value of the dollar, partially in hopes of increasing exports while chastising China for trying to do the same. Just think what would be the result if all currencies were tied to gold and all prices were denominated in gold prices.

  • Report this Comment On April 15, 2010, at 10:09 AM, eee3hallajw wrote:

    The U.S, Europe and the global market are victims of economic exuberance. All are mired in debt secured by assets whose value is transient? There are also holders of debt in the global market who doubt the value of what they hold. There will be defaulters both municipal and sovereign. The question is who is taking the hair cut today or tomorrow. Neither the Dollar or Euro will fail but their value will respond to the traumas of the users. The market will accommodate all. None will be immune from the fallout from the trading system that will stabilize while managed.

    New rules will have to be enforced to maintain transparency for all. Some users could have to leave the market because they cannot meet current criteria temporally.

    The traded weight of each currency is what we all rely on although gold could be used if there was enough for all. The present problem is to keep the system going for everyone rather than allow stagflation or worse to take over globally. Few economies could maintain themselves as separate entities in the current world and have a worthwhile standard of living.

    The Dollar will win out at present purely because might is right. This doesn’t guarantee in the next few years that it will not be sidelined along with the U.S. But this is a seismic change supported by some.

    The current deficiency of lost wealth from the developed world will not come back and will be difficult to accommodate along with new banking rules.

  • Report this Comment On April 15, 2010, at 1:37 PM, DJDynamicNC wrote:

    @ xetn: "Just think what would be the result if all currencies were tied to gold and all prices were denominated in gold prices. "

    Instant, immediate contraction. How much gold do you think there is in the world? Compare how fast the rate of mining has increased over the past 50 years with the rate at which human population has ballooned over the same time frame.

    I think the term is "deflationary death spiral."

  • Report this Comment On April 15, 2010, at 1:39 PM, DJDynamicNC wrote:

    I'm not nearly as optimistic about the Euro as I once was, largely due to this site's reporting. I can freely admit that I just don't know on this one, though I will be watching closely and with a lot of interest.

    Maybe I'll invest in Ameros :lol:

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