Why the Euro Will Save the US Dollar

Many commentators have raised an alarm that the United States is gambling with its debt driven fiscal policy. They believe that the government is continuing to issue debt to pay for social programs. Fears have also arisen because one of the main foreign buyers of US debt, China, is signalling that it may decrease its holdings of dollar denominated debt. Other large buyers might follow similar strategies if they fear for the dollar's value. This could potentially endanger the dollars standing as a worldwide reserve currency. Such a move would likely force the Federal Reserve to increase volume of dollars in circulation. This expansionary policy is, in effect, a devaluation of the dollar which will lead to inflation.

One of the earliest and most influential economic equations I've ever learned was the simple MV=PY. This simple equation states that the supply of money times its velocity will be equal to the price level times output. If the velocity of money and output are constant (or at least moving at a glacial pace), then the price level is depended on the amount of money in the system. Thus, the amount of currency in circulation will drive inflation.

A large problem might exist for foreign buyers of Treasury debt is where they would move their money. Obviously, these countries might use some of this money for domestic spending and investment. Yet, there might be too much money to use just for those purposes. Countries would still need some type of assets to hold their reserves.

It was often mentioned that countries might move assets out of dollar denominated debt and into Euro denominated assets. The Euro was seen as a potential currency competitor of the dollar. However, as recent events, such as the debt problems in Greece, have unfolded the safety and value of the Euro have been questioned. Bets have been placed against the Euro and the value of some Euro denominated debt has fallen precipitously. So, it is increasingly unlikely that major foreign holders of US debt would move into Euro denominated debt.

The question then becomes 'where else?' Fortunately for the US government there really aren't many other options. It is possible that countries would also attempt to move into physical assets such as gold and oil, however, there are not enough of these assets to compensate for a move out of Treasury debt. The pound is unlikely because of domestic currency issue in Great Britain. The yen is unlikely because the Japanese followed a similar monetary policy as the US has, just many years earlier. Their debt pays little to no interest and their currency is not exactly safe from inflation. The only other major world currency is the yuan in China. A move to have that become a reserve currency is almost impossible as it is the Chinese who are a major investor in US debt. They are a country of surpluses to invest elsewhere, not domestically. Additionally, China has attempted to undervalue their currency relative to the dollar - any move away from US debt would likely break this peg.

As the Euro-zone is facing domestic currency problems, it is unlikely that the world would move to the Euro as a replacement for the dollar as a reserve currency. These problems might act to save the value of the dollar even in the face of what are normally inflationary devaluation policies. The dollar's savior is its demand, not its actual value. If there is nothing else to move into, demand will remain high in the face of the government's attempts to devalue.

The Downward Spiral of the States

According to a recent survey, individual American states are about to see worsening economic conditions even as the nation, potentially, emerges out of recession. The problems on the state level mirror those of the federal government save one important difference - the Feds can print money.

Over the last half century, state budgets have expanded as more and more services were provided without the necessary taxes to pay for them. While the federal government has a relatively easy time running a deficit, the states are forced to use much more draconian measures to balance their budgets. Many states are about to (or have been) lay off huge numbers of employees and begin cutting social programs while they may also need to begin raising taxes to cover their costs and service their debts.

The problems for the states may be multi-fold. First, as employees are laid off tax revenues are going to decline as will the demands on the unemployment and pension systems. But, as there are fewer employees, state governments will become less and less responsive. Secondly, as interest rates begin their inevitable move upwards, the cost for states to borrow money will become higher forcing the states to cut even more programs.

Unfortunately, there probably are no painless solutions for the individual states right now. A major part of the 2009 Federal government's stimulus package was transfer payments to the states to help hold up their budgets during the recession. As NJ Governor Chris Christie explained, these payments may have only delayed the inevitable pain which the states are going to feel unless the federal government continues them indefinitely. Such a move is highly unlikely and will be politically impossible.

The states are going to have to accept some pain now and then learn from their mistakes in the future. Plans must be made during prosperous years for the lean years. States also must limit the amount they allow themselves to expand when things are good so they do not need to make such deep and painful cuts when things are bad.

The End of European Sovereignty

George Soros wrote a rather interesting article in the FT this morning to outline some potential problems which the European Union is facing in its potential attempts to prop up the Greek government in the face of its debt crisis. He began his article discussing how the Euro was not a political union, but solely a monetary one and finds it difficult to reconcile such a financial system. A number of flaws are pointed out, specifically putting the proverbial cart before the horse in unifying only the monetary systems instead of the political system.

While I see the reasoning in his argument, I have difficulty fully accepting his arguments. He seems to describe the worst possible conclusion to the Greek (and potential Irish, Spanish, Portuguese) debt crisis as a collapse of the joint monetary system.

My first major issue with his thesis is that the Euro is a politically unifying force in Europe. By tying their monetary systems together, the European governments have intertwined their political structures as well. Stronger countries, like Germany and France are forced to act to protect the strength of their own financial systems from problems which could be caused by a collapse in their currency. When other governments, such as the Greeks, can damage the strength of the Euro, stronger nations must step in to protect not only their neighbors but themselves. Likewise, the European community is nearing steps to force the Greeks to institute austerity programs and increase taxes against their national will. The Greeks would potentially, in essence, cede their sovereignty to its neighboring countries.

Another major problem I see is the thought that the 'Euro' system could fall apart. It would be incredibly unlikely for the nations of Europe to abandon their common currency. Such a move would likely be incredibly unpopular with people who would see their savings and purchasing power collapse along with a defunct currency. Also, a move away from the Euro would likely take quite a long time to implement. Countries would have to re-institute national currencies from scratch - printing, valuing, etc. Such a move would be incredibly costly, not just in terms of the printing and distributing, but also politically and psychologically.

In my opinion, the Euro is here and it is not going anywhere anytime soon. While the value of a Euro may drop, it will not fall to zero or any other point to justify taking it out of circulation. Additionally, counties who have adopted the common currency have given up their independence. When neighbors can damage a country's economy through its currency, that country will act to protect itself however it can. If it must impede on its neighbors sovereignty and force it to take undesirable actions it will. And thus, the sovereignty of the Euro countries is no more.

A New, Mixed Regulatory Approach

While trolling through The Economist this week, I came across an article detailing potential next steps for those regulating the banking system. One section that stuck out to me was in regards to mark-to-market accounting rules for assets held on the balance sheets of financial institutions. While it may seem logical for financial institutions to value their assets at what they could be sold for on the open market, problems can arise when the bank has no intention of ever selling them. Many firms hold securities on their books as reserve assets since they have a greater return than simply holding cash - though there is added security.

Should the institution wish to hold such an asset, they must also value that asset at a 'market' price based on the value for which it could be sold. I do see a value in marking assets which are held for trading purposes at a mark-to-market value, but I think there must be a better way to base instruments meant to only be held on the balance sheet and never sold.

A hybrid solution to the accounting rules is a potential fix. For such an idea to work, the banks will be able to delineate some assets for 'trading' and others for 'holding'. Those assets held for trading would be treated according to the current mark-to-market rules. Their value would be determined on the open market and they would use existing tax regulations.

The difference in this model would be in the treatment of 'holding' assets. These securities would be placed on the balance sheet and have their values determined by a mark-to-model method. This would give the banks protection from declines in their values and the need to increase their reserves at inopportune times. The institution would be forced to declare which assets they would like to classify for this status. If the asset is held to maturity, it would be treated using the existing tax structure. However, if the institution wished to reclassify the asset they would be charged an additional tax surcharge. Such a penalty rate would curtail the reclassification of assets from 'holding' to 'trading' and prevent firms from benefiting under both sets of rules.

This solution would not solve all of the problems currently facing the financial industry, but it might help to support institutions in times of great crisis and would possibly even prevent panic selling of securities. Such actions can, potentially, act to stabilize markets and prevent crashes in the future.

To the Winners: Carry the Losers

As Greece comes close to defaulting on its national debt, the structure of the European Union as a whole is about to be challenged. It has widely been reported (WSJ, FT) that the member countries of the EU, led by Germany and France, have stepped up to prevent a Greek collapse. Such a move was made to protect the value of the European common currency. In the event Greece were to default, the value of the Euro would likely follow downward harming the finances of all EU members.

The safety net created by the EU countries for Greece was an action to protect their common monetary base. However, this move may have severe political consequences for each individual country and the continental system as a whole. What is of yet to be seen is how citizens in countries like Germany and France react to their tax dollars (or issued debt) being used to prop up spending in Greece - and possibly Ireland, Portugal and Spain. Likely, these moves will become increasingly unpopular unless the finances of their practically bankrupt neighbors can be quickly repaired.

The EU nations will likely demand new austerity measures along with increased taxes on countries they are forced to bail out. Unfortunately, as reported this morning, these measures are incredibly unpopular in Greece. It seems a strange situation where the populace of the beggar nation is protesting budget cuts while asking for protection from their creditors. Such actions will likely breed resentment and anger in the populations of the countries that are bailing them out. There can be seen a situation where a Greek government trying to fix their finances falls to a more 'generous' one. Meanwhile the governments in their neighbors may see defeats by more conservative parties who take a harder line on helping to support overly indebted neighbors.

Along those same lines, could this type of event ever occur in the United States? Obviously, the federal government will not see such problems as it could monetize its debts. However, individual states could see such situations. Places like California, New Jersey and New York, with large deficits could potentially run out of funds and access to debt markets. If this were to happen, there is little question that the Federal government would step in and bail them out. But, would these states act to fix their budgets or would they just continue on their paths and hope things get better? If they fail to change their policies there would be large amounts of resentment by the other states in the Union and severe political consequences.

The End of Easy Money

In his testimony before Congress today Federal Reserve Chairman Ben Bernanke gave a clear indication that his bank is to begin tightening monetary policy in the near future. His testimony gave a number of actions the bank is preparing to take to remove the liquidity it has created over the last few years. Once the bank begins taking its actions, such as raising the interest rate it pays on excess bank reserves along with its discount and federal funds rates, loan markets will quickly follow with higher demanded rates on all loans from corporate credit to federal debt. While these actions are necessary to stem any inflationary effects that may begin to creep into the system due to the flood of money in the last two years, they may be ill timed with the fledgling economic recovery and planned increase in government borrowing.

Though Bernanke only described the banks options as something they were beginning to consider, markets likely will not wait for action to price in higher interest rates. Any effects that are going to be felt will likely be felt much sooner than the Fed is predicting. A rise in any and all rates over the coming weeks is increasingly likely along with their associated effects on the financial sector as a whole.

Such a move might also have an impact on the government's upcoming fiscal plans. There have been recent rumors of a third stimulus or 'jobs' bill along with a proposed FY 2011 budget. All of these plans have have included a large amount of new Federal debt issuance. There were a number of relatively conservative estimates of the cost to service this debt in the budget proposal. Should interest rates rise, this debt will become increasingly expensive which may endanger the passage of such spending proposals. The government would be given three uncomfortable choices: spend less, pay more or tax more.

On a small side note, there might be an interesting arbitrage opportunity for institutions with access to the Federal Reserve system. The Fed currently is paying a 0.25% rate on excess deposits within its system while maintaining a overnight Fed Funds rate of 0.00-0.25%. There might be opportunities for banks to bet on a rise in the Fed's interest paying rate by taking longer term loans from the Fed system at any amounts up to 0.25% and holding them as excess deposits. Should the Fed then pay a higher rate of interest at anytime, that bank could essentially have a free 0.25% spread for the term of its loan.

Can An Unemployment Rate Drop Be Bad?

This morning, the national unemployment rate fell from 10% in December to 9.7% in January. On the surface this appears to be positive progress in the country's march out of recession. Yet, the unemployment rate fell as approximately 20,000 jobs were reported to have been lost. This seems to point to serious problems in the economy. Likely, the unemployment rate drop was caused by more and more people running out of unemployment benefits, dropping out of the labor force or taking part time work instead of full time work. These three events would all cause a drop in the purchasing power of the American citizenry which might signal problems on the horizon for businesses who need increased sales to expand and increase hiring. Unfortunately, such a move would have a negative spiraling effect on the national economy. Traditionally, the unemployment rate is seen as a lagging indicator of economic performance; however, in this instance it might be a signal of problems that are of yet to occur.

US Downgrade Danger?

I saw an article today in the Financial Times that Moody's was warning that the US may face a downgrade to its AAA credit rating unless it can achieve either more robust economic growth or do something to limit its increasing need to borrow. Obviously, such a downgrade would inspire political sniping and cause the government to pay more for its debt, but could there ever be a real danger of default? Since the US uses a fiat currency, in such a case where they lacked the funds to service the debt (or could not get anymore credit) they would just print new money. Clearly, this would devalue the dollar but it would also prevent an actual default. There is value in ratings for municipalities, states, corporations and countries that do not directly control their currency (the EU countries), but there is no real harm in a downgrade to a country like the US or the UK who can just print more money to cover their interest expenses. I didn't think it was Moody's (or any other agency's) responsibility to rate the projected future value of money as it appears they are doing with this morning's warning.

Not As Bad As I Thought - The 2011 Budget Deficit

Upon first thought the 2011 budget recently proposed appears to be a ticking time bomb with regards to the US budget deficit. However, upon deeper reflection it might not be so bad. Conceding the point that there are excess amounts of recession related social spending, a large portion of the deficit comes from expanding social security and Medicare payments. This might be what actually neutralizes part of the deficit's size. Looking at the current unemployment and underemployment rates there is a huge base of people not currently paying into these systems. If a quick economic recovery can be achieved, these people can massively increase the tax receipts upon which these programs are dependent. Thus while the expanded 2011 deficit is a major concern it might not be as large as currently feared.