Feldstein and Goldman Sachs: Making a case for the euro

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This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

Former European Commission President Romano Prodi this week said the worst of Greece’s financial crisis is over and other European nations won’t follow in its path.

The Sunday Telegraph also reported the European Union (EU) nations were preparing a “bailout package” for Greece that could exceed $34.4 billion as early as Monday the 15th, with Germany and France the main cash backers.

So far, Greece has not sought help from its EU partners. However, an April and May deadline to repay debt has pushed Greece to seek financing of around 20 billion euro on the bond market.
Greece has promised to cut its deficit from 12.7% to 8.7% this year while its long-term plan is to reduce the shortfall to below 3% by 2012.

Traders betting big on euro’s decline
Meanwhile, futures traders placed the biggest bets on record that the euro will decline against the dollar even as European officials mulled over guaranteed debt sales to help Greece, according to Commodity Futures Trading Commission (CFTC) data of March 9. It was the fifth week in six that the amount climbed to a record high.

EUR/USD pair dance
The sheer liquidity of the euro and dollar pair has had an overwhelming influence on the single currency for the past year or so. The dollar was heading towards a debasing path on concern of the mounting national debt and budget deficit. The euro, by virtue of being the market’s favored alternative currency, typically moves with the dollar, but in the opposite direction.

However, the Greece sovereign debt crisis has switched the euro to the driver’s seat this year as investors fled the euro, seeking safety in dollar-based assets.

Although Europe’s common currency fell against all of its 16 most active counterparts this year, the euro touched a one-month high versus the greenback as stocks gained as concern eased Greece would default, eased.

Implicit guarantee
For years, the Greek government has demonstrated rather thriftless spending behavior. This was exacerbated when Greece started to pay lower interest rates on government bonds by virtue of having entered the European Economic and Monetary Union.

Greece’s interest rates were subsidized due to an implicit guarantee from the strong members of the euro zone, who were expected to support weaker members in times of trouble.

Buy euro now, says Goldman
It is this implicit safety net that prompted euro optimism from Goldman Sachs (GS). As reported by Bloomberg, Goldman Sachs is advising investors to buy the euro against the dollar, betting it may rise to $1.45, as sentiment towards Greece improves.

Goldman Sachs believes backing from European leaders for Greece’s measures to narrow its budget deficit will provide impetus for more “growth surprises” from the euro region than from the U.S. in the near term.

Feldstein – euro’s fall an ‘overreaction’ over Greece
In a recent Bloomberg TV interview (see video below), Dr Martin Feldstein, who warned in 1997 that a European monetary union would spark greater political conflict, is also of the view that the euro’s 4.6% decline against the dollar this year has been an “overreaction” stemming from the financial crisis in Greece as there are other stronger member nations not at risk.

Perception and sentiment rules short-term
In the short term, Goldman Sachs and Dr Feldstein may have a point as it could be relatively easy to distract investors from the euro’s deep-seated fundamental problems. As long as market sentiment is stable or improving, Greece will be able to raise cash through the credit markets, buying time to work down its staggering deficit.

Nevertheless, perception and sentiment are always a moving target. Once uncertainty and fear prevail, “growth surprises” of the euro should quickly evaporate.

Structural weakness weighs long term
A potential correction of an over-sold euro cannot disguise the bull in the china shop. Greece’s crisis has highlighted the political and structural weakness in the single currency union. As Dr Feldstein puts it:

“…one-size-fits-all monetary policy has fueled big deficits as countries’ fiscal records differ.”

While Société Générale SA strategist Albert Edwards noted:

“Any help given to Greece merely delays the inevitable breakup of the euro zone…. the need to tighten deficits is a particular issue for the U.S. and U.K….There will be more crises to follow Greece, both inside and outside of the euro zone.”

Expect further euro weakness
Ultimately, other debt-troubled countries including Spain, Portugal and Italy will also need to be bailed out by the EU, leading to more debt monetization in Europe and further weakening the euro. More importantly, bailouts also implicitly encourage more reckless spending

Fitch Ratings Agency has already expressed caution over the medium-term outlook for Greece, while there is also evidence of increased tension within the Greek government on plans for budget cuts.

Dollar worries more than euro
In the same Bloomberg TV interview, Dr Feldstein further expressed deep pessimism about the dollar more so than the euro:

“If I want to be more nervous about the future of a currency over the next five years, it is more reason to worry [about] the dollar…given the size of the U.S. trade and account deficit.”

Indeed, one could easily draw a parallel between the U.S. federal government and the EU. The U.S. government will most likely have to bail out certain states such as California and Illinois, which is not that different from the EU having to bail out weaker member countries.

And states such as California, Illinois, New Jersey and New York dwarf Greece and other European debtor nations in economic importance in terms of income, output and consumption.

On that note, it is not that far-fetched that the United States, similar to the euro zone in size and equally deep in debt, could face its own sovereign debt crisis at some point of time.

A Race to the bottom with euro winning
Fortunately, in the medium term, the dollar’s fortunes look decent against the euro and sterling as well, as the Fed is still seen as likely to hike rates sooner than its counterparts in Frankfurt and London.

The overall mood of risk aversion should continue to support the dollar, and there will still be expectations that the U.S. will outperform the euro zone over the coming months, which will tend to underpin the dollar.

This trend, however, will most likely put a damper on President Obama plans to double U.S. exports over the next five years, as the dollar now has the euro to contend with for the global export advantage.

“Reality doesn’t bite, rather our perception of reality bites.” ~ Anthony J. D’Angelo

Source: Dian Chu, Economic Forecasts and Opinions, March 15, 2010.

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