Until recently it wasn’t a big deal for investors to move money between the euro and the dollar depending on which looked stronger.  With both now looking weak, the big question now is where the money will go to if international investors and traders move out of both euros and dollars, and what impact this will have on economies – and prosperity – around the world. 

Which one is safest...?

Troubled by the prospect of losses in its United States debt holdings once massive new borrowing kicks in, China was recently talking about the need for a new reserve currency.  The dollar is in many ways a less attractive proposition today than it was during the financial crisis of 2008.  With a massive new entitlement program now on the books – government run health care – U.S. government borrowing is set to rise towards the same sorts of levels as Greece (whose budget deficit is 13.6 per cent of gross domestic product) .  Meanwhile, the reckless government-sponsored mortgage holding companies that created the financial crisis in the first place, Fannie Mae and Freddie Mac, are still in business, unfettered by the President’s planned financial reforms and the happy recipients of a $126 billion bailout – so far. 

With Greece on the verge of bankruptcy, the Euro too has been undermined – so much so that the dollar has actually benefited in the short-term despite the parlous state of America’s own finances.  A €110 billion rescue plan spearheaded by Germany may buy some time but, without the ability to devalue its currency, Greece must face up to brutal economic realities if it is to recover.  Perhaps the easiest political solution will be for Greece to leave the Euro and revive the drachma at an exchange rate that would allow its economy to recalibrate.  Of course, this would wipe out a lot of Greek wealth – but investors, homeowners and pensioners are unlikely to riot in the streets of Athens in the same way that government workers have. 

Some commentators are calling for the return of the gold standard to reestablish a stable basis for international commerce.  This might encourage greater fiscal discipline in America and Europe by making today’s premier reserve currencies more reactive to economic realities but it doesn’t solve the basic spend, tax and entitlement culture that modern democracies seem to spawn.  Even the UK, which is not shielded by the euro, has vastly increased its borrowing to pay for ever more expensive social welfare programs and its budget deficit now stands at a whopping 11.6 per cent of GDP.  Did it learn nothing from the run on the pound on Black Wednesday in September 1992, when currency traders continued selling pounds even after interest rates were raised from ten to fifteen per cent? 

In the short-term it is likely that other major currencies will come to be relied on more, as investors look to hedge their holdings, with the dollar and euro maintaining their premier status but to a somewhat lesser extent.  This, of course, will weaken and destabilize international trading overall and make these second tier currencies – such as the yen and the pound – more vulnerable to the effects of sudden sales and purchases. 

In the longer-term, legislators and voters in the United States and Europe need to find a way to curtail their addictions to ever-expanding social welfare programs and stop fooling themselves that debts can be increased without end.  A good start would be for political leaders to stop labeling this profligacy as an investment and for voters to give greater value to balanced budgets.  Tea party activists in the United States are demonstrating that there is a vocal constituency that recognizes the unsustainability of current spending – and who also are unwilling to lose the freedoms that come with big government. 

If he plays true to form, President Obama will blame the greed of others for the increased volatility in currency markets that will result from spend and borrow policies.  Doubtless he will lecture us on the need for greater regulation of currency traders.  Perhaps he will convene a Bretton Woods style summit of world leaders to find ways to solve the problem, as if the issue boiled down to matters of market confidence and mechanics.  

In reality, confidence in the dollar and euro as the reserve currencies of choice will only be reestablished once government borrowing in America and Europe is seen to be under control.  Politicians should note that it is responsible governing that creates the conditions for long-term economic stability and prosperity.  Spend and borrow leaders only have themselves to blame for current economic difficulties.

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