It wasn't too long ago that the parity pontificators were out in full force claiming that the European currency would trade one-to-one with the U.S. dollar. On June 7th 2010 the Euro hit a low of $1.1917. Since then, the Euro has risen over 17% against the US dollar, hitting $1.3961 as of today. That recent move, engendered courtesy of the Fed, has at least temporarily silenced the critics who questioned the viability of the European Union and its currency, while also serving to impugn the notion of the U.S. dollar's permanent position as the world's reserve currency.
To be clear, there has never been any question in my mind that the euro is just another flawed fiat currency. However, it has since its inception deserved to maintain its status as an excellent diversification-currency for those who hold excess dollars. Now we find the question being correctly asked today more than ever before if the USD can act as a safe haven from the troubles found in international currencies. The answer to that question can be found in the data and from the lips of our Federal Reserve Chairman.
The 27 countries comprising the European Union's economy is the largest in the world. Its GDP on a purchasing power parity basis was $16.5 trillion in 2009, which is greater than the $14.2 trillion US economy. The economies of the 16 countries in the Euro zone that use the Euro currency produced GDP of about $10.5 trillion on a PPP basis according to the CIA 2009 world fact book. That is equivalent to 74% of US total output. Therefore, the economies of the EU (27) or Euro Zone (16) are similar in size and scope to those of the US and should be viewed with the same gravitas. The size of the European economy had never been an issue.
But according to the IMF, the US dollar accounts for 62% of global central bank reserves even though it represents less than 25% of global GDP. In comparison, the Euro currency represents just 26% of FX reserves. Why is it that the U.S. economy deserves to represent such a tremendous over-weighting of central bank reserves? Since their currency holdings are so vastly concentrated, it places global central banks in a tenuous and vulnerable position. Should they ever need to reduce their dollar holdings -- especially in concert -- it would place tremendous downward pressure on the US currency. But unlike the greenback no such over-owned condition along with its concomitant pent-up selling pressure exists for any other currency.
Currently the gross national debt of the U.S. stands at 93% of GDP. The European Commission projects that their gross national debt will reach 84% of output this year and 88.2% in 2011. And In contrast, the Congressional Budget Office projects our national debt to reach over 100% of GDP in 2012, whereas the national debt of the EU will not reach 100% of output until 2014, according to the European Commission. Finally, U.S. interest rates are much lower as compared to those of the European Union. Therefore, the Euro should never have been viewed as a currency that is inferior to the USD.
But What Happens the Next Time Down?
Investors the world over have traditionally flocked to the USD for safety. This past credit crisis caused the greenback to surge 27% on the DXY and crushed most commodity prices including gold. How do we know the next international crisis won't cause the same global flight into the "safety" of U.S. debt and dollars and out of other currencies like the Euro? The answer can be found in our central bank's reaction to that same crisis. Ben Bernanke's initial response to the credit crisis was fairly muted. It may surprise investors to be reminded that the Fed left interest rates unchanged throughout the entire period from April 30th thru October 8th 2008, despite the fact that the S&P500 dropped from 1,413 to 899. And Bernanke only slightly increased the monetary base by $160 billion to just over $1 trillion during that drubbing in equities. During that time of relative inaction, global investors flocked to the dollar as they have done in Pavlovian fashion since the Bretton Woods agreement was signed. But after that, Ben sent out a fleet of helicopters to demonstrate to the world that he would not tolerate the appreciation of the USD or allow the rate of inflation to contract.
Our central bank has now clearly inculcated to global investors that they will severely be punished if seeking shelter in our currency and bond market. The monetary base has now reached $2.0 trillion and the announcement of another dramatic increase is expected once again at the conclusion of the next FOMC meeting on November 3rd. The Fed has engineered robust growth rates in all the monetary aggregates and is also now on record for the first time in its history saying that the rate of inflation is too low. All this has resulted in the U.S. dollar losing nearly 13% of its value since June.
I'm went on record last summer saying that selling Euros (or most any other currency) to buy dollars is sort of like exchanging your ticket on the Titanic for a ride on the Hindenburg. A viable solution cannot be to sell one sinking currency and jump on another one that is drowning as well. The only safe forms of money are those that can act as a store of wealth, that cannot be diluted by fiat and whose purchasing power cannot be corrupted by a government. The Fed has put the world on notice that the USD can no longer be viewed as a safe haven currency. During the next crisis, investors should seek the safer harbor that is derived from owning commodities and precious metals, rather than to believe the USD will once again offer them any real protection. Precisely because the position of the U.S. buck as the world's reserve currency has been burned and buried by Ben Bernanke.
Michael Pento is the Senior Economist for Euro Pacific Capital
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