Watch the Currency, Stupid!

The value of a currency is “the single most important price in a nation’s economy.” So claims Paul Volcker.

If this is the case then the eurozone continues to have problems.

As information has filtered out that European banks may have more problems than originally thought given recent “stress tests”, the Euro has shown continued weakness, almost across the board.

“The euro suffered and haven demand sent the yen and the Swiss franc to record highs amid renewed concerns over the health of the eurozone financial system.

Analysts said nervousness was heightened by news from the German Banking Association, which said the country’s 10 biggest lenders might need another €105bn of additional capital. Hans Redeker, of BNP Paribas, said the outcome of the European bank stress tests were being put in doubt.

He added that there were increasing signs that countries on the periphery of the eurozone, such as Greece and Portugal, were showing a frightening decline of growth momentum with the risk that these economies were moving into a debt spiral.” (See http://www.ft.com/cms/s/0/9a698e7a-ba61-11df-8e5c-00144feab49a.html.)

This news seemingly resulted in declines in the euro against the dollar (down 1.4%); against the pound (down 1.2%); against the yen (down 1.8%) and to a record low against the Swiss franc (down 1.6%).

With all the weakness the United States dollar has experienced in recent months against other major currencies, the value of the dollar has shown substantial strength against the euro since the problems in the eurozone were exposed earlier this year. The euro reached a near-term high against the dollar in early December 2009, but then fell about 21percent against the dollar into early June 2010 as European nations rallied to stem their joint fiscal crisis. The euro recovered some after a “combined solution” was reached, but its value has declined once again and still rests around 16 percent below the December high.

Furthermore, there still seem to be unknown unknowns surrounding some of the nations in the eurozone (see “EU Probes Hidden Greek Deals as 400% Yield Gap Shows Doubt”; http://www.bloomberg.com/news/2010-09-07/greek-debt-deals-hidden-from-eu-probed-as-400-yield-gap-shows-bond-doubts.html) and some of the banks (see “German banking weaknesses come to light”; http://www.ft.com/cms/s/0/9f1c0752-ba9f-11df-b73d-00144feab49a.html).

Financial markets don’t like surprises.

It appears as if there are still some surprises to surface within the eurozone.

These revelations will continue to apply pressure to the leaders in Europe. It is so hard to form a common union where people want to maintain all the privileges of independence (fiscal and otherwise) yet hope to produce a common good (greater economic strength and unity).

Like any marriage, the partners have to give up some of the things that they cherished as individuals. Furthermore, openness and transparency is a “must” for any such relationship. The road to “unity” may be quite bumpy at times, but the partners must work through these periods and establish common understandings and good habits.

In the case of nations, there is an information market in which people can “bet” on whether or not the marriage will succeed. This market is the foreign exchange market. Right now, the market value of the euro is declining, indicating that the investors are concerned about how the eurozone marriage is working out. This weakness in the euro will continue until the fear of surprises disappears.