Ambrose Evans-Pritchard: With no serious rivals except gold, dollar won't collapse


By Ambrose Evans-Pritchard
The Telegraph, London
Friday, July 13, 2007

Disregard all hysteria. The ailing greenback will not collapse this year, not in 10 years, not in 20 years, not in half a century. There is no credible currency against which it can collapse. (Unless you count gold). None of the world's rival power blocs has the economic and demographic depth to challenge American dominance.

Yes, we have a dollar rout on our hands. The markets have suddenly begun to discount a nasty crunch in the United States as the subprime debacle spreads through the credit markets. The prospect of rate cuts by the Federal Reserve is drawing closer, knocking away the dollar's yield prop. Investors have switched reflexively to the euro as the default currency.

This cannot last. It assumes that Europe has "decoupled" from America and now has the umph to go it alone. German finance minister Peer Steinbrueck played to this illusion on Monday when he professed to "love the strong euro" -- directly contradicting testimony he gave to the European Parliament earlier this year.

Whether or not Germany is really that immune to an exchange rate of $1.38 to the dollar (Professor Peter Bofinger, one of the country's five "wise men," insists adamantly that it is not), it is in any case a foolish error to treat Germany as if it were a proxy for the whole euro zone. In reality it has become the nemesis of Euro-land. While the Teutonic tiger is indeed springing back to life after a decade-long slump, it is doing so by conquering market share from the Club Med bloc in what amounts to a beggar-thy-neighbour shift within the euro zone. This has a zero-sum flavour to it.

France, Spain, Italy, Portugal, Greece, and latterly Ireland are all facing very serious trouble. They are at or near the top of the cycle. Housing bubbles caused by ultra-low interest rates (geared for Germany, when Germany was down -- the dirty secret of EMU) are starting to burst. Club Med's share of global exports is collapsing.

Bernard Connolly, global strategist at Banque AIG and former head of economic research at the European Commission (the best informed euro-critic in the City and the one most feared by Brussels), says Spain will face an outright "depression" by 2008-2009 and Italy will face an "Argentine crucifixtion" until it is ejected, or chooses to escape, from the euro zone.

How has this "divergence" happened? In a nutshell, Germany has gained 20 percent in unit labour cost competitiveness against France, 30 percent against Spain, and 40 percent against Italy since the currencies were locked together in 1995 (EU data). It has done so by screwing down wages while Club Med has done what it always does -- let rip on wages.

Or put another way, Europe's ancient nations have reverted to type, as they were always bound to do. The elapse of a decade has allowed this to go beyond the point of no return.

How is Italy, for example, supposed to claw back lost competitiveness on this scale against low-inflation Germany? Yes, Italy did this in 1927 under the "lira forte" policy of Mussolini, but he was able to use fascist powers to ram through a 20 percent cut in wages. Try that in a democracy. It would take a severe recession to force down Italian wages enough to make a difference. The budget deficit would balloon. The national debt (108 percent of GDP) would spiral upward, setting off panic sales of Italian bonds. The policy would instantly defeat itself, even if it did not set off civil conflict -- which it would. Italy cannot break out of this impasse unless Germany agrees to tolerate much higher inflation for the whole euro zone. Berlin would sooner choke on sauerkraut.

The longer the euro stays near $1.40, the more severe the crisis coming in a year or 18 months -- as the lagged effects of overvaluation turns boom to bust with even greater violence across Club Med. Sooner or later the markets will twig in any case. The screams coming from southern Europe will be too loud to ignore. Worth noting that Goldman Sachs has begun to recommending shorting Italian and French bonds, expecting them to diverge further from German bunds. This is exactly how the unravelling begins.

It will become obvious at some point that the euro zone is just a glorified fixed-exchange rate system, not a sacred union. The euro is an orphan, stateless currency, lacking the mechanisms (a debt union, pension union, a shared treasury, and fiscal transfers) that makes a currency union work over time.

Contrast that with the dollar, the currency of a nation forged by wars and the ancestral chords of memory (Lincoln's words) -- all for one and one for all. America is a country. (Again a Lincoln sentiment, but now a truism.) That massive historical fact makes all the difference.

Ah, but there is the Japan, at last breathing again after its near-death brush with deflation. Now I don't doubt that the yen will at some point snap back violently as interest rates (now 0.5 percent) return to a semblance of normality. As soon as global risk appetite fades again, the yen carry trade will doubtless unwind -- perhaps brutally as in 1998 -- and some of that $500 billion shipped overseas will come home.

That said, anybody who follows the rhythms of Tokyo's stock market must suspect that a sharp appreciation of the yen will cause the Nikkei index to plummet -- bringing Japan's fragile expansion to a swift halt. The "Seven Samurai" exporters -- Honda, for example, which earns 70 percent of its revenues in America -- will take a battering. As month after month of disappointing retail data this year keep showing, Japan lacks the demand growth to take the baton from America. Wages have fallen for the last five months.

Japan is already the oldest society in the world, shrinking since 2005. The population peaked at 128 million in 2005 and is expected to fall below 100 million by the middle of the century. If, as expected, Japan's aging grannies and housewives raise the share of foreign assets in their portfolios from 3 to 12 percent over time, the yen must weaken further. It is the dying currency of a dying country -- albeit a charming one.

Which brings me to China, a country that is growing old before it ever becomes rich. The working-age population peaks in 2015 -- just eight years. China then dives into the steepest demographic decline ever known by any nation in peacetime.

As for China's current boom, you need know only three things so see where this is going: Credit is being channelled for political purposes through Communist state banks that are not subject to market discipline; almost half of GDP is going on investment, leading to a glut of factories; return on that investment, measured by the incremental capital output ratio, is 4.4. Much of it is being wasted. Compare that to Japan (3.2), South Korea (3.2), and Taiwan (2.7) during their growth spurts.

China is not going to take over the world economy, now or ever. The window will close shut before they get there.

No, the 21st Century will be the American century, just like the 20th Century. Americans may have to tighten their belts a bit after all the sins of Alan Greenspan and the Clinton-Bush debt generation. But the dollar will still be the world's reserve currency long after the euro has disappeared and the yen has been forgotten.

Now, the Indian rupee? Hmmm. ... Another day.

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