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Safe haven under euro uncertainty – a reply

2012/05/10

In his comment to my post on The Home-currency Problem in the Euro Area the Wirtschaftsphilosoph raised an important point which I would like to elaborate here in some detail. This is what he wrote:

“You are right that the euro is a large problem for all countries. However, the problem is not symmetric and Germany is not the next weak link but the economically strong country that holds the whole currency union together (at least until now but perhaps not much longer). Formally, Germany has the same problem as Greece, lacking its own currency and thereby being at risk of becoming insolvent. In fact, the situation is very different. If (when) Greece leaves the euro, the new drachme will be very weak. If Germany does the same, the new D-Mark would be very strong and the remaining euro would fall or be destroyed. Looking for a save haven in Europe, the markets find it in Germany.”

This comment in my view has two aspects:

1)      The currency which is in use in Germany and

2)      The safe haven function.

Currently, the euro is no country’s currency. It is too weak for the stronger members of the euro area and too strong for representing the economies of the weaker ones as I wrote.

Germany is one of the strong countries which explains why at the moment within the euro area capital is flowing to it above all from weak southern European countries. Foreign-exchange risk does not appear to bother investors which, in my impression, indicates that they implicitly assume that the euro will survive in a group of core countries even after members from the periphery such as Greece have left. It is this latter view which I challenge in my article:

In my opinion the euro will not survive. Markets will “test” one country after the other and financial firewalls will offer no shield to stem the floods of speculation and search of “credit insurance”. In this situation, the economic strength  mentioned in the comment is no argument to convince traders who increasingly consider the euro as unsustainable. This has two consequences:

With rising probability that the euro will not survive it matters less and less which country is the strongest in the euro area. If the future of the euro is regarded as uncertain investors will flee the currency – no matter where it is held – and German investors will not differ from others since, as I argued, in this case the euro is as foreign to them as to any other euro-zone citizen.

Which brings me to the second consequence, and the second point mentioned above, the safe haven function.  As long as investors in the euro area (and outside) expect the currency to survive the argument of the Wirtschaftsphilosoph has some justification: For investments in euro (!) the strongest economy in the euro area has the greatest appeal.

With a return to national currencies, however, it is no longer Germany’s relative position to other euro zone countries which matters. Investors will compare the new “D-mark” to its international rivals – the US dollar, the Japanese yen and maybe a handful of other currencies which are all outside the current euro area.

In this comparison, Germany will appear rather weak. High indebtedness, a recession looming on the horizon, the threat of political instability (the failed euro experiment will further destabilize the country) and neighbour countries and main trading partners severly damaged by the crisis and austerity policies – all this will reduce its attractiveness. As a consequence, investors from Germany and elsewhere will try to reduce the share of certain European assets in their portfolios, which suddenly will appear far too high, and shift capital from the former euro area to other parts of Europe (i.e. UK, Switzerland …) and, above all, to other world currencies. Investors in and outside Europe will feel a strong need to revise their diversification strategies. Many had markedly increased their  exposure to the newly established euro area after the introduction of the common currency expecting that it will play a greater role in international relations than individual regional currencies ever had. Now they will have to dismiss this idea.

This is, very briefly, what I had in mind when I wrote that there is no safe haven in the euro area. As the end of the euro experiment is drawing nearer, Germany, just like Spain or Portugal or any other member country, may become the target of the next market attack. Maybe the economically weaker euro area members will be the first victims. On the other hand, in anticipation of the rebirth of a possibly highly overrated D-mark the strongest country may appear just the most attractive candidate to test.

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