Thursday, June 3, 2010

DOLLAR DESTRUCTION VERSUS EURO DEVALUATION: Divergent Actions by the US and EU

The US and European Union (EU) have taken radically different approaches to the financial crises that they are facing. We believe the results of their actions will lead to unique futures for their economies and citizens over the next five years.


In the US, the financial banking crisis started when mortgage based securities became illiquid following the revelation that their purported value was greater than their underlying real estate collateral. As the extent of the overvaluations became known, bank stocks plunged and hundreds of banks went bankrupt and are still going bankrupt as the downturn continues. These bankruptcies eradicate the financial value of the banks, their stock, uninsured accounts, jobs, and the taxes once paid by the corporations and employees.


The dropping prices of real estate in the US has erased equity in the homes of tens of millions of Americans. Banks have cut back on consumer credit removing hundreds of billions of dollars in credit from the economy. Tax revenues have shrunk due to the drop in real estate values lowering spending by cities, counties and states across the US. The combined value losses from bankruptcies, layoffs, lowered real estate valuations, stock value losses, reduced tax revenues, and shrunken lines of credit are in the of trillions of US dollars.


These financial value losses are functionally a destruction of US dollars; less dollars exist in the economy now than five years ago. The disappearance of this value and its underlying dollar amount has had a deflationary effect making a lot of things cheaper in the US.  Though we aren’t getting any interest on our savings right now, our dollars, are buying more house, more shares of stock, more electronics, and a lot of products for substantially less than five years ago. The ongoing shrinking amount of dollar currency available in the US economy should continue to raise the value of the dollar and maintain the deflationary trend.


The European Union’s banking crisis has unfolded differently. Their financial banking crisis started when bonds sold by EU member nations to large European banks became illiquid following the revelation that the EU’s member nations had understated their debts and it became clear that they could not pay off their bond debt or maintain a credit rating to borrow more at low interest rates.  Instead of letting the exposed European banks take their losses from the bad bonds, the European Central Bank (ECB) stepped in and bought the worthless bonds at full price.  This action functionally expanded the Euro currency in circulation.  Euros given to the member nations from bank bonds are still circulating in their economies while the European banks have been “repaid” all the Euros they lent by the ECB. Though the ECB has increased its debt on paper, unlike the US process that destroys functional dollar currency and shrinks the economy, the EU process is increasing their functional Euro currency by creating new Euros to cover bad bond loans.


The EU’s approach seems too good to be true: no loss of capital by their banks, no bankruptcies, no layoffs of bank employees, no restraints for overspending member nations, and no collateral damage to businesses and cities forced to cut back spending.  It looks like a brilliant solution.


But, won’t a surge in the amount of Euros in the Euro zone’s economy cause inflation and result in a huge devaluation of the Euro against the US dollar?
Won’t the member nations maintain their excessive spending because they know the ECB will rescue them from their debts?
Won’t the ECB be expected to cover any other debts of the EU member nations?


Though living in the US’s current trying economic times is not easy, we think that the EU’s approach may cause more problems for Europe than it solves in the long run.

4 comments:

Steve S. said...

It appears that Euro-Europe is only suffering from a "ECB below target" annual inflation rate of 1.5%.

But, due to the sharp deflation of the Euro, they will more than likely experience much higher import costs.

It's good time for foreigners to travel to Europe!

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