Question: I diversify my investments like you suggest, and some of my holdings are in Europe, where countries are struggling with too much debt and unsustainable social welfare programs. What do you see happening with the Euro and European investments?
Answer: There is plenty of speculation about the future of the Euro, the official currency of the Eurozone. The significance of the Eurozone cannot be overemphasized. It represents the second largest economy in the world behind the United States and the Euro is the second most traded currency in the world behind the U.S. dollar. Seventeen countries comprise the Eurozone: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Notably absent are the United Kingdom, Denmark, and Sweden. Greece is the worst off financially. Some Greeks think that if they abandon the Euro and return to the Drachma they will be able to devalue their currency and avoid austerity. For Greece, that would be a disaster. Germany, on the other hand, is the strongest member. Some Germans are unhappy seeing their country on the hook for so much debt created by other countries and would like to see Germany reinstitute the Deutschemark. They think that even though a strong Deutschemark might hurt some German exporters, imports would be cheaper and inflation would be easier to control.
But neither Greece nor Germany is likely to abandon the Euro because the rational for establishing the Euro still exists. Prior to the Euro, each of the seventeen countries had its own currency, and there was a cost associated with every currency exchange. The Euro eliminated that cost. It also removed exchange rate risks. Prior to the conversion to the Euro, companies and individuals in the Eurozone had to deal with changes in the exchange rates, just like we do today if we travel to Europe and exchange dollars for Euros. Since the introduction of Euro coins and banknotes on January 1, 2002, the Euro has ranged in U.S. dollar value between $0.86 and $1.60. It currently trades around $1.25. Another advantage of a common currency in the Eurozone is that prices of commonly traded goods tend to converge, removing speculative trade to take advantage of price differentials. The independent European Central Bank, which is modeled on the German Bundesbank that has been successful keeping inflation low, offers the Eurozone countries this same advantage. Other advantages of the Euro include increased trade and physical investment within the Eurozone and a decrease in cost of trade in bonds, equity, and banking assets.
Countries that entered the Eurozone with relatively weak currencies and correspondingly higher interest rates benefited by the stronger Euro and lower interest rates. Countries whose interest rates dropped the most were Greece, Ireland, Portugal, Spain, and Italy. The lower interest rates prompted these countries and their banks to borrow more and increase their public deficit. After the 2008-2009 global financial crisis, these countries had to increase their public debt even more, causing their debt to reach unsustainable levels and resulting in the current European sovereign-debt crisis.
We can’t predict the future, but in all likelihood the sovereign-debt crisis will resolve, the Euro and the Eurozone will stay, and your investments will grow over time.