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European Affairs
The European Economy
The Unconventional Case For a Stronger Euro
Robert H. Dugger
Managing Director, Tudor Investment Corporation
Might there be reasons for the euro to strengthen against the dollar in the coming months, apart from the familiar considerations of economic growth and interest rate differentials between Europe and the United States?
Could longer-term non-macroeconomic factors such as demographic trends or restructuring shifts, for example, have an impact on the exchange rate between the two currencies? Or might it be influenced by a slowdown in the diversification of European investment that accompanied the introduction of the euro at the beginning of 1999?
Let us first examine whether demographics might provide some answers. Contrary to market perceptions, Europe is young. The postwar baby boom generation in the 12-nation euro zone is five years younger than in the United States and 15 years younger than the equivalent generation in Japan.
Demographically, the euro zone is where Japan was in the mid-1980s and the United States was in the mid-1990s.
In the 1980s, Japan's baby boom created an export juggernaut. In the 1990s, America's baby boom created a technological powerhouse. The parallel European achievement may be the euro and its competitive new political and institutional infrastructure.
Is it correct to think in these terms? Is the emergence of a large population of risk-taking young adults a key factor in reshaping and strengthening an economy? If so, the euro zone may be about to experience a strong upturn in growth.
If this analysis is right, household saving rates may decline in the euro zone, as they did in Japan in the late 1980s and in the United States more recently, and aggregate demand may be stronger than forecast.
The value of the euro and asset prices may surge as capital begins to flow into Europe to capture the returns associated with the maturing of Europe's risk-oriented baby boom generation. If demographics matter, and if the European Central Bank is not careful, such an upturn could result in financial asset inflation.
Next, let us look at restructuring. Although macro-economists pay little attention to them, market participants are keenly interested in relative rates of restructuring occurring in different economies. The key seems to be the degree to which actual restructuring deviates from trend and market expectations.
U.S. investors are beginning to wake up to the enormously positive restructuring changes under way in Europe. Financial markets are continually hearing news of pension reforms, tax reductions, modernized corporate ownership rules and other signs that Europe's rigid government-dominated economies are changing.
The under-allocation of U.S. investments to the euro zone in 1998 and 1999 has reversed - in 1998 Americans sold $60 billion of euro equities; in 2000 they bought $20 billion.
Market mechanics are important. The worse a country's conditions, the higher its potential marginal return on investment. In other words, the worse state a country is in, the more attractive it is to investors once true restructuring reforms are initiated.
When real restructuring reforms get underway, "potential" becomes "expected," and currencies begin to strengthen. The slow trend reversal in the euro/dollar exchange rate that has been becoming apparent over the past six months probably reflects this.
The introduction of the euro required euro zone fund managers to initiate a massive risk-reducing diversification of investment holdings. The common monetary policy caused stock and other asset markets to begin to move up and down together. To achieve diversification benefits, euro zone fund managers needed to carry out a one-time adjustment of investment holdings.
The result was a large net outflow of euro capital into dollar markets. The diversification wave reflects the success of the euro experiment, not its failure. If and when it slows - and certainly when any slowdown is completed - downward pressure on the euro from this source will end.
The sheer scale of euro investment diversification contributed to the U.S. stock market bubble. From 1995 through 2000, euro-area gross purchases of U.S. equity securities rose ten times from $61.1 billion to an astonishing $618.5 billion. Net purchases rose from $17 billion to $109 billion.
The diversification flow now appears to be moderating. Downward pressure on the euro is probably declining.
In the past quarter century we have seen two equity market bubbles emerge in conjunction with the maturing of postwar baby boom generations. The first was in Japan in the late 1980s; the second was in America in the late 1990s. We need to consider the possibility that the euro zone could be in the early stages of an asset price surge and could experience a blowout.
There may be a link between demographics, business confidence, and economic growth. That is, the age waves in a population may impact business activity and the direction of an economy. It appears that the age group that powered the U.S. economy with its entrepreneurial and management skills in the early 1990s was the same age group that powered Japan in the early 1980s - 25 to 36 year-olds.
During the second half of the 1980s, in Japan, credit growth surged in parallel with Japan's current account surplus, the yen strengthened, and Japanese asset prices soared. When the stock market crested in 1990, the peak baby boom age was about 41.
After the Japanese bubble burst in 1990, 35 to 45 year-olds found themselves financially overextended and betrayed by the economy. The 30-somethings that were key to getting the whole thing started in the late 1970s and early 1980s were 40-somethings in 1990, complete with marriages, mortgages, kids, and aging parents.
Now, this group is moving into its 50s. Its members are holding back on consumption, and saving as much as they possibly can for their future.
The peak age of the U.S. baby boomers was about 31 in 1990, and most boomers were between 25 and 36 years old. The drive of these creative, young adults provided the energy and risk acceptance that fueled the boom in information technology.
During the second half of the 1990s, capital flowed massively into the United States, asset prices surged, and the dollar strengthened. By the time the peak age of the American boomers reached 42 in 2000, the stock market topped out and began to fall.
The peak age of Europe's baby boom generation appears to be about 35 now, roughly what Japan's was in 1985 and America's was in 1995. If there is merit in the idea that large numbers of young adults can affect the course of an economy, Europe may be where Japan was in the mid-80s and where the United States was in the mid-90s.
Europe may be at the beginning of an upturn in currency strength and asset prices of historic scale. If so, we should be able to identify developments in Europe that are the counterparts of Japan's surge in export competitiveness and of America's information technology breakout.
One of those developments is the restructuring that is now under way. Thus the future of the euro, the dollar and the yen may depend on the degree to which European restructuring deviates from baseline market expectations.
Restructuring is generally political and micro-economic in nature. Fund managers and policy makers who focus mainly on macro-economic trends are frequently surprised by market trends that reflect restructuring processes.
Two guidelines may be useful:
When restructuring initiatives are not underway or are very slow, capital flows to the country with the lowest amount of needed restructuring - it generally has lower taxes, is more productive and is growing faster.
When restructuring efforts are actively underway, capital flows to the country whose restructuring needs are the greatest - its expected marginal rate of return is higher.
n example of the first rule is the way the United States has attracted capital from Europe in recent years. An example of the second rule is the rise of the yen against the dollar in early 1998, when it appeared that Japan's banking problems were going to be aggressively addressed.
We may now be seeing a shift in market perceptions of euro area restructuring. Investors have for years thought that Europe was restructuring more slowly than the United States. But this may not be true.
Europe has many social protections and inflexibilities dating from the Cold War era, but it is making clear progress toward changing them. The progress is sometimes irregular and frustrating, but pension systems, tax frameworks, and corporate ownership laws are unmistakably being reformed and modernized. Labor market flexibility is increasing. Cross-border communications and transportation are rising.
The United States may be more restructured from the standpoint of economic flexibility, but the question is which area is restructuring more rapidly in relative terms and in relation to market expectations. In this respect Europe may be moving ahead of the United States.
Now let us turn to investment diversification. Once the path to economic and monetary union was secure, the development of European financial markets exploded. The issuance of debt in euros, for example, tripled from 1998 through 1999, from €254 billion to €536 billion.
The common monetary policy in the euro zone caused stock and other asset markets to move together. To achieve diversification benefits, euro zone fund managers needed to carry out a one-time adjustment of their investment holdings.
Most diversification strategies involve keeping investment positions in line with market-capitalization benchmarks. Because dollar-zone markets have such large market capitalizations, global investment managers have to hold large amounts of dollar assets.
We can get some idea of the size of euro to dollar area investment flows by looking at relative market size and fund manager positions. In 1997, the market capitalization of the U.S. equity market constituted about 45 percent of the world equity market. In the simplest terms, full diversification would require investment managers to have a little less than half their equity holdings in dollar assets.
In 1997, German fund managers held DM297.5 billion of equity assets, of which 68.9 percent were domestic shares and 31.1 percent foreign. To achieve full diversification the non-German share would have to increase by DM41 billion and all of it would have to be in dollars!
The point of this bit of arithmetic is not to specify the amount of adjustment German fund managers needed to accomplish. The numbers are too crude, and there are many additional factors that should be considered.
The point is that, viewed on a euro area-wide basis, the necessary diversification of stocks was undeniably huge and probably one of the largest in financial history. In a recent discussion of the issue, the International Monetary Fund notes that the adjustment may not yet be over.
There can be little doubt that the quickening pace of euro zone purchases buoyed the U.S. stock market in the last few years in unexpected and probably undesirable ways. The contribution to the U.S. stock market bubble of euro zone diversification reflects deficiencies in current diversification strategies, and, to an important degree, the lack of intermediate-term information on the positions of investment funds. The combination makes it difficult for central banks to detect the evolving capital flow patterns and then to respond to them.
Where does this leave us? Can we say anything concrete about the effects of demographics, economic restructuring, or investment diversification on currency trends? Probably, yes and no. Yes, there are clearly effects - this is undeniable, particularly with regard to restructuring and diversification.
But we also have to answer, no - there may be effects but they are so little understood, or even studied, that their existence provides little guidance about where the euro and the dollar are going in the coming months.
Our perspective may be too short-term though. Maybe we should ask these questions in terms of years rather than months. In this context, there can be no doubt that formation of the euro zone is an unprecedented economic event. It is an event that speeds European modernization and restructuring which in turn must have an impact on capital markets. The resulting diversification is having the effect one would have expected. Considering just restructuring and diversification, there should have been no surprises. They initially lowered the euro relative to the dollar.
The question remaining is demographics. Here we need to ask about history, and curiously we should address our question to baby boom Europeans, the ones who comprise the current economy-shaping population wave. Where do they rank the euro effort in their economic experience? If they rank it at the top or nearly so, we have our answer - the euro is going to strengthen. "When" is not measurable in months, but it is in years.