The Euro’s Permanent Political Crisis
The euro is one of the most important political experiments in European history. Born with a huge democratic deficit, it is still a legal tender for 300 million people in 17 countries and accounts for about a quarter of world currency reserves.
Not a bad record for a new monetary unit, whose chief architect former German Chancellor Helmut recently admitted that he would have lost the referendum had he asked the voters twenty four years ago whether they wanted to abandon the German mark for a European currency.
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But the ambivalence remains. Being essentially an act of political faith, the euro is a unique example of an asset class with intrinsic investment features, at the same time ridden by quasi permanent spells of investor neurosis about its viability as a transaction currency and a reliable store of value.
To simplify things, both of these aspects of euro asset valuation can be considered as short-term and long-term investment issues.
Euro's Good Short-Term Outlook
In the short run (a time period of up to one year), intrinsic features dominate as expected risk-adjusted returns of euro-denominated assets are analyzed – and compared – with other outlets in the investment universe. In that context, the euro is doing quite well: it keeps rising against the dollar in spite of the widening interest rate differential favoring dollar assets (against German fixed-income instruments of comparable maturity) and is up about 4 percent since the beginning of the year in trade-weighted terms.
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The euro's gains are underpinned by a large – and continuing – improvement in the monetary union's external surpluses, its declining budget deficits (with a huge drop in structural deficits) and a slowing growth of public debt. Of particular importance is the euro area's fast increase of excess savings – currently approaching 2 percent of the gross domestic product (GDP) – because that makes it less vulnerable to vagaries of global capital flows.
From a short-term investment perspective, it is not a bad idea to buy euro area's bonds and equities. The region's economy seems to be bottoming out, and the likelihood of a weak and noninflationary recovery offers attractive investment values in both asset classes.
Widening Euro Area Political Fault Lines
But longer-term investments, in my view, are a different story. Recent events have convinced me that long-term euro investors are exposed to serious uncertainties. These range from (a) the euro area's flimsy institutional structure to (b) uncoordinated economic policies, (c) fragmented financial systems and (d) absence of any consensus on substantial sovereignty transfers to create an integrated political structure required to run an effective monetary union.
The current crisis is providing a clear demonstration of how devastating these euro area failings are for jobs, incomes and political viability of the single currency.
The issue is not – as German leaders keep repeating – that some countries violated the budget deficit rule (3 percent of GDP), and that others did not properly supervise their banking systems. In fact, the irony is that Germany should follow the old advice that "people who live in glass houses should not throw stones." Indeed, the country was the first major euro area country to violate the budget deficit treaty obligation of 3 percent of GDP for four consecutive years, beginning in 2002. Germany also had to deal with banking problems of its own in the wake of the subprime crisis.
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No, the issue is that when "stuff happens," as the popular saying goes, the euro area is unable to handle problems in an effective and expeditious manner.
The euro area has no mandatory surveillance and enforcement mechanisms to prevent serious economic mismanagement in its (sovereign) member states. And when "stuff happens," the euro area is incapable of correcting the problem before it becomes a crisis of systemic proportions.
A recent IMF report points out some of these difficulties by blaming the euro zone, specifically the E.U. Commission, of mismanagement for the Greek tragedy, which was followed by similar tragedies of deepening recessions and soaring unemployment in Spain and Italy. Now, to be fair, the IMF knows that the E.U. Commission could not do anything because Germany and France could not agree on what had to be done, allowing the Greek crisis to spin out of control.
French-German Discord Can Kill the Euro
Investors should realize that nothing of substance has been done to prevent similar situations in the future. And there is no credible assurance that the euro zone will operate as an effective and irrevocable monetary union.
The new fiscal agreement (i.e., the "fiscal compact") concluded in late 2011 maintains old budget deficit and public debt rules (3 percent and 60 percent of GDP, respectively) and provides for some E.U. oversight of the budget process, but mandates no automatic and inescapable sanctions for countries failing to respect these rules. Essentially, everything remains as before; subject to political considerations of sovereign states.
The current wrangling about the euro area's banking union to give the European Central Bank (ECB) the supervisory and regulatory authority – essential functions it should have had from its inception – is showing deep political disagreements among key member countries.
Germany's constitutional probe of the ECB's offer of conditional government bond purchases – an unused instrument whose mere announcement prevented the demise of the currency union -- is an example of the regrettable acrimony surrounding the euro area's monetary policies. Two German members of the ECB's governing board had already resigned in a huff, and the current leader of the German central bank – the key plaintiff – was one of the German chancellor's closest economic advisers.
At the core of all this is a serious crisis in French-German relations. This is not just a "friendly tension," as the French president calls it. This is a political brick wall along a broad range of key issues at a time when the management of the euro requires substantial sovereignty transfers Paris and Berlin disagree about.
Things are so dire that Hans-Olaf Henkel, the former President of the Federation of German Industries, wrote last Friday in an eloquent and well-documented article that the French-German friendship can only be saved by abandoning the euro -- an ominous thought at a time when the two countries are supposed to celebrate 50 years of their reconciliation.
For a convinced Europhile, this has been a difficult piece to write. But I have come to the conclusion that – barring an unlikely reversal of the French-German political disagreements – the future of the euro is bleak indeed. Currency traders don't risk much on their short-term euro transactions, but long-term investors should think twice about their commitments to euro-denominated assets.
—Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia Business School.