My career in the investment business began on September 2, 1992. It was an interesting time.  The S&P 500 was just above 400, and a few years away from a major liftoff, but Europe was in a deep economic crisis. The first serious attempt to tie Europe together using something other than military force was coming unglued. It was called the exchange rate mechanism (ERM).  The ERM set specific trading bands within which currencies could trade relative to one another, with the German mark at the center.  It blew up in September 1992. This was the now famous period when George Soros “broke” the pound, and made a billion dollars in the process.  Then, markets blew up the currency regime, which forced the weaker economies to devalue to restore their relative competitiveness. Recovery only became possible without the weight of an artificial currency peg.

Europe once again finds itself in an economic mess tied to the inability of some nations to remain competitive within a currency regime. Today though, much of the Eurozone is using one currency – the euro – and you can’t devalue within a single currency. Peripheral countries struggling with high debt levels and inflexible labor markets are trying to restore their competitiveness with big spending cuts, a.k.a. “austerity.” It amounts to an internal devaluation and the results are grim. Unemployment in Spain is now 26%¹ overall and more than 50%² among young people. Italy has unemployment of more than 10% and is in a very long recession³.  This, to me does not look sustainable (duh). But while there isn’t an economic mechanism to devalue, there is a political one, and we are seeing it emerge in Italy.  

I believe the fear of a euro break-up has parallels to the ERM. It is, after all, merely its successor, and a more rigid one at that. Italian voters appear to be reconsidering the logic of severe deflationary austerity. After all, why not? The benefits of the single currency appear to largely have accrued to Germany and the southern European nations got ugly consolation prizes – unemployment and deflation. The political drama in Italy will either usher in Italy’s departure from the euro and the beginnings of a real recovery, or a more realistic approach to pan Eurozone economic policy and a real recovery.

Although it seems like it would make a bad economic situation worse if a country were to leave, it actually was not with the ERM.  It may not be now, either. The ugly truth may be that the single currency might be part of the problem, and not the solution. I believe equity investors should nevertheless be patient. Valuations are not high, and Europe may get at least partially bailed out by an improving world economy. That just might allow some space to rethink the approach in the context of a less stressed European economy.

1. Haver Analytics as of 12/31/2012
2. Haver Analytics as of 12/31/2012
3. Haver Analytics as of 1/31/2013

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