The fiscal crisis that started in Greece, and drove attention to similar problems in Portugal, Spain and Italy, is way more than a fiscal crisis. This is about the euro as a currency and about the EU as an institutional framework for governing a union, even more so now that there appears to be a bailout. The analogies between the dollar and the euro are not good and actually lead for a case for the dollar. However, all of G7 has a not so pretty fiscal picture and outlook, which should be changing how investors allocate medium-term wealth. But markets seem to continue to respect old patterns of what is risk free and what is more risky.

First on the euro

When ECB president Trichet compares Greece to Massachusetts, modesty aside, he is making a critical conceptual mistake. The EU does not have a central federal fiscal authority like the US has, with significant federal taxation powers to back the currency. The euro is only as good as the sum of its parts, and as countries like Greece are allowed to run fiscal imbalances and get bailed out by their richer cousins, the sum of the parts gets to be smaller. Following Trichet’s analogy a few more steps, it is plausible to have several large states in the US run into serious fiscal problems without the federal government suffering a fiscal crisis. This is not the case in the EU, where fiscal imbalances in a non-trivial set of countries does affect the sum of the parts, as there is no real federal government. The EU is a club with strict membership application processes, but no expulsion mechanisms or rules.

On the economic growth dimension, EU member nations have different economic policies, regulatory frameworks and taxation schemes, which make it more likely that there would be high dispersion and differences across countries on economic and productivity growth. Persistent differences make the euro a curse to those nations with low productivity growth, as only deflation would make those economies preserve competitiveness. True, the same would happen across states in the US or provinces of any country, but those share federal taxation and regulatory schemes, more fluid resource mobility, which reduces the likelihood of persistent differences.

Theoretically, the EU should have the capacity and prove its willingness to expel a member nation. In reality this is highly unlikely. An easy bailout would set a poor precedent and incentives on fiscal policy. Most likely, the noise we witnessed in terms of contradictory statements from different EU officials is due to the difficulty in striking a balance between short-term crisis management and medium-term incentives.  Not to mention the possibility of poor coordination and policy mistakes… Details should be coming out this afternoon, at least the first strokes.

Where is the dollar in all this?

More broadly, these events draw attention to fiscal imbalances across G7, and this is where the US does not fare so well. The size of its budget deficit (for the US 9.9% of GDP in 2009, expected to be 10.5% this year) and debt to GDP (88% for the US), together with the medium-term outlook (cost of entitlement programs), makes the whole G7 fiscal picture depressing. Goldman Sachs recently put out a piece showing the debt dynamics of G7 countries and comparing to EM countries, and the takeaway is impressive. EM countries are an example of fiscal prudence and debt dynamics.

What are G7 currencies worth? Can they really be reserve currencies or we are at the beginning of a drastic break with the past?

We definitely are in uncharted waters with respect to the reserve currency question, as the worst fiscal situations and government balance sheets are in G7, with the opposite in the best EM countries, Asia, etc. However, we do not take the argument to the extreme, as some do (see Niall Ferguson in the FT yesterday). We do not believe what started in Greece ends up with the demise of the dollar. The US has in its track record a serious fiscal adjustment (at least in the 90s), though it was to a large extent growth related. But that is exactly the point, the US economy has the capacity to reallocate resources, change, and show high productivity growth. Moreover, being the reserve currency for so long provides for a more forgiving reaction, not only because of path dependency but also because of the base for its seignorage and inflation tax. Thus, we do believe the dollar can depreciate versus the best non-G7 OECD currencies and best EM currencies, but would remain the reserve currency.

Asset Allocation

We believe there is more than enough reason to fear that inflation is part of the solution to G7’s fiscal problems, and that their currencies will depreciate vis-à-vis the group of the next best currencies (some are up and coming currencies, like BRL and TRY, in a group with AUD, NZD, etc.). In that vein, our portfolios have currency diversification, commodities and US, Asian and EM equities as protection, together with inflation linked debt. However, at high frequency markets continue to follow old patterns, in which flight to quality continues to be buying US Treasuries and the dollar.

It would be naïve to believe such a change in attitude and focus would happen in one year, it would take time. Especially, it will take for global asset allocations to change in that direction gradually (not sharply during sell-offs). But the change is happening, as shown in some flow of funds. EM local markets funds have had secular inflows for some time now, with weekly inflows of more than 2% of assets under management for many weeks (10-week average was 1.3% of AUM a couple of weeks ago). Many other asset classes have had outflows during recent weeks.

Flows of funds are one way of measuring this (and test this view). Another method is to analyze if betas reflect this dynamics. Betas of the asset classes that can offer shelter from G7 fiscal imbalances and upcoming inflation should fall. What market index to use for such analysis is a relevant conceptual question for future pieces.

In sum, asset allocation according to these ideas has to balance higher current volatility with the medium-term benefits of such diversification.

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