Before coming to Fletcher, I worked on the floor of a major Wall Street currency sales and trading group. I will admit it; my job was to keep the profit and loss statements up-to-date, the Wall Street equivalent of sweeping the floors, but it was an interesting place to observe capitalism at its finest.

When the Russian government announced in August 1998 that it was defaulting on its debt, I was introduced to the global economy through the medium of a wide-eyed and screaming Anthony Pitt, the firm’s proprietary currency trader (meaning his only job was to speculate). Upon hearing the news from Moscow, he remained quietly at his trading desk, lost in thought. Then suddenly, he burst out his chair and began selling tens of millions of U.S. dollars to buy Japanese yen. He then picked up his phone and began yelling for our bond desk, selling more millions of short-term interest rate futures. Then he sat down, leaned back calmly and waited--and when nothing happened, he went home for the day.

By the next morning, the dollar/yen exchange rate had fallen by 20 yen in little more than 12 hours and the U.S. stock market was scheduled to open limit down (the maximum allowed by exchange laws). The bond markets were in full-scale panic mode on rumors that a major hedge fund had collapsed. Investors were piling into the safest financial instrument available--short-term government bonds--causing short-term interest rates to decrease sharply. Pitt hadn’t slept all night and had made over $2 million in his own account for the firm.

I happened to catch up with Pitt on Jan. 1, 1999, when another market milestone, the launching of the euro, was set to occur. He was in a spirited mood (it was bonus day), and I asked him what he thought of the euro's prospects. In the weeks leading up to the currency's launch, economists couldn't outdo each other in forecasting its impending strength. Some even claimed that billions of dollars held in central bank reserves worldwide would be converted to euros, causing it to appreciate 10-20 percent (a huge move in currency values) in its first two months. The media had seconded this line, dramatizing the inevitable demise of the dollar as the world's indispensable currency.

Pitt laughed and answered, "The euro is a piece of s---." As if to emphasize his point, he called over to the euro trader and sold 20 million before turning to the more important business of consuming his lunch. Such was my introduction to the erudite, refined world of global currency trading.

However, in the past year, his assessment, however blunt, has not been far off the mark. The euro has been in a continuous decline since January of last year. Recently, it fell through "parity," or 1:1 with the dollar, a significant event in the currency markets. The break was accompanied by a barrage of comments from official Europe that there wasn't anything to be concerned about. Yet judging by the vociferousness of the repeated denials, perhaps there is.

Martin Feldstein, Harvard economist and a long-time skeptic of European Monetary Union, has repeatedly written that EMU was driven by a political rationale, namely to bind Europe together in a way to that would make future war on the continent unthinkable, rather than an economic one. The laudatory nature of the motive notwithstanding, history has not been kind to politicians attempting to subvert economic laws. The first economic shock that occurs (and one inevitably does) is usually enough to expose the dysfunctionality in the system, as demonstrated by the European Rate Mechanism's disintegration in the early 1990s following the shock of German reunification. If the world is reluctant to hold euros, it may be because the currency, despite its initial "success," has yet to pass a real test.

The Euro's slide against the dollar

The reaction of the European Central Bank to the euro's slide has revealed this insecurity. As the price level of the dollar/euro exchange rate approached parity, officials from the ECB let the word out that they thought the Euro was "undervalued" at these levels, which market participants interpreted as a threat to intervene. This would have involved massive buying of euros and selling of dollars by the central bank if the 1:1 exchange rate was broken. Given a target, the currency market will always test it, and when the European currency was pushed below this level, the ECB responded by doing nothing. The market, capable of smelling vulnerability from a mile away, had called the ECB's bluff and interpreted the bank's lack of follow-through as a green light to sell. U.S. interest rates are set to increase--which will attract even more capital to the U.S.--and barring a major U.S. stock market correction, the euro's descent is very likely to continue.

The currency's longer-term trend, rather than the changes driven by more immediate market concerns, is revealed by the fact that interest rates have been rising, and are about to rise further, in the United States. Beginning with the Reagan administration's efforts to reduce inflation and President Reagan's decision to fire the striking air-traffic controllers during his first year in office, the U.S. has enjoyed an era of unprecedented economic growth—recently growing at a rate of 5.8% in the last quarter of 1999. Reagan's action signaled the beginning of widespread corporate restructuring that infused new life into the American economy and continues to this day. A contrasting event occurred in Germany last month when the state intervened to prevent a private company, Phillipp Holzmann AG, from a well-deserved bankruptcy. The next day, the euro fell further.

Sound macroeconomic management leading to stability and economic dynamism is what attracts capital in today's global economy. The ECB, if it is really concerned about the euro's price, would be wise to try the following:

1. Feign indifference to the level to which the currency markets push the euro ("the markets will fluctuate" as J.P. Morgan famously responded when asked for his stock market prediction) and concentrate on their real mandate: controlling inflation.
2. Use public relations to encourage Europe's political leaders to: reduce the structural rigidities in the European labor markets, permit mergers and other constructive forms of corporate restructuring, and catch up in the Internet race.

Ultimately, if these efforts succeed, Europe will once again become a favorable place to hold assets, the euro will stabilize on its own without the help from centralized state authorities, and regional pride in the euro may become more than just an empty fantasy.

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