Pessimism batters euro, bolsters dollar Currencies and confidence

A growing number of economists agree that the U.S. dollar is over-valued, but that hasn’t stopped investors from shunning the euro, which dipped to fresh seven-month lows last week after the European Central Bank resisted pressure to cut interest rates. If money talks, Uncle Sam is getting more air time than all the crowned and uncrowned heads of Europe put together.

The world’s love affair with the U.S. greenback has prompted some European pundits to complain that America’s economic prospects are worse than their own, and that its superior performance of recent years was driven not by real growth and productivity gains but by a borrowing binge and the biggest equity bubble in history. They argue that the euro is a safer ride than an overshooting star destined for a nasty encounter with gravity. (Gold producers have made similar pleas, albeit less forcefully, and with even less success.)

The continued strength of the U.S. dollar, even in the face of gloomy economic data, suggests that investors aren’t heeding the warnings. Indeed, if currency strength is a measure of economic confidence, then America is winning the game, leaving even its most touted rival, the European Union (EU), eating its dust. However, it’s not that America is doing everything right but rather that the EU is doing too much wrong. In recent months, more red lights have flashed across Europe than green, making it difficult for the EU to convince the financial community that it has the right stuff to reach its stated goal of becoming the world’s most powerful economy by 2010.

The Financial Times, for example, recently noted that the defeat of legislation to create common rules on takeovers “sends a signal that Europe is not serious about opening up its capital markets.” This is a sensitive issue, particularly after the EU blocked General Electric’s US$4.3-billion takeover of Honeywell. And last year, the EU came under fire when Alcan and a Swiss-based company merged to create a global industry leader in aluminum and specialty packaging. It was supposed to have been a three-way merger that included Pechiney of France, but the grand plan was thwarted by the EU’s Merger Task Force.

Jacques Bougie, then president of Alcan, complained that Europe’s “regulatory complexities” made the merger process complex, time-consuming and expensive. “These inefficiencies unfairly and significantly penalize shareholders, employees, customers and consumers at large. There is enormous economic leakage.”

Silence has been the sad reply. In the wake of anti-globalization protests in cities as far-flung as Seattle, Sydney and Prague, some European nations have become increasingly ambivalent about liberalizing their economies. France in particular is being criticized for policies that pander to public sector unions (who make up 25% of its workforce) at the expense of economic liberalism. Germany also has adopted restrictive labour regulations that are cramping growth and job creation. Meanwhile, feisty Ireland is being criticized by the EU for the very policies that transformed it from one of Europe’s poorest nations to one of the richest.

Instead of focusing on improving cross-border trade and competition, the EU has been obsessed with agricultural policy, regional aid and social standards. Far too many of its programs are based on subsidies and re-distribution schemes rather than on investment incentives aimed at real wealth creation. Small wonder investors are getting mixed messages about the EU’s commitment to economic liberalization, and small wonder that Euro-skepticism is giving a by-product boost to the American dollar.

The currency market, like most financial markets, is an emotional beast responsive only to the battery of signals that illuminate the strengths and weaknesses of any given currency. For proof, one need look only at the Brazilian real, which recently slumped to a record low of US39 amid fears of energy rationing and political scandals. Other Latin American currencies also weakened in light of socialist rumblings in Venezuela and Peru, and economic woes in Argentina. In Africa, Zim-dollars are near-worthless, and South Africa’s rand has been devalued so many times investors have lost count. These political and economic uncertainties have fuelled demand for the American greenback, which is rapidly becoming the de facto currency of the world.

The U.S. dollar isn’t just the currency of choice for sophisticated investors. Citizens who lack confidence in their own nations’ policies buy short-term necessities in local currencies, and accumulate long-term savings in U.S. dollars. It happens routinely in China, in Latin America, in many African nations, and in most parts of the former communist world. Some nations have scrapped their currencies altogether in favour of dollarization.

The strength of the U.S. dollar is an indirect vote of confidence for open markets and free enterprise, and a wakeup call for governments moving in the opposite direction. It could be a wakeup call for gold too, if investors truly believe that the dollar is too strong and its competitors too weak.