Why the Euro Will Survive and Thrive

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It's easy to believe the euro will fail if you look only at the equity markets. Greek shipping company DryShips (NAS: DRYS) is trading for a 50th of its former self. Shares of Spanish telecommunications giant Telefonica (NYS: TEF) continue their descent despite its double-digit dividend yield. And Irish biotech Elan (NYS: ELN) has yet to reclaim the ground it lost over three years ago.

What if I were to tell you, however, that the greatest minds in investing believe the markets are wrong on this count? In an interview with Fool analyst Morgan Housel, Wharton professor Jeremy Siegel predicted that European stocks will jump 25% if and when the European Central Bank gets serious about quelling the continent's problems. And Berkeley professor Barry Eichengreen postulated in his book Exorbitant Privilege that the euro will not only survive the crisis but thereafter thrive due to the world's longing for a currency to rival the American dollar.

In what follows, I take up Siegel and Eichengreen's mantel by showing that the history of the euro and the implications of its failure demonstrate that it'll be around a lot longer than the markets have led us to believe.

The history of the euro
The history of the euro is one of political as opposed to economic expediency dating back 600 years. According to Exorbitant Privilege, the idea underlying it was first proposed by a 15th-century king of Bohemia to finance a European army to fight the Turks. Four hundred years later, Napoleon agitated for a single currency issued under the auspices of promoting the integration of the continent. And in the 1950s and 1960s, French economist Jacques Rueff argued for a single European currency linked to gold.

The horrors of World War II added considerable urgency to the idea. The drafters of the European Economic Community, a precursor to the monetary union, saw integration as a means of preventing similar conflicts in the future. This became particularly important in light of Germany's economic resurgence in the 1950s courtesy of the Marshall Plan. The theory was that Germany's participation in the union would discourage it from reigniting hostilities.

While the Continental powers hadn't come to an agreement by 1989, the reunification of Germany provided the final impetus. On the one hand, it became more urgent to lock Germany into Europe now that its population, land area, and economic capacity were set to expand. And on the other, Germany needed the ascent of the occupying powers -- the United States, France, Britain, and the Soviet Union -- to reunify. The decision to negotiate a legally binding agreement on monetary union was therefore taken in December 1989, little more than a month after the fall of the Berlin Wall.

What this history demonstrates is that the European powers see the euro as more than a common currency. To them, it's the price of peace. As a result, the union and its currency are likely much more resilient than modern-day political and financial pundits recognize.

The unpalatable alternative
In addition to the historical and political ties to the euro, fragmenting into individual currencies simply isn't a palatable alternative. Today's currency market is akin to a dark alley in an unfriendly neighborhood -- it's not somewhere you want to go alone. And the looming presence of an omnipotent dollar makes the situation even worse. In the words of an influential German banker, it's like "being in a boat -- or a bed -- with an elephant."

The experience of South Korea during the Asian financial crisis provides a case in point. In less than two months, from November to December 1997, the Korean won had lost half its value relative to the dollar. This wreaked havoc throughout the peninsula's economy, as it doubled the debts of banks and firms that had borrowed in dollars. And to make matters worse, unlike in the recent financial crisis here in the United States, the Bank of Korea was almost entirely powerless. The only thing it could do is print more won -- and nobody wanted won, they wanted dollars. The situation didn't stabilize until the U.S. Federal Reserve loaned the Bank of Korea $30 billion, which then forwarded those dollars to the institutions in need.

In the event Europe's leaders don't look for precedent abroad, they have their own experience of being on the proverbial business end of the dollar. Their familiarity dates to the late 1960s and early 1970s. At the time, the international monetary and financial system was governed by a series of rules formulated at the Bretton Woods Conference in 1944. Under this system, the majority of the world's currencies were tied to the dollar, which in turn was convertible to gold at a rate of $35 per ounce. While fissures in the system started to develop in 1960 when American international monetary liabilities first exceeded its gold reserves, the problem didn't come to a head until the United States devalued the dollar in 1971 and 1973. This sent capital flooding into currencies like the deutsche mark -- though notably not the franc, much to the consternation of a proud French government.

The negative effects of these capital flows are almost too numerous to list. In the first case, the recipient countries' central banks felt obliged to offset the capital inflow by buying massive amounts of dollars to maintain the agreed-upon parities, only to watch the dollar continue to decline. The disproportionate flow of capital thereafter had secondary effects on the continent. Much to the ire of France, for example, a rising deutsche mark decreased the real price of agriculture imported into Germany. And much to the ire of Germany, it increased the real price of its exports, leaving its exporters less competitive in the global marketplace.

It should be noted, moreover, that none of the European countries had any power to stop this. Because their separate currencies were so insignificant relative to the dollar, as the saying goes, they were simply holding the tail of the tiger -- that is, of the United States. This is the reason that France's finance minister under Charles de Gaulle referred to the dollar's international hegemony as America's "exorbitant privilege." And it is fear of this impotency that will keep the European countries united behind the euro going forward.

The final analysis
If I were a betting man, I'd wager that the euro will not only emerge from the continent's current economic woes intact, but that it will come out stronger, being backed by the fiscal authority of a more integrated union. When this happens, as Siegel suggests, it will likely send shares of European companies soaring. Two such candidates for this bounce are French environmental services company Veolia Environnement (NYS: VE) and Europe-oriented steel producer ArcelorMittal (NYS: MT) , both of which have been hammered by the uncertainty in Europe.

For more ideas about companies that are primed for the inevitable recovery, check out our free report about stocks that some of the smartest investors are buying. It discloses the identity of a company that Warren Buffett recently invested in, as well as a small bank that he likely would have purchased in his younger days. To access this free report while it's still available, click here now.

At the time this article was published Fool contributor John Maxfield does not have a financial position in any of the companies mentioned above. The Motley Fool owns shares of ArcelorMittal and Telefonica.Motley Fool newsletter serviceshave recommended buying shares of Veolia Environnement and Elan. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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