As economists grapple with the ongoing global crises, they’re asking themselves a pair of important questions. First, why have European policies let problems fester for so long? And second, whatever happened to the notion that trade and budget deficits impact currency values? The answers to these two questions are interrelated, and they will have a huge impact on your portfolio in coming years.

The Greek blueprint
Let’s tackle Greece first. Watching all of the parties angle for the best possible deal has been like viewing a slow-motion train wreck. German taxpayers hate the idea of perpetually subsidizing countries like Greece. European banks took a bold yet hated step by writing off the value of many Greek loans, and Greek citizens hate the idea of ever-increasing cuts in their social safety net. Nobody is happy, yet nobody is willing to acknowledge an unspoken reality: Simply put, Greece’s economy will never be able to turn around while it is tied to the lofty euro. The banks, agreeing to a 50% haircut on their loans, didn’t go far enough, as reflected by the fact that bond prices peg the likelihood of loan payback rates closer to 25%. And German policy makers are unwilling to admit that any benefit of being part of a currency union with weaker member states runs the risk of crippling its own economy. Germany’s economy has just slipped into recession, and further crises could really tank its economy.

The solution is increasingly clear, even though it is simply bad politics to acknowledge it: Greece needs to move out of the house, re-institute a (much-cheaper) drachma as its currency, and focus on a turnaround that is based on rising exports and shrinking imports (which is what always happens when a currency is devalued).

Two Europes emerging
That’s not the end of it. Instead, it’s just the first step in a realization that there are two Europes: Northern Europe and Southern Europe. Greece is small potatoes compared with the much larger Italian and Spanish economies, but those countries’ involvement in the broader European Union framework creates the same problem. Their economies will remain weak (or in recession) as long as they are tied to a too-strong currency that inhibits their export competiveness. The need to cleave Northern Europe and Southern Europe will become even more apparent this winter as interest rates in places like Italy rise to levels that bring the economy to its knees. The recent rate rise for Italian bonds is a direct reflection of the doubts that Italy will grow its way out of the current mess.

So let’s look at a world where weaker countries that are either unable or unwilling to comply with eurozone rules can leave the currency union while remaining in the EU (which is currently being discussed). As a reflection of their weak economies and trade flows, countries in Southern Europe would likely be tied to currencies that are weaker than the current euro. The converse is true in Northern Europe, where countries like Germany and France are so strong — on a relative basis — that their currency would be closer in value to the even stronger Swiss franc.

What does this mean for American companies and investors? Well, a rising Northern European currency would be like manna from heaven. Industrial factories in places like Ohio or Wisconsin instantly become much more competitive against factories in Lyon, France or Stuttgart, Germany. The fact that the cost of doing business is rising in China only underscores the notion that U.S. manufacturing is about to undergo a renaissance. This report, put out by the Boston Consulting Group in August, spells out the case for a rising American industrial sector in the next few years better than anything I’ve come across. As an investor, it may be the single most important thing you read this year.

What should play out with the dollar — and how you can profit
Back to my earlier point about trade flows and the dollar… Economic theory holds that whenever a country runs a trade deficit, its currency has to weaken as funds are exchanged to purchase imported goods. The United States has run a negative trade balance of at least $350 billion for more than a decade.

 
Budget deficits are yet another factor in weakening a currency as printing presses crank up to meet budgetary shortfalls. That’s precisely what started happening in the last decade. Measured against a basket of currencies (with 1998 representing a baseline of 100), the dollar slid from 130 in 2002 to just 95 in 2008. Then the economic crisis set in, pushing that measure back up above 110. Since then, the dollar has weakened again, most notably against the Japanese yen, the Australian dollar and the Brazilian real.

 
The dollar hasn’t weakened against the euro yet, but it will if the European crisis resolves as I mentioned earlier. Simply put, in terms of trade flows, a U.S. currency should be 15% to 20% weaker against a more focused French/German-based currency.

Action to Take –> So what does this mean for investors? It means it’s time to stop writing off the U.S. industrial sector. It’s hard to spot on a daily basis, but U.S.-based businesses are slowly gaining a pricing advantage against Japanese, Australian and Brazilian rivals, and they will soon be able to make similar claims against European rivals.

Check out the SPDR Industrials ETF (NYSE: XLI), which holds shares of United Technologies (NYSE: UTX) and Caterpillar (NYSE: CAT), while carrying a low 0.2% expense ratio. The Vanguard Industrials ETF (NYSE: VIS) provides similar exposure. And don’t forget about the American farmer. Agricultural exports are already booming, and a weaker dollar should help power them even higher. The Market Vectors Agribusiness ETF (NYSE: MOO), which owns shares of companies like Monsanto (NYSE: MON), Potash (NYSE: POT) and Deere (NYSE: DE), has great exposure to the weak dollar thesis.