Sunday, 21 March 2010

Will the euro be around in 20 Years

Will the Euro be Around in 20 Years?

21st March 2010

The Malta Independent on Sunday

Alfred Mifsud

Unlikely, according to investor and commodities guru Jim Rogers who was interviewed this week in London on CNBC Europe TV. If you think that’s an extreme view, my own is even more extreme. It could disappear much sooner than 20 years unless the whole structure under-pinning the euro is urgently and thoroughly reformed.

Let’s put this issue in a historical context. No freely traded currency that is not underpinned by a sovereign state can sport any impressive longevity. Euro apart, all existing major currencies belong to individual sovereign states with a Treasury tasked to adopt fiscal policies in support of such currency.

Success for monetary union across different sovereign jurisdictions depends on a commitment for political union. History shows that monetary unions which were not underpinned by a political union proved short-lived. The Latin Monetary Union involving Italy, France, Belgium, Switzerland and Greece collapsed in 1920 after 60 years because of lack of fiscal discipline among its members. A Scandinavian monetary union in 1873 proved short-lived as political circumstances pulled countries apart rather than closer together.

The German Central Bank used to argue in the 1980s that monetary union ought to be the end result of a political union. In going ahead with the project without a commitment for a political union, the euro founders must have been hoping for one of two things. Either that the monetary union would itself be a catalyst for the gradual formation of consensus for a political union to underpin it, or that the constituent sovereign States would co-operate closely and align their fiscal and financial policies to make them resemble the policies of a single State.

Such assumptions can only be validated when the system is under severe stress. And after 10 years of relatively stress free performance, we have suddenly precipitated to the point where the financial stability of the constituent sovereign states has come under severe stress. The Stability and Growth Pact, which was meant keep the fiscal policies of individual euro member states in harmony, was blown away by severe financial and recession stress. Without harmonized fiscal policies, the future of the euro has to be compulsorily brought into question, as its short existence over a mere 11 years is too shallow rooted to give confidence on its ability to withstand continuing severe stress.

The official line so far is that the members can bring themselves back to within the Stability and Growth Pact under their own steam by forcing cruel adjustment policies on domestic players to bring back to within a three per cent fiscal deficit, which in the extreme case of Greece has gone as wide as 13 per cent.

This is a pious hope. It is like believing that Haiti can rebuild itself after the quake disaster without external help. Achieving a 10 per cent GDP fiscal improvement in a short time is like putting the local population through a sausage machine, which will continue to depress the economy and so create larger not smaller deficits as the economy shrinks.

If this line of thinking prevails, the future of the euro is uncertain indeed. The pressure building up internally would become so great through the mismatch of economic performance and efficiency levels among the constituent sovereign members, that the whole system will blow up, sooner rather than later. Let there be no doubt on what such a ‘blow up’ would mean in practice.

It would mean that the weakest members would have to crash out of the system, re-adopt their national currency, devalue it to regain instant competitiveness and probably default on their external foreign debt. This will bring about so much instability in the European banking and financial system, given that European banks and institutional investors are major investors in such would-be defaulted sovereign bonds, that Europe will be thrown into a very deep recession involving a substantial loss of value of the euro on the foreign exchange markets, possibly leading to its disintegration and bringing into question the sustainability of the European Union itself.

These consequences are so dire that at some point in time European politicians will have to wake up from their pious dream about self-correcting dynamism, and do something to facilitate the adjustment of the faltering members.

What can they do? The obvious thing would be to proceed with either a full blown political union, or something quite close to it through the creation of a European Monetary Fund that will transfer resources subject to conditionality from the well-off states to the needy states. This will clearly involve loss of political sovereignty for the defaulting members. This was recently proposed by the German Finance Minister, but it would need a renegotiation of the EU treaties. Given the travailed ratification of the Lisbon Treaty, this seems as practical as Chelsea or Milan, which were eliminated before the quarter-finals, winning the Champions League next May.

More practical would be achieving such shift of resources by market mechanisms through strong countries running higher deficits and inflating demand in their economies to create external demand for the products and services of the troubled members, thus facilitating their adjustment by inflating economic growth. In practical terms, Germany, France and Holland could temporarily run higher deficits by allowing tax breaks so that their citizens will have more spending power to take holidays in the Mediterranean EU members. After such a harsh winter, who would miss a holiday if it is financed by savings on their tax bill?

All that this would require is for Merkel & Co to realise that they cannot have their cake and eat it too. Germany cannot have the benefits of enhanced competiveness through the euro single currency without paying the price for helping the weaker members of the Union to recover their state of health in a practical manner.

Unfortunately, Germany seems to be going in the opposite direction. They continue to amass huge balance of payments surpluses both with regard to intra EU trade and with regard to the outside world, in the latter helped by having the euro as their currency which is much softer than the situation would have been had they retained their Deutsche Mark. They even had the audacity to pass a law to ensure they balance their budget by 2015 and to keep it so balanced thereafter.

Let Greece, and its companions in distress, bear the main brunt of the necessary adjustment to regain fiscal sanity. But they cannot do it on their own and certainly cannot do it at all if the Germans continue with their ultra conservative fiscal policies irrespective of their obligations for keeping the monetary union sustainable.

If the Germans wish to continue enjoying their successes they had better take steps to ensure that Jim Rogers is wrong and the euro will be sound and around in 20 years’ time.

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