Saturday, 26 November 2011

Who's Laughing Now?

Can you believe that I had asked the question everyone is asking today more than two years and 9 months ago when Greece was still borrowing as if it had no problems?  At the time many criticised me that I was trying to spread panic by making unrealistic, even unthinkable assumptions.  Now see the front cover of the ECONOMIST this week:

I stand today by every word I wrote on 13th February 2009 including that the only solution to save the Euro is, amongst other measure but certainly the very first one, having the ECB following a 'reckless' monetary policy by flooding the money supply to bring down the value of the Euro to levels that reflect the southerners economic reality.


Will The Euro Survive?

13th February 2009
The Malta Independent - Friday Wisdom
Alfred Mifsud

I suppose this is a question which should not be asked and if it is asked those who are in charge of protecting the integrity of the euro can only answer in the most absolute way that the euro will most definitely survive and even prosper.

But such absolute assurances should not bar thinkers and realists from asking the question. The very act of posing such question implies the existence of doubt about the euro’s long-term staying power.

The euro has just celebrated its first very successful decade and doubters could easily be dabbed as spoilers. But 10 years is a very short time to prove the longevity of a monetary union. History is riddled with similar monetary unions between separate sovereign states which blew up after several decades of initial success. In fact if one looks around it is clear that the major currencies of the world apart from the euro, are the currencies underpinned by individual sovereign states.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the US economy.

We are now at the point that the late Milton Friedman had perceived. The euro is being tested by a fierce global recession and developments going on within the individual component states of the monetary system do not suggest much optimism that the system has the necessary resilience to come out of this challenge unscathed.

We are seeing the euro area economy being dragged into a deep recession at an astonishing speed. In this context we are bearing witness not only to external measures of protectionism but we are also seeing measures of protectionism even between members of the EU and the euro area.

The euro and single market rule book has been shelved. Faced with the primary responsibility to the electorate of the sovereign state that elected them, governments have to put taxpayers’ money at risk to try to stabilise the financial system and to cushion their sovereign economy from the possibility that the recession will deteriorate into a depression. And it is obvious that once taxpayers’ money is put at risk, governments have to take narrow sovereign circumscribed measures to ensure that the benefits of such extraordinary fiscal measures will be enjoyed by the sovereign taxpayers and not by the general members of the Union. The we-are-all-in-this-together syndrome rarely goes beyond lip service.

So we are seeing France bailing out its car industry but making conditions to ensure that jobs are kept in France and if redundancies are needed these are squeezed out of plants in other EU states. We are seeing Ireland nationalising its banking industry, guaranteeing all bank deposits, and making conditions on its now state-owned banks to give preference to local borrowers in their normal operations across the whole EU.

It is evident that under the stress of an acute recession, potentially a depression, a monetary system that does not have the benefit of a federal government that can draw up a federal budget to support monetary measures with fiscal measures, is unlikely to withstand within its boundary the tremendous pressures that are building up within it.

So what could happen if the internal stress of the euro monetary system becomes too much for the system too bear?

The first thing that will happen is that further expansion of the monetary union will be frozen till the financial markets get back to a state of normality. One could argue that the fact that countries like Denmark, Hungary and Iceland are clamouring to join the monetary union (even though Iceland is not yet an EU member and would have to become one before being accepted in the monetary union) is a sign of strength resulting from the attractiveness of the union. I doubt it! A system which has de facto suspended its rules cannot bring in new members before it re-establishes discipline. And, frankly, bringing in members motivated by their economic weakness rather than their economic strength is not conducive to stabilising what is an already fragile structure.

The next thing which could happen is that some of the existent members could find the conditions, legal or de facto, of the monetary union tough going in order to protect their sovereign national interest or indeed to protect the popularity of their own government with the national electorate. It is tempting to think that I am referring here to the weakest links in the system, countries like Italy, Greece, Ireland and Spain either because of their huge national debts (Italy and Greece) or because they are suffering more than others in the recession from exposure to a burst national property bubble (Spain and Ireland). Wrong! These countries would be hurt most if they leave the system and would suffer substantial downgrade of their national debt and consequently an explosive increase in the cost of servicing it.

I am referring to the strong countries that can leave without suffering such consequences. It is countries like Germany, France, Netherlands and Austria, among others, who can afford to leave the system with little damage. If the recession worsens to an extent that weak link countries could risk default on their sovereign debt or would need support from the stronger members, we will have to see whether the fraternity bonds are strong enough for the healthy to bear the cost of bailing out the weak.

In practical political terms it is inconceivable that taxpayers of the strong countries would accept to carry such hardship. So the only way it could be done outside the fiscal structures is by adopting more liberal (more reckless if you wish) monetary policy leading to a downward floatation of the Euro against other major currencies in order to give on a supranational basis what individual euro countries can no longer do on a national level.

Is it not strange that I am arguing that only reckless monetary policy can save the current composition of the monetary union?

Alfred Mifsud

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