Revert to Old Currencies Temporarily

Financial Times



Sir, Vincent J. Truglia (Letters, June 18) is right in maintaining that the status quo in the eurozone is unsustainable, but is wrong in prescribing as a solution that peripheral countries should exit the euro as soon as possible.

Irrespective of whether or not conversion of the euro-denominated debt back to domestic currency would be a default, there is no argument that such a measure would cause turmoil in the European banking system as banks incur heavy exchange losses on their massive holdings of euro-denominated sovereign debt of EU peripheral countries. This cannot be good for anyone, least of all the weaker EU economies.

A better solution would be for the core countries to exit the euro and temporarily revert to their old currencies, which would harden substantially against the euro. This would bring an instant re-adjustment of competitiveness to address the current grave intra-EU trade imbalances.

It would shift macro-adjustment in EU peripheral countries away from counter-productive austerity measures to more bearable growth policies. It would also spread the adjustment pain across a much wider spectrum, including the surplus EU countries and foreign holders of EU reserves.

Eventually, when the euro architecture is rejigged through the creation of a single treasury, or at least through the creation of an EU authority that controls national budgets and centralises all borrowings on an EU-wide basis, the currencies can be remerged into the euro version 2.

Square Circles

The Malta Independent on Sunday - 13 06 2010

The US economy seems well entrenched in a gradual recovery from the banking induced recession. The recovery is now being reflected even in the US jobs market, which is normally a lagging indicator of economic growth. Employers initially meet increased production demand with overtime and part-timers until they are convinced the demand is sustainable enough to risk hiring new full time personnel. The recovery is not moving with the same momentum as the fall experienced in 2008, but things work like that. A downturn through sudden loss of confidence is like a fall in a lift shaft, whereas recovery is in gradual, small escalator steps.

Asia, excluding Japan, was never seriously affected by the recession. On the contrary, many Asian countries, China in particular, have problems in calming down asset price inflation while protecting the momentum of economic growth in near two digits terms. Even the UK seems to have hit bottom and retail sales are getting better while unemployment is not getting worse. The new government seems confident enough in the strength of the recovery to embark on a fiscal tightening programme to reverse the economic stimulus of its predecessor without risking a relapse into recession. This confidence is also being reflected in the strengthening of its currency, which this year so far has gained more than six per cent versus the euro.

The obvious question is why the euro economies are still suffering so much and not moving along with the rest in rooting a successful recovery story. I propose that this is a combination of three reasons. Firstly, the euro is suffering from its artificial strength during 2008/2009 when it averaged around USD1.45 and GBP 0.88. This was a double blow for the euro economy. Not only did it suffer reduced demand for its exports as a result of the general recession, but it also lost competitiveness against competitors who instigated or allowed a depreciation of their currency. As things work with a time lag, the euro area is now suffering this loss of competitiveness while competitors are enjoying their gains. Obviously, this situation will self-correct next year as the euro area will enjoy recovery of competitiveness through the current weakness of the euro while competitors will suffer from the current hardening of the USD, GBP and JPY.

Secondly, the euro economy is suffering from continued weakness in its banking system. Banks in the US and UK took very robust measures to bring out all the losses in their books and to take on new capital to rebuild their own depleted resources. Euro area banks by comparison have been much slower in cleaning up their books and to acknowledge their losses and consequently their efforts to take on new capital. As a result, euro area banks remain fragile, pummelled as they potentially would be by further losses they would incur if they were to mark to market their vast portfolio of sovereign euro bonds. Inter-bank financial markets in euro are still gummed up and consequently there is scant diffusion credit through the financial channels for SMEs to have access to the necessary finances to survive, prosper and create employment.

Thirdly, the euro area is suffering from inadequate support from the ECB which the US and UK economies received from their respective central banks in what is technically referred to as monetary easing. Both the US Federal Reserve and the Bank of England supported their respective economies beyond reducing official interest rates to one per cent or less. They actually started buying bonds in the market, effectively inflating the quantity of money to make up for its reduced velocity of circulation. The ECB tried all ways to avoid having to buy bonds. It wanted to avoid the question of whose bonds to buy given that the euro area has 16 different Treasuries issuing sovereign bonds whereas the US and UK central banks have only one Treasury to deal with. Furthermore, the credo of strict monetarism still inhibits the ghostly halls of the ECB through the Bundesbank traditional belief that any increase in the quantity of money ultimately leads to inflation.

When the Greece, Portugal and Spain crisis reached breaking up as the bond markets were practically shutting down for these sovereigns, the ECB had to swallow its pride and embark on a crisis driven bond purchase programme in an unusual display of division of opinion between the ECB governing body and the Governor of Germany’s Central Bank, who remained opposed to the very principle of the ECB embarking on any bond purchase programme. To appease Axel Weber, the president of the Deutsche BundesBank and widely tipped to take over the ECB reins after Trichet’s tenure elapses next year, the ECB committed itself to neutralising the increase in money supply through bond purchases by rolling back other credit lines to ensure that the overall quantity of money remains unchanged.

While the first reason is basically self-adjusting, the second and third causes remain serious and will not self-adjust. On the contrary, as euro area governments will be constrained to roll back their fiscal laxity in order to protect their credibility on the bond markets, failure to compensate fiscal austerity with monetary leniency will seriously risk tipping the euro economy into a double dip recession. A double dip recession would make fiscal austerity doubly harsher, render euro area banking system even more fragile and raise the spectre of sovereign default as spending cuts through austerity are more than neutralised by a drop in tax revenues as a result of reduced economic activity.

The ECB has the near impossible task of putting together a common monetary and interest rate policy for 16 member states in very diverse economic condition. On top the ECB now practically has the sole responsibility for keeping the euro area out of a double dip recession without losing its credibility as the guardian of a sound currency that pretends to be an important contender to the US dollar for international reserve status.

Anybody selling square circles?

Plan C for the Euro

The Malta Business Weekly  - 10 06 2010


Doubts about the sustainability of the euro monetary union are being expressed openly as never before. The foreign exchange value of the euro has fallen some 12 per cent against the US dollar over the last two months and, notwithstanding Greece’s bailout and a pledge for a trillion dollar stability fund as a defence against market assault on the next weakest links in the monetary union, instability remains.

Instability persists because the bailout of Greece, and the promise of bailout for other weak links, addresses only the liquidity problems of such sovereigns but does pretty little to address the underlying solvency problems. If Greece is over-indebted, switching its existing debts to banks and private investors to loans from fellow sovereign countries in the euro system and the IMF does little to solve the underlying problem. It just swaps one debt for another. This has kept international bond markets jittery about Greece’s long-term ability to service its debts, to whomever they are due, and about the ability of the next weakest links to enjoy unhindered access to bond markets for smooth operations of their debt management programmes.

International investors have good reasons to be concerned. The euro monetary union can only survive if Member States operate a harmonised fiscal policy alongside the common monetary and interest rate policy. Members of the monetary union are like runners in a three-legged race whose legs are tied together with a somewhat elastic rope. They have to move forward in harmony if not in perfect synchrony. The bailout packages augur the exact opposite. Given the conditions associated with such bailouts, the phenomenon of a two-speed Europe will be made even worse. Greece, Ireland, Spain and Portugal will be suffering deep recessions while Germany continues to rev its export engines without apologies, aided as it is by the fall in the euro’s external value.

The two-speed nature raises problems for setting a common ECB monetary and interest rate policy. These problems already existed but will become more accentuated. Spain, Portugal and Ireland are suffering the consequences of the ECB keeping low interest rates to accommodate the German economic recovery programme when domestic conditions in the periphery countries would have necessitated higher interest rates to avoid dangerous speculation and bank exposure to an artificially inflated real estate boom. The property bubble exploded with a vengeance in Ireland, Spain and Portugal, causing gummed up financial markets, a shaken banking sector, high unemployment, a deep recession and a sudden and huge increase in public budget deficit, mostly due to loss of revenue from subdued economic activity at a time when social triggers of unemployment and social payments were activated.

The gap in two-speed Europe grows wider. While Nordic EU members gain a competitive advantage from a devalued euro, which make their exports more competitive, some periphery members of the monetary union, forced as they are by bailout conditions to address their public finances, will see their economies move in reverse gear into a recession. Will Europe tolerate rising unemployment and austerity measures (including wage cuts, wage freezes and reduced entitlements) on the periphery while Germany continues its export driven economy?   Will the elastic rope binding together the euro members in a single monetary union be stretched to the point of rupture?   When pressure builds up beyond a certain level something will have to give.

In an effort to avoid such rupture, many distressed members are taking harsh austerity measures that were considered politically suicidal before the Greek near-death experience. Greece’s problems seem to have conditioned public opinion in Ireland, Spain, Portugal and Italy to accept austerity measures before it gets forced on them by bailout conditions.

 It is gravely doubtful whether austerity is the right medicine. Austerity is more likely to push periphery countries into a depression spiral making debts heavier in a shrinking economy and without any palliative from the inflation front. What these countries really need is an instant gain in their external competitiveness through a devaluation of their currency coupled with a freeze on internal costs. But the devaluation tool is no longer available within a monetary union. Leaving the monetary union is greatly unappetising as the burden of their euro-denominated “foreign” debt (the euro would become a foreign currency for whoever leaves the monetary union) will get much heavier leading to default with all the unpleasant consequences across the whole continent and the world economy, of which the EU economy is a most important component.

So what future is in store for the euro?  Plan A, built on hope rather than realistic expectations, sees austerity in errant countries bringing order for the euro to continue as it did during its first decade of existence. Plan B is just to muddle through somehow from crisis to crisis as the austerity measures cause instability and greater disharmony within the euro club. The ECB had better think of a plan C!

As Plan C it is much more practical for the stronger members of the euro area (Germany and other countries that have no structural negative imbalances) to exit the euro system and either go back to their national currencies or form a new Hard Euro currency union among the strong countries. The newly adopted currency or currencies will then inevitably float upwards against the existing euro (though not necessarily against other currencies) and this will lead to instant re-instatement of competitiveness for the euro distressed economies without having to default on their euro debt.

This would make growth rather than austerity the key solution for economic re-sanitisation of Greece and its companions in distress. It is the most practical way to address intra-EU payments imbalances. Eventually a plan will have to be worked out for the re-merging of the Hard Euro (or the newly re-created sovereign currencies) and the Soft Euro. The ECB can remain the central bank for the two distinct euro areas operating dual monetary policy as appropriate for each area until a plan for the re-merging can be worked out gradually.

The architects of such re-merger will have to get it right the second time round. If full economic and fiscal union remains politically unacceptable then sovereign borrowing, in all its forms including derivatives and debt of semi-government organisations, will have to be abolished. Euro members will have no direct access to capital markets. The capital markets will only be accessed by a supra-national EU institution which raises debt guaranteed by all euro member sovereigns (thus lowering borrowing costs for all members) and which then lends to individual sovereign members in the framework of pre-approved budgetary submissions. So, while fiscal revenues and expenditures will remain within the sovereign domain, fiscal borrowing, guaranteed as it is by all Member States, will be controlled by those who are effectively responsible for it.

 Strange as it may sound, Germany and other strong members of the euro can save it by leaving it, and work their way back into it under new conditions.