ECONOMICS:Amid the hysteria, it's worth remembering the euro is as much a child of politics as economics: but is it really in as much danger as is being made out? asks MICHAEL CASEY
IN THE MONTHS preceding the creation of the euro on January 1st, 1999 many believed that the project would not go ahead. It had been known for some time that the interlocking of national currencies to form the euro was being contemplated for political rather than economic reasons. A symbol of further European integration was required by politicians and a common currency seemed to fit the bill.
It was also a handy device for some finance ministers to emasculate their own central banks. There was, of course, no question at the time of any aspect of fiscal policy being harmonised. Finance ministers had no intention of sacrificing their own functions on the altar of European integration. However, such fiscal harmonisation – and loss of sovereignty – may now be part of the price that will have to be paid. The law of unintended consequences always applies where economic decisions are made for political reasons.
For some reason it was German chancellor Helmut Kohl who fought tooth and nail for the single currency. His reasons have never been fully explained and, no doubt, they relate in part to events during the second World War. No other head of state was nearly as committed to the single currency as Kohl. It was remarked, in the days before January 1st, 1999 that if he walked under a bus the euro would never appear. He didn’t and it did.
Kohl’s attitude seemed all the stranger since the Deutsche Mark was already the strongest currency in the EU and would be “watered down” by the addition of other weaker currencies. The Bundesbank was de facto the Central Bank of Europe; even the Bank of England had to follow the Bundesbank’s lead. Why go to all the trouble to create a new European Central Bank in Frankfurt when you already had a perfectly good one in Bonn? Why join a monetary club where most of the other members did not worry about inflation as much as you did? Even today it is difficult to understand the motivation of Kohl.
The economics of the single currency were never properly teased out. The complete absence of fiscal harmonisation was a major flaw, as was the limited mobility of labour between member countries. Not all of the member countries had the same structure, so that there was a vulnerability to ’asymmetric shocks’. For example, if international tourism collapsed then countries like Greece and Portugal were bound to suffer more than Germany, and they could not use the exchange rate to mitigate such an external shock.
There was a view that, over time, the single currency would tend to mould all the countries into the same structure. At best this was little more than an assertion and it was clear that any such mechanism would take decades to work. The last decade certainly has not displayed any greater similarity of economic structure. The Netherlands has an unemployment rate of 4 per cent compared with one of 20 per cent in Spain. This does not suggest that there is much convergence going on.
The differences in structure are matched by differences in attitudes or revealed preferences. German people, for example, believe in hard work and thrift, whereas the people of other countries prefer a more relaxed work-life balance and are not overly concerned about saving for the future.
The Maastricht criteria on inflation, debt and exchange-rate variability were meant to weed out those countries which were not ready for the single currency. But these criteria were not implemented very rigorously and there were ways of circumventing them. In Ireland, for example, almost all prices which were subject to regulation of some form were held down by fiat until we passed the inflation test. No doubt, other countries resorted to similar tactics, not letting their hair down until they had gained admission to the party.
The growth and stability pact was a belated attempt to impose some sort of fiscal order. The real fear was that Italy, with its history of fiscal deficits and Lire devaluations, might destabilise the euro. It is salutary to remember when France and Germany were taken to task for breaches of the fiscal rules, there were no sanctions whatever. This set a very bad example for other countries.
Perhaps the efficiencies promised by the Lisbon Treaty have not yet kicked in and this may explain the slowness in reaching a decision about the question of rescuing Greece. Germany and France probably had little option since if Greece defaulted, it would have put sizeable holes in the balance sheets of German and French banks, from which it had borrowed heavily. Whether the fund of €110 billion from EU governments and the IMF will be enough to satisfy the international markets about Greece, is not yet clear. Non-euro countries, like the UK, will not be very happy about contributing their share. Another issue of contention relates to proposed EU controls on hedge-funds. The recent unilateral ban on short-selling by Germany seems to have added to the confusion. It goes without saying that closer scrutiny of national budgets will raise hackles in many countries. It would be foolish to deny that the EU is going through a period of stress, which does not help the euro.
The market reaction to the wider proposal of setting up a European Monetary Fund has still not gelled. A permanent stability fund might indeed require a new Treaty and it is already clear that Germany has difficulties with this concept since it builds in a bail-out clause which was never the intention of the founders of the eurozone.
There is still a lack of clarity about the ECB’s intention to buy government debt. There is also considerable doubt as to whether the eurozone as a whole should borrow on behalf of its individual members, thus ensuring better terms from the capital markets. There is certainly a view among the stronger members of the EU that when a country gets itself into difficulties it should pay a penalty; otherwise lessons will not be learnt. The only reason Greece is being helped is because of collateral damage to the euro and possible adverse effects on French and German banks.
In short it is still too early to make a judgement about the survival of the euro. Stability funds will create moral hazard by allowing countries to ignore fiscal discipline. This is why far more EU scrutiny and control of national budgets is required. It goes without saying that a large part of this scrutiny will depend on accurate statistics and bodies such as Eurostat and the Directorate of Economic and Financial Affairs will have to raise their game substantially to prevent countries massaging the books. Indeed, it is remarkable that the creative accounting of the Greek government was not discovered sooner by these organisations.
The markets provide some discipline on countries but it would be foolhardy to assume that the markets always get it right. This is because they are subject to bouts of hysteria. As argued in a previous article, it would be better if an agency like the IMF took over responsibility for sovereign credit-rating.
Actually, the euro has not fallen all that much against the dollar, it is close to its launch rate and not much below its average over the last 10 years. Ironically, the US has a larger fiscal deficit than the EU as a whole. As far as fundamentals go – assuming that markets take any account of these anymore – there is little to choose between the EU and the US. Remember, the US has its own Greece; it is called California.
It is not being suggested that international markets are engaged in a conspiracy to unravel the euro. Fear is much more likely to motivate the markets. Unfortunately, fear and irrational stampedes can do enormous damage. If the euro were to be driven below $0.80 (way below its “true” value) and if it were to stay at such a low level for a sustained period of time, it is possible that Germany would begin to resent the inflationary effects of an undervalued currency. If the inflationary costs outweighed the perceived political benefits, it would not augur well for the future of the euro.
Although the dollar may be viewed as a “safe haven” currency for the time being, it is far too soon to write off the euro, despite all the flaws of its conception and adolescence. It might also be borne in mind that the sunk costs underlying the euro are very high; to unscramble the omelette now would be very costly and the disorderly market conditions could be a nightmare. Although not entirely clear, there is a possibility that from a legal standpoint a country which leaves the euro may also have to leave the EU. This vista is too appalling to contemplate. Let us not be scared by the collective hysteria of financial markets, and play the cards we have been dealt. In for a cent; in for a euro.
Michael Casey is a former chief economist at the Central Bank and board member of the IMF
