Is the Future of the Euro in Doubt?

Many commentators see the euro as the logical successor to the dollar as the reserve currency. Yet the Financial Times’ Lex column points out that most currency unions fail. However, the dollar is the product of of that very type of arrangement. Nevertheless, the piece serves as an important reminder against blindly assuming current trends will continue. Lex sees differential inflation rates among EU member nations (always a problem, since it is impossible to devise a monetary policy to suit all) as a growing source of stress.

From the Financial Times

Some last longer than others but most currency unions end in collapse.

In the mid-1700s, Massachusetts, faced with devaluation and inflation, broke from a monetary union of four New England colonies. A century later, the French-led Latin Monetary Union, which included Belgium and Italy, struggled along before being subsumed into the gold standard. The East Africa Currency Area blew up at the same time as sterling in 1977. Germany’s Customs Union and the monetary union of the US were rare successes. So history suggests that the euro’s chances of survival are not terribly high. The question, therefore, is when it might implode. That is hard to say but, at the margin, the currency’s appreciation during the past few years is not helpful. That is because, for the first time since the euro’s birth in 1999, the strong currency appears to be having a negative effect on growth in the core eurozone countries of France and Germany.

The main trouble is that the European Central Bank’s benchmark interest rate of 4 per cent is probably too low, given the overall inflationary environment – and definitely too low for the eurozone’s “periphery” countries. Ireland and Spain already have huge asset price bubbles due to their inability to set appropriate monetary policy.

The economies of some Baltic states, and others such as Bulgaria with currencies pegged to the euro, are overheating. Whether the pegs hold until these countries are welcomed into the eurozone is now open to question. Failure here could shift attention to imbalances elsewhere in the union.

Potentially slower growth across the eurozone would also hit tax receipts, putting already strained budgets under further pressure. In Italy, for example, burdensome government debt and a widening fiscal deficit leave no room at all for manoeuvre. If fiscal discipline begins to lapse, that is when the real trouble could start. So far, the euro is seen as a triumph, but all currency unions are tested from time to time. Further appreciation could well herald one of those periods.

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11 comments

  1. Anonymous

    But the triggering moment wont be caused by fical indiscipline, but by the unwillingness of central countries to keep financing the monstruous c.a. deficits of the periphery (Spain, in particular-140 $ bill c.a. deficit expected in 2007)

    Without these flows the peripheric economies will implode, and half the rationale for the euro (cheap, unlimited external finance) will vanish.

  2. Charles Butler

    Usually excellent, Yves, but this flyweight item needs your normal picking through. How does he get directly from “chances of survival not very high” to “when it might implode”, the subjunctive in the latter phrase apparently only referring to the moment, not the ‘fact’? Then, “Ireland and Spain have huge asset bubbles due to their inability to set appropriate monetary policy”. Fortunately (I suppose), Great Britain, the U.S., among others, are not shackled by this encumbrance.

    Anonymous — I believe the 140 bn figure is Spain’s merchandise trade, not CA, deficit. The latter, though very large for a considerable period now, has never been funded by transfers from central Europe, but rather by gold sales by the Banco de España itself. The problem has been dealt with domestically. Included here is no prediction of the future.

  3. Clark

    The ECB has published its consolidated financial as of Friday Dec. 21, showing that Eurozone credit has ballooned to more than Euro 617 Billion.
    This is 15.6% above the previous all-time high reached last summer and 37.0% growth in the past year.

    As I post this a day after the ECB reported, the Hussman funds website is still claiming that the Eurozone credit at this date was Euro 485.5 Billion.

    I note, while naming no names, that some blogs carried this Hussman article, and even, perhaps in an uncritical holiday spirit, referred to it as a very good posting. Of course not everything in the article was mistaken. In coming weeks some of this Eurozone credit will be taken back as is the pattern, but the growth trend is unmistakably significantly higher than that of the Fed. And the ECB did not drain liquidity last week by Euro 3 Billion as Hussman claimed, but in fact added more than a staggering Euro 128 Billion.

  4. Anonymous

    Charles Butler:-Spain´s c.a. deficit till September was 75,5 Billion €, (111 Billion US$). Full year 2007 will easily reach those 140 Billion Us$

    You can find the (official) numbers here:

    http://www.bde.es/infoest/e0701.pdf

    Regarding gold sales, they have been no more that 3 € billion this year, and so negligible respect its c.a. deficit (although noteworthy to the gold bugs).

    Here:

    http://www.bde.es/infoest/e0708.pdf

    Spain´s c.a. deficit is funded by going into debt with the surplus savings countries of Euroland, in the same manner as US sells its debt to China.

    As a result, foreign (gross) external debt has exploded from 0.9 Trillion € in 2004 to 1,5 trillion € in IIIQ 2007 –

    Here:
    http://www.bde.es/infoest/e0709.pdf

  5. Anonymous

    Clark,

    You are being harsh as far as the Hussman post is concerned. Hussman chained through the open market desk operations for the US and for Europe, did note that we’d need to see the December 21 report. His point does stand re the Fed, that its liquidity operations have been overplayed, and the MSM just reports on gross liquidity injections. I think that was Yves’ reason for using the post.

  6. Anonymous

    There are other unions which have worked, but we do not hear of them because they accompanied political union. For instance, the UK uses the same currency in England Wales Scotland and Northern Ireland. Italy uses the same currency in all its former states. So perhaps your judgement ought to be that it will blow up if it is not accompanied by closer political union?

    The key is transfer payments, surely? If you have adequate and automatic transfer payments to counterbalance the effects of inappropriate interest rates, it will survive. This is why it has survived in the US. And, arguably, why it may survive in Europe. Given the choice, probably transfer payments will be introduced rather than breaking up the currency union. What do you think?

    I agree on one thing though, Spain and the Spanish credit boom is a real issue. This one is going to take some work.

  7. Anonymous

    What I find interesting is how currencies are valued in relation to other currencies, e.g, if the dollar is worth 50% less than the euro, how staggering is that in dollar terms? Its just hedge funds playing with positions!

  8. Anonymous

    I fail to see why Hussman is not spot on! Hussman is calling this better than anyone out there, unless your a hedge fund that is betting the wrong way!

  9. Jeff

    I fail to see how this kind of complaint is relevant to anything unless the EU monetary system isn’t really unified. Does anyone track, or care, if the inflation rate in Hawaii is more or less than the inflation rate in Montana? (or choose your favorite states, CA, TX, NY, Ohio, etc…) As far as I know, nobody cares, since the US monetary system really is unified.

  10. Charles Butler

    Anon, Dec 28..

    Bad time of year to maintain a conversation. I stand corrected, on the CA/MT deficit. I was working with second hand info (another casualty of the Xmas season). As for gold, it would seem that a decrease of reserves from 13.4 million oz. to 9.1 over the year might translate into perhaps 30 bn dollars in sales. Also to be taken into consideration would be the probability that the Spanish economy is some 25% larger than official stats indicate.

    The problem, though, would be that continuing to run deficits into a downturn will convert into a bad strategy from the good one it was in boom times.

    Behind much of this is the relative cheapness of labour in Spain due to massive immigration, there being no business reason for many Spanish companies to improve productivity. The government has rightly been trying to make this an EU issue for a long time now, with some limited success.

    Regardless, my issue was with the typical unbearable lightness of Lex’s take on just about everything and its inclusion herein.

    Reagrds,

    CB

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