Friday, January 11, 2019

It’s Been a Messy 20-years, but the Euro has Been Successful Enough

by Roy C. Smith

The euro and its companion institution, the European Central Bank (ECB), are products of the Maastricht Treaty of 1992, approved by the 18 EU member countries at the time, with three “opting out” of adopting the new currency. On Jan. 1, 1999, the euro was introduced as an “accounting currency” (with notes and coins arriving three years later). On the same day, Credit Lyonnaise, the largest French Bank run by the former head of the Treasury, announced in full page adds all over the world that it was already, and prepared to remain, the largest bank to the euro community.  The 1999 Nobel Prize in Economics was awarded later in the year to Canadian Robert Mundell (the only well-known North American economist to support the euro – Milton Friedman gave it no more than ten years in which to collapse).  Credit Lyonnaise did collapse in 2003 as a result of too much over-eager lending and too many overpriced acquisitions.

So, right from the beginning it was a mixture of wishful thinking, fanfare, and fundamental misconceptions. It didn’t follow monetary traditions, or economic theory, and the political justification for joining varied widely among member countries. But, it happened.

Its chief sponsors were German Chancellor, Helmut Kohl, and French President Francoise Mitterrand. For them this was the natural follow on the Single Market Act (1986) that would bind EU countries together economically to make another war between them impossible. But the binds were imperfect because the EU was unwilling to shed national sovereignty to the extent necessary to for a real economic “union” (like the US). The Treaty provided for “monetary union” (currency, interest rates) but no “fiscal union” (taxation and budgetary powers), and expressly rejected the notion that countries could be called upon to assist other member countries. So, the linkages of the EU were never destined to be more than those of a “confederation of states” (e.g., similar to the loosely bound, ineffectual united states that preceded the signing of the US Constitution in 1797). 

But among the wishful thinkers were those who saw a different future for Europe. They saw a base of free-market democracies expanding to form a more competitive, energetic private sector and making the association available to all or many of the 29 countries of the USSR and the Soviet Bloc that were forming anew after the collapse of the Soviet Union in 1991.  They also saw that the rule making and enforcement powers of the EU Commissions, and of the new ECB, would begin to force all the member states to converge into less interfering and subsidizing economic bodies that would have to compete with each other for workers and investment capital, which under the Single Market Act, could move wherever in the EU they wanted. The more of this, the healthier the system they were trying to create would become.

In the first decade of its existence, the euro faced a number of painful shocks – two financial crisis that affected the real economy significantly; Islamic terrorist attacks after 9/11 that opened a floodgate of trouble - the Arab Spring, ISIS, several civil wars, great instability and massive illegal migration to Europe from the Middle East; and a “hollowing out” of European manufacturing jobs due to Chinese and other imports. But despite these shocks, the interest rates on all member country government bonds were very close to the rates charged on German bonds for a decade, despite substantial credit differences between them.  The market believed that despite no obligation to assist each other, the euro countries would do just that if necessary. This proved to be true in 2010 when the EuroArea (EA) bailed out Greece, Portugal, Ireland and Cyprus after the banking crises in these countries overwhelmed them. Further, abundant market liquidity was supplied by the ECB during the crisis as necessary to resolve it. All of this was done with the reluctant, step-by-step approval of the northern EA countries, ever fearful that their southern neighbors would suck them dry. Indeed, all of the recipient countries, despite stormy political changes, agreed to tough conditions that they have followed (more or less) and have made reasonable recoveries since.

Indeed, the sovereign debt crisis frequently raised the question as to whether Greece (GREXIT) or Germany (GERXIT) would be better off outside the euro than in it. By leaving, Greece would consign itself to being a developing country again, would have to devalue its new currency from the euro, but still bear the burden of the euro-denominated debt it undertook from the EA. The cost of imports (Greece imports much of its food, clothing, energy and manufactured goods) would rise, but its export businesses are largely confined to tourism and agriculture and would lag behind.

If Germany were to leave, its currency would revalue, making exports more expensive and as Europe’s largest exporter, especially within the EA, it would cause a significant slowdown in Germany’s growth rate. Germany’s departure would very likely bring an end to the euro, which would have a variety of unwanted consequences, including perhaps, also bringing an end to the EU.

Arguably it should be easier to leave the EU than the euro, which has additional complications. The UK’s experience in attempting to leave the EU however, has shown how difficult and potentially harmful to its economy leaving the EU would be.

Meanwhile, the euro ticks along, being widely accepted by 340 million EA citizens, and by global financial markets. It is the only alternative to the US dollar, it is the second most traded currency in foreign exchange markets and the second largest reserve currency with 1.2 trillion outstanding at the end of 2018.

The euro was never designed to be perfect. Just adequate to hold what union there is together. So far, so good.


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