Wednesday, April 09, 2008

The End of the Euro?

Jim from The Depression of 2006 has started a very interesting conversation on the return of the Deutsche Mark. I have been arguing that the Euro is here to stay and that it has benefitted Europe in many ways, not least, through higher efficiency and by making cross border consolidation of industries easier, since currency arbitrage is no longer necessary, at least within Europe.

But this article is another piece of "evidence" that there is dissastifaction with the project. So I wanted to address it.

Jim and others have taken the view that the Euro is a real drag on competitiveness, particularly for Germany, a country that is heavily dependendent on exports. Germans often complain about prices under the Euro, calling it der Teuro, which is a pun on the German word for expensive, which is teuer (pronouced toi´-er). The German pronunciation of Euro is Oi´-ro, so it rhymes.

I countered that the actual influence of the higher Euro on finished goods prices was not that large, because a stronger Euro was making raw materials relatively less expensive. Raw materials are a major factor in the price of automobiles and other high-end export products. The higher Euro primarily creates a price disadvantage in labor costs - this is not nothing, but a 50% increase in the value of the Euro does not translate into a 50% cost change, more like 15-20%.

This, of course, is still an issue, but there are other positives that offset some of this decline. First, Europeans are experiencing higher purchasing power - energy costs, food costs and other basic materials, not to mention imports of equipment like computers and software from the US have become less expensive. The higher purchasing power allows Europeans to increase aggregate consumption, meaning that more economic growth can be driven by the home market. Overall, I argue (and most economists and business leaders would agree) that the Euro has been a net positive.

Politics, of course, is something else. Focused on Germany, I largely neglected the other side of the coin - the Mediterranean economies, Italy, France, Spain, Portugal and Greece. An article in Forbes argues that they desire to pull out of the Euro, because they are prevented from using their traditional strategy for restoring economic balance: currency devaluation.

Andre Sapir, a major insider at the EU, has published a paper on the European Social Models, which argues that there are really four different economic models offered in Europe. Each model offers certain strengths and weaknesses, though some more strengths and some more weaknesses. A key factor is that the Mediterraneans have traditionally resorted to devaluation to escape structural problems in their economies, such as demands for high wages from relatively unproductive union workers. Because it enforces a consistent monetary policy (and one that reflects the desires of the "Continentals" - Germany, Belgium, Luxembourg as well as Austria and France) it essentially runs counter to the political situation in Spain, Italy and Greece, and that they may chose to leave. (Note that the Nordics and Anglo-Saxons largely avoided joining the Euro altogether).

The argument in Forbes essentially says that if they were to leave (certainly if France were to pull out) the Euro as a currency would collapse, and Jim would be right, we would have a new Deutsche Mark. (Though, were this to happen, I believe the Germans would still engage in policies such as fiscal displine an a positive balance of payments that would ensure the Mark would be strong, not weak).

I still think this outcome unlikely, in spite of the glacial progress of European integration. More and more, that integration is leading to substantial gains. Moreover, many of the countries, particularly Germany and Austria and to a much lesser extent France, have made real strides in improving the productivity of their economies. A collapse of the Euro would invite many other changes which are generally well received in Europe. It would ask whether the common market should really be maintained, or whether the Schengen system (which allows for free movement of people, i.e. the ability to work outside of one's home country) should be continued and on what scale. All of which would lead to reduced, not enhanced, opportunity for Europeans.

Economic nationalism is rearing its ugly head in many places, the US presidential election, particularly in places like Pennsylvania, which has seen a decline in manufacturing employment (much of which has moved South, not offshore, or simply been automated out of existence).

Globalization is not an inexorable trend. Largely global markets in the late 19th century, which coincided with massive gains in labor productivity and also purchasing power, were undone in the period 1915-1935, especially 1930-1935, when international trade declined by over 30%. The outcome was predictable. With the loss of global markets, local surpluses of goods, services and commodities could not reach needed customers and prices, employment and investment fell precipitiously. At the same time, consumers could no longer tap global sources of supply, so local shortages resulted in higher prices and lower consumption.

I remain optimistic that Europeans will keep the Euro. I find it much better than changing currencies all the time (how many Austrian shillings to the dollar again?) and it creates a sense of a broader European market, rather than a series of small national ones - a sense which is slowly becoming a reality. I am even getting used to the 1 and 2 Euro coins, though, as an American, I still believe change should be for amounts smaller than a basic currency unit.

The article has some advice on what to do if you want to speculate on a disintegration of the Eurozone. I have no better suggestions, but I will point out that the devaluation that is anticipated would be bad for commodity prices (in US dollar terms). But it is a bit early to go short on commodities over anticipation of the demise of the Euro.


  1. I think you hit upon the key to the whole thing. It revolves around Politics. Inflation is an invisible government tax. Politicians just love it. You really can't have that with the Euro. The rest of the world can debauch their currencies while the Euro sits high on a pedestal.

    In countries like Spain and Italy, figuring out how not to pay income tax is a national past time. I remember the Germans use to accuse the French of devaluing the French Franc every time they changed their underwear.

    Inflation is a legitimate government form of taxation that is very effective. No forms to fill out. The strength of the Euro could be its biggest weakness.

  2. Jim, thanks for the comment. You are right, the politics is the key and and the politics are complicated.

    The French and especially the Italians and Spanish were devaluation kings. I like the underwear comment.

    The "austerity" of the Euro is forcing them to find other ways to enhance competitiveness. It has been working, if slowly, in France and Spain. In spite of this, there has been protest, particularly by France about the Euro.

    I still think a French departure would be a surprise. The EU is a French project, really and for France to oppose "ever tighter union" by reneging on the common currency would truly imperil the whole thing. For now, I think it's bluster and provides some cover for Sarkozy as he tries to reform the government sector of hte economy, which remains arount 44% of economic activity.

    Italy is a basket case where no government can really make any changes, as coalitions require many, many small parties so the agenda is driven by the most narrow interests, which usually exist to preserve the status quo.
    Without a 5% rule, it is hard to see how the necessary reforms can be implemented.

    Leaving the Euro would probably be easier than chaning labor rules, so if anyone is going to start - it will be the Italians, I believe.

    But, I am starting to think that you may be right about the return of the DM.

  3. Another thing that plays an important role here is the "Lender of Last Resort" theory. When Bear Stearns tanked, the Fed printed some money to cover the mess. Congress didn't have to float a bond issue to pay for it.

    There is no unified government behind the Euro. Without a Lender of Last Resort you cannot inflate the currency. Keeping the government out of the Euro, is what gives it its strength. Its kind of like being the last honest man in a world of thieves.

    It seems amazing that such a great concept could end up falling short for political reasons. The US government could do with some fiscal restraint of this sort.

    I will be interesting to watch this play out.

    The comments at the end of the Forbes article are what really surprised me. The words "tunnel vision" come to mind.