Monday, November 24, 2014

The Euro Awaits Its Verdict

WASHINGTON, DC – The creation of the euro just over a decade ago was a courageous and unique experiment. Today, the outcome – whether the euro will survive, and whether the Europeans are right to keep it – is very much in doubt. But, if the eurozone does survive, it promises great advantages for member countries – and perhaps for the world.

The euro is an ultra-fixed currency among members: participating countries locked themselves into an initial exchange rate vis-à-vis their pre-existing currencies and then threw the keys into the long grass. Nowadays, an increasing number of Europeans are combing that grass, quietly looking for those keys.

The euro shares important features with versions of the old gold standard, under which countries fixed their exchange rates relative to each other by setting the price at which domestic currency could be redeemed in gold. Today, some people espouse the view – often loudly – that the gold standard was synonymous with economic and financial stability. But that is completely at odds with the historical record: the era of the gold standard is replete with boom-bust episodes fueled by over-borrowing by governments, firms, individuals, or all of the above.

There are three differences between the euro and the gold standard – none of which is particularly reassuring at this moment.

First, the gold standard’s central premise was a finite quantity of gold in the world; more of it cannot be created or discovered, at least not quickly. By contrast, the European Central Bank can create more euros if so desired. Countries cannot run out of liquidity, because the ECB can always provide more cash.

But governments and investors know this, and the result has been much higher debt-to-GDP ratios than would have been possible under the gold standard. The eurozone as a whole has a debt-to-GDP ratio of 90%, which is high by any standard.

Such debt levels are sustainable as long as investors continue to assume that another bailout is just around the corner. But if the ECB is threatening to cut off support – for example, because a government will not comply with what the Germans regard as good economic policy – the whole house of cards can come tumbling down.

Second, financial markets have become huge relative to anything seen under the gold standard. European banks could bulk up in large part because it was assumed that their respective governments backed them. Not only are these banks now large relative to some national economies, but the quality of government credit is now in question across the eurozone periphery – up to and including Italy. The term “risk-free asset” has become an oxymoron in contemporary Europe.

European banks have been operating on a great deal of debt and very little shareholder capital – the essential buffer against potential losses. Any shock to sovereign debt or further downturn in local economies will be transmitted through an overleveraged and undercapitalized banking system to other European countries and – quite possibly – elsewhere, including the United States.

Finally, for all the talk today of the discipline that the gold standard supposedly provided, countries that adhered to it regularly suspended convertibility – meaning that the domestic currency could no longer be converted freely into gold. But today’s Europeans have no domestic currency – just the euro. If any country – for example, Greece – left the euro, all contracts in that country would have to be rewritten. The disruption, particularly to credit, would be profound.

The proper functioning of the gold standard required a high degree of flexibility in wages and prices. If exchange rates cannot depreciate, wages and prices need to fall when a country has an unsustainable current-account deficit. But, as peripheral Europe can now attest, this is a cumbersome, painful, and politically unpopular form of economic adjustment. Expect the backlash against it to grow in the months and years ahead.

The news focus today is on how hard it is for the eurozone periphery to adjust and return to growth, owing to the combination of high public debt and actual or perceived austerity measures. But there is a flip side to the problem: capital is flowing to Germany as the regional safe haven, making credit more readily available there. The dynamics of adjustment within the eurozone exacerbate the underlying imbalances – Germany is becoming more competitive while the periphery remains uncompetitive.

The recent Greek elections have brought more radical parties to the fore. Alexis Tsipras, the head of the Coalition of the Radical Left has a valid point: “internal devaluation” – cutting wages and prices – is failing as a strategy. His alternative appears to be to abandon the euro. If Greece can’t do better than this, he argues, then it should leave.

But this is not about Greece any longer. Italy, Spain, Portugal, and even Ireland face the same issues, but are at an earlier stage in the backlash. Unemployment is rising, their economies are not becoming more competitive, and the interest rates on their debt continue to rise. These countries may eventually decide to leave. And, even if they don’t make that choice, fear of such exits can easily become self-fulfilling.

The euro system was designed to deliver prosperity and stability for all. It has clearly failed for some countries, and it may fail for many. Severe mismanagement by European politicians has caused damage that will last for decades.

Perhaps a stronger fiscal union, a central ministry of finance, and debt sharing would reduce the difficulties and imbalances enough to allow the euro to survive. Perhaps adjustment will start to work just in time.

There is a lot of shouting in the jury room. Expect a verdict soon.

Read more from our "The Euro at Bay" Focal Point.

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    1. Portrait of Asgeir B. Torfason

      CommentedAsgeir B. Torfason

      It is sometimes forgotten but the euro system has also delivered prosperity and stability even though current times are turbulent. Severe mismanagement by national politicians, utilizing the system to its extremes and outside of reasonable and even legal boundaries, is not good argument for the failure of the system. We have to fix this together.

    2. Portrait of Gregor Schubert

      CommentedGregor Schubert

      Boone and Johnson's view of the reasons why countries like Spain or Greece need a nominal adjustment is too narrow: Even if those countries had a balanced current account, a nominal adjustment by exiting the euro zone and devaluing or by ECB-led inflation would be necessary. The reason is that the "outflow of gold" that would have led one to worry about current account deficits in the gold standard days can and does happen internally without any cross-border transactions being involved: disintermediation in the financial system reduces the velocity of money and increased demand for holding money balances ("Hiding euro notes under the mattress") increases the need for base money. If that need for a higher money supply to enable the same number of economic transactions as before is not accommodated by the central bank, the economic activity in the country will drop no matter what the current-account deficit is.

      However, the policy conclusions are the same: the ECB needs to start doing its job and increasing the money supply/inflation to make enough liquidity available to enable growth in ALL EUROZONE countries and not limit itself to getting it just right for the overheating German economy. Otherwise, all that remains for the affected countries is regaining control over their money supply by leaving the eurozone and thus regaining the ability to make the means for economic transactions (money) less scarce, which is the same as saying that their new currencies will need to be devalued.

      So lets not focus on the mere symptom of current-account deficits to critizise the euro system: When Greece leaves it is not to be able to export more stuff but rather to regain control over its monetary system because the ECB with its "lowest inflation ever" pride has failed to use its much-vaunted credibility for the purpose of actually doing its job.

    3. CommentedZsolt Hermann

      The Eurozone is just another human experiment in the long line of experiments when humans try to establish some kind of limited alliance, a union without a strong foundation, thus the experiment fails and usually ends in a much worse state than the state before the experiment.
      The greatest such experiment for unity, and equality was the Communist expedient which went much deeper than the Eurozone, since it established a full integration in between social layers and even nations, but it failed and has become the most corrupt human system ever created because it failed to adjust the most important ingredient, human nature.
      So far all human social systems, civilizations started or ended up with oppression, forcing, threatening, and our civilization has reached this point now. We can see how in Europe democratic institutions are dismantled, people go on the street, and we can see huge social inequality everywhere else, and the Occupy movement gave us a glimpse of things we can expect.
      We are all subjective, egoistic by inherent nature, with any thought or movement we only serve our self interest, all our calculations are about ourselves.
      The Eurozone was just the same. And it did not even go deep enough to have any chance how could a financial or even economical Union survive without establishing a common foundation?
      Today the only option for the survival of the Euro would be full integration in between the participating nations, but people are understandably weary about it following the Communistic example that was not that far away.
      Whatever we do it has to start with the adjustment of our inherent nature, instead of 100% self serving we need to start considering the whole system first of all, and only then think about ourselves.
      How could we achieve such a fundamental change without terror, backlash as it happened in Russia?
      Only through a global, integral education program, providing objective transparent information about the nature of our global, integral system in which we are all interconnected, "sitting on the same boa" to help people understand that our own progress, health and prosperity is completely tied together with the fate, stability and optimal function of the whole system, and we can only get 100% reward for ourselves if the system is perfect.
      This way we could start building a new fully integrated human system, but not by force or trickery but willingness and free choice.
      In truth we do not even have a choice, even today we already live in such a system, being slaves to it, but we do not want to acknowledge it and we use our interconnections in a negative way.
      Through the above mentioned education we could fix our connections and adjust to this global system.

    4. CommentedManfred Dix

      Professors Boone & Johnson may agree with Alex Tsipras that "reducing wages and prices" is a "failing" strategy. Sorry for giving these news, but... unfortunately, within the context of the Euro, it is the ONLY strategy. Exiting the Euro has the same effect, it devalues wages compared to the rest of the world, and sets lower prices compared to rest of the world as well.
      The beauty of a system where you do not print your own money is that you cannot shove your shortcomings under the rug with internal inflation. You cannot pretend that you are richer than you actually are. The Euro is showing countries like Greece (and others) what they always were: low productivity, low capital, low investment countries, who want to have a social welfare system like Germany's. It does not work; you cannot finance a huge welfare system with one third of German productivity. Greece must make itself more attractive to investors, and for that it must reduce all of its prices, including wages.
      Exiting the Euro will destroy wealth and destroy savings. Is this really what distinguished economists want for Greece? Do these distinguished economists believe that you can print your way to prosperity? Or do they believe that prosperity ONLY comes from investment and productivity growth?

    5. CommentedStéphane Genilloud

      The euro does not replicate the gold standard. It is in fact closer to gold itself (with Draghi holding a philosopher's stone in his hands).
      It is a substantial difference, because it means, as said in this article, that there is neither convertibility to suspend, nor currency to depreciate.
      The standard view on an euro exit suggests that a country would simultaneously introduce a new currency and convert all private and public domestic debts into that currency (which would trigger instant depreciation, and de-facto partial default). This looks complicated and risky (and also increasingly likely).
      There might be another way that is not much discussed:
      1. Reduce debts to sustainable levels. It's called a default, and it can be imposed by national debtors, suggested by creditors, or negotiated. What can't be repaid, won't be repaid anyway.
      2. Introduce a new local currency in small quantities, and at a par with the euro. That's what happens if the government pays some of its expenses with IOUs for example.
      3. As long as the government remains credible, there would be a fiscal effect (it would spare a few percentages points of austerity) and a monetary effect. Hopefully enough to restore growth and financial viability. Then it would be time to consider the following options: withdraw the new currency, withdraw the euro or retain both.
      Of course, such a scheme would have better chances to work in a healthier economy (which would not even need to default in the first place). Spain could do it. Why not Germany?
      It would look more uncertain for Greece. But Greece may have no choice.