Some Thoughts on the Problems the Euro Has Fostered

If the euro were abandoned, then the previous regime of free-floating fiat currencies, each of them administered by its own central bank, would presumably be reestablished.

After all, unless the euro were to revert to its previous incarnations of national free floating fiat currencies the supply of which can be altered at will by the national central banks, there would be no point in leaving the euro area.

From the point of view of sovereign debtors that have difficulties financing themselves in the markets, the idea of being able to print their own money and have their national central banks back-stop the financing of the government is of course quite seductive and the primary motive that may induce some of them to consider leaving the euro. Moreover, the ability to pursue ‘beggar-thy-neighbor’ type trade policies by unilaterally devaluing one’s currency is similarly tempting, as most modern-day governments continue to believe in the mercantilistic fallacy that trade is not mutually beneficial, but instead creates winners and losers. The popularity of this facile and entirely wrong notion will probably never go away. Naturally, not everybody can beggar his neighbor – if everybody did, then the desired effect could not be achieved.

It is widely acknowledged that one of the main problems the euro has created consists of the inner-European current account imbalances and the large differences in the competitiveness among the various member states that have arisen.

However, if we think these assertions properly through, it should be obvious that there can be no simple aggregated arithmetic determination of these effects. Ricardo’s law of comparative cost remains operative after all – albeit, given the mobility of labor and capital in the euro area, only in a somewhat restricted manner.

We could for example compare a range of products that can be produced by both Germany and Spain and come to conclusions about which mix of production activities would yield the greatest output for all these products. It seems inconceivable, even if one agrees that Spain has become relatively ‘uncompetitive’, that it would be better for Germany if it became autarkic and produced all the goods it could in theory produce by itself and that it would no longer make sense to produce any of them in Spain.

Moreover, there are certain things that Spain or Greece can produce that Germany can not produce at all and vice versa. Greece is not known for the achievements of its automobile industry, but neither is Germany famous for its olive groves.

We happen to believe that the fundamental nature of the problem the euro has fostered remains widely misunderstood. To say that Greece or Spain have become ‘uncompetitive’ relative to Germany and the Netherlands is not enough. One must rather ask: why has this happened? Once one grasps the why, it should be easier to determine a viable way forward.

Ignoring for the moment the question of whether the original exchange rates of the national currencies to the euro that were applied upon its introduction were valuing these currencies ‘correctly’, one can probably assume that the condition of the regions comprising the currency area on the eve of its introduction were such that this uncompetitiveness problem did not exist. It is clear however that with the passing of time, conditions always change. The market economy is in constant flux after all – the only thing that can be said to be permanent about it is change.

And yet, why should using a common medium of exchange per se be the primary agent of the changes that are now considered a negative outcome of its adoption?

The Example of Argentina

In a way, the euro acted like a ‘peg’ roughly comparable to the USD-Peso peg Argentina employed in the 1990’s, which was guaranteed by a currency board.

The case of Argentina in fact sheds light on the problem:

In theory, every peso in issuance was to be backed by one US dollar held in reserve by the currency board. This removed foreign exchange risk and caused a notable drop in Argentina’s interest rates. Foreign capital was attracted to Argentine government debt, as it promised to pay a decent spread over comparable US government debt, even while the peso was guaranteed to remain unchanged against the dollar. The IMF was enthused by this scheme, as it helped to combat the recurring evil of inflation that had plagued Argentina previously. After all, so it was reckoned, Argentina’s monetary policy was no longer independent and so the temptation to inflate was permanently removed.

Only, it wasn’t.

Nobody gave due consideration to two major points:

Firstly, Argentina’s government, egged on by the surge in international demand for its debt and the concomitant lowering of its interest costs, was tempted to issue far more debt than it had been able to issue prior to the adoption of the peg and began spending money hand over fist. After all, it could suddenly afford to do so on account of interest rates having fallen.

Secondly, while Argentina adopted the rigidities of a currency board, it did not abandon the practice of fractional reserve banking inside Argentina. The same low interest rate environment that tempted the government to increase its spending and take on ever more debt financed by foreign investors set an ultimately unsustainable domestic credit boom into motion. The banks rushed to create ever more credit and fiduciary media, businesses embarked on major new investment projects financed by this sudden abundance of credit, while consumers concurrently never endeavored to restrict their consumption – on the contrary, they increased it. All the effects trade cycle theory predicts and expects under such conditions began to manifest themselves. A giant boom began to take hold.

For most observers, this boom provided additional confirmation that Argentina’s peg worked – at least initially. In reality, the currency board’s promise of backing every peso extant with one US dollar soon became nothing but an empty slogan: money substitutes began to pile up in Argentina’s banking system at astonishing speed, and these claims to money proper were of course not ‘backed’ by anything at all.

Inevitably the point was reached when foreign investors began to have doubts. It became increasingly evident that Argentina’s boom, its deteriorating current account balance and its growing mountain of public debt were utterly dependent on an uninterrupted continuation of capital inflows from abroad.

The boom had of course exerted all the inflationary effects that are the hallmark of such an unbridled credit expansion: prices and wages in Argentina rose, with no concomitant offsetting increase in economic productivity. The country became uncompetitive.

In short, on the eve of its crisis, Argentina found itself in exactly the same situation as the ‘PIIGS’ found themselves in on the eve of their recent crisis.

Argentina’s government eventually defaulted and decided to rescue the banking system by means of a confiscatory deflation stiffing depositors and savers: it restricted access of depositors to their money, forcibly converted all dollar deposits into pesos and then abandoned the currency board and massively devalued to peso.

Today, a little over a decade later, Argentina is once again on the cusp of a major crisis. It has returned to its old ways. Amidst price controls, capital controls and a growing pile of authoritarian government decrees, it slowly but surely slides toward yet another hyper-inflation episode – precisely the thing the currency board was once designed to avert.

So what can we conclude from this with regards to the euro area? There is in fact no practical difference at all.

Think for instance about Greece : its interest rates fell to a tiny spread over German ones, tempting the government to take on far more debt than previously and inducing it to spend money hand over fist. Foreign investors, no longer worried about exchange rate risk, piled into the debt issued by the government. The Greek banking system, egged on by the same low interest rates, began to expand the credit and money supply at astonishing rates. A major boom ensued and prices and wages rose sharply.

And then, one day, foreign investors began to have doubts about the sustainability of this arrangement. 

In short, it is the fractionally reserved banking system and its ability to create money from thin air that is at the root of the problem. The fact that this banking system is backstopped by a central bank only has made the problem far worse. It is not, as many maintain, impossible for European citizens to use a common medium of exchange. The problem is that the medium of exchange is a fiat money the supply of which can be expanded willy-nilly.

A notable difference between the ‘PIIGS’ and Argentina is that the withdrawal of foreign private investors has not led to imminent collapse, devaluation and theft of deposits (not yet, anyway), because the euro-system of central banks has made it possible to replace the financing of current account deficits by private sector investors with a behind-the-scenes bailout by the central banks (see the ‘TARGET-2’ imbalances we showed yesterday).

George Soros on the Prospect of the Euro’s Demise

In a recent article at the Financial Post, George Soros was quoted with regards to his opinion on the possible break-up of the euro area.

“A collapse of the euro and breakup of the European Union would have catastrophic consequences for the global financial system, billionaire investor George Soros was quoted as saying.

“Today, the euro is potentially endangering the political cohesion of the European Union,” the Business Line newspaper cited Soros as saying in the south Indian city of Hyderabad.

“If the common currency were to break down, it will lead to the break up of the European Union itself. And this will be catastrophic not only for Europe but also for the global financial system.” The eurozone crisis is “more serious and more threatening than the crash of 2008,” the Economic Times reported, quoting Mr. Soros.

In the near term, some of the eurozone countries may have to take more austerity measures because of the imbalances between the “creditor and the debtor countries,” Mr. Soros said at a business school event, the Mint newspaper reported.

“Unfortunately, they haven’t yet solved the acute financial crisis and that is causing the situation to deteriorate…and (it) is not at all clear it will have a solution,” he said.”

From experience we know that a sudden switch from one economic arrangement to a completely different one is likely to create a lot of upheaval. On the other hand, it is often not as bad as people believe beforehand. After all, if the euro were to be abandoned, it would in the main simply be a return to the status quo ante euro. The situation prior to the euro’s introduction wasn’t a situation of permanent crisis, so its abandonment should in theory, after a period of transition, simply lead to a recreation of what was in place before.

However, Soros has a point insofar as the euro has, similar to Argentina’s former peg, led investors to amass exposures that are a multiple of what they were before, based on the expectation that all foreign exchange risk has been removed. In fact, these exposures also assumed that interest rate risk had largely disappeared – it was generally held that all of the euro area’s interest rates on government debt would simply continue to be closely correlated with Germany’s. The change in merely this one aspect of the arrangement was enough to greatly aggravate what was already a major crisis for the banking system. It stands to reason that if free-floating exchange rates were to return, the exposure of the euro area’s core banks to the periphery would suffer a major haircut – one that would make the Greek debt exchange haircut look like a walk in the park in terms of the sums involved.

Soros is correct in surmising that the entire EU could fall apart if that were to happen: after all, most of the deficit countries would likely be forced to break their treaty obligations in order to escape the burden the sudden growth in the value of foreign creditor claims following devaluation would impose.

Moreover, the return to national currencies would not immediately lead to a recovery of economic activity in the debtor nations: on the contrary, as foreign investment and financing of their debts would likely cease altogether for a while, they would be thrown into a major economic crisis and would likely adopt highly inflationary policies to replace the funds no longer flowing in from abroad, which would eventually serve to make the crisis even worse.

They would also be likely to institute bank holidays, capital controls, trade restrictions and a host of other authoritarian measures in violation of their EU treaty obligations. It is indeed doubtful whether the EU could survive such an event.

In that sense, the euro has indeed became like a roach motel: it was easy to get in, but it is nigh impossible to get out. The ECB’s inflationary special liquidity provisions meanwhile represent an attempt of a socialization of the banking system’s losses through the back door, and increasingly look like a quasi-nationalization of the banking system. The more bank assets the ECB holds in exchange for the liquidity it provides, the less private sector creditors of the banks can hope to extract in the event of a default. This is slowly but surely destroying the private  bank funding markets.

In summary, one must agree with Soros that a break-up of the euro area would be anything but painless. It would be an event reverberating around the world, given the fact that euro-area banks provide large amounts of credit all over the world. It would be like Argentina’s crisis, only orders of magnitude worse in its impact. 

One must therefore doubt the ECB’s resolve to hew to the Teutonic principles of a strict partition of the monetary and fiscal policy realms embodied in the traditions of the Bundesbank. If its recent measures and the exertions of the eurocrats prove insufficient to save the euro project, a last ditch attempt will likely be made, involving quantitative easing of the form practiced in the US and UK.

It should be obvious that this would fail to address the underlying problems, but this does not mean it won’t be done.

Addendum:

Euro area credit market charts will be posted separately – the markets remain as unsettled as ever following the Merkel-Sarkozy meeting on Monday.


 

 

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14 Responses to “How Catastrophic Would a Break-Up of the Euro Zone Be?”

  • rodney:

    In short, it is the fractionally reserved banking system and its ability to create money from thin air that is at the root of the problem. The fact that this banking system is backstopped by a central bank only has made the problem far worse

    Dear pater,

    I agree on the fractional reserve banking side of things, but not on the argument that their central banks were backstopping the banking systems. I believe the problem Argentina and Greece shared is precisely that they gave away their ability to have a central bank backstop, so the weaknesses of a fiat money system were exposed sooner.

    This does not mean that those who have such ability do not have weaknesses, they simply have more time, i.e. the fiat money experiment is alrealdy 40 years old and counting. That’s what Argentina and Greece lost, the ability to buy time.

    • Rodney, I agree, the crisis arrived sooner, but in the euro area not because the central bank did no longer backstop the banking system, but because it can not backstop the sovereigns directly. The ECB continues to backstop the banks (see the recent LTRO’s and other measures) and has clearly enabled and worsened the credit expansion during the boom – this is how I wanted this to be understood.
      Even in Argentina’s case it was the central bank that managed the currency board, but what enabled the credit expansion during the currency board era was of course primarily the inflow of foreign funds, so its case was slightly different in this regard.

  • worldend666:

    Hi Pater

    Just one question about Argentina. You wrote that they embarked on a deflationary confiscation.

    But at the same time they devalued the peso and in the end everyone got access to their accounts. This is inflationary, surely?

    • rodney:

      Hi worldend, how nice to have the chance to politely answer your question ;-)

      Dollar deposits and debts were converted 1:1 to Pesos. If you had US$ 1,000 in deposits, they became Peso$ 1,000 overnight. Then they devalued the Peso 75%. How is that for confiscation?

      If a large number of deposits, plus all dollar denominated debt, lose 75% of their value with one swift stroke, you tell me if that’s inflationary.

      • rodney:

        A few years after, the government imposed (they simply refused to pay more) a 75% haircut on bondholders (mostly Japanese and German).

        You can see which direction they were going: default instead of printing their debts away. The phrase ‘confiscatory deflation’ sums it up pretty well.

        • worldend666:

          >>You can see which direction they were going: default instead of printing their debts away. The phrase ‘confiscatory deflation’ sums it up pretty well.

          I am not sure they were able to print their debts away were they? After all those debts must have been Brady Bonds denominated in USD.

          • rodney:

            Not quite, and I quote Pater’s article:

            In theory, every peso in issuance was to be backed by one US dollar held in reserve by the currency board. This removed foreign exchange risk and caused a notable drop in Argentina’s interest rates. Foreign capital was attracted to Argentine government debt, as it promised to pay a decent spread over comparable US government debt, even while the peso was guaranteed to remain unchanged against the dollar.

            So international investors loaded up on peso denominated government debt during the boom years.

      • worldend666:

        Hi Rodney. Feel free to tell me if I am talking bollocks any time :)

        I can see that dollar deposits being converted to pesos would take real money out of circulation.

        But a devaluation of the peso implies that goods become more expensive, correct? This is inflation is it not?

        My less-than-adequate reasoning tells me these 2 moves seem to have opposite effects on the money supply.

        • equality72521:

          “But a devaluation of the peso implies that goods become more expensive, correct? This is inflation is it not?”

          No, it’s not. Rising prices of goods and services does not define inflation. The proper definition of inflation is an expansion of the “aggregate” [national] money supply.

          Ask yourself: was the 1930s (FDR) dollar devaluation inflationary?

        • rodney:

          Worldend,

          I agree with equality71, you are confusing terms here. ‘Inflationary’ to me is defined as causing the money supply to expand.

          I would note as well that goods becoming more expensive doesn’t have to have a positive effect on the money supply, as you said in the last paragraph; rather, an increase in the money supply may or may not lead to an increase in the prices of final goods.

          I would also say that they didn’t have to actively devalue the peso by inflating. What they did was simply to let the peso float freely against the dollar (as Pater says, they shut down the currency board) and it adjusted very quickly to a much lower value.

          • worldend666:

            ok, points taken. So in fact suspending convertibility to the dollar was aggregate neutral then? No currency was created nor destroyed.

            What was deflationary or aggregate negative (in the short term) was limiting access to bank funds to 250$ per week.

        • A brief remark: it was confiscatory deflation first, followed by inflation of the ‘new’ peso after the currency board was abandoned.
          Here is an article by Joseph Salerno that describes the events in great detail:
          http://mises.org/daily/890

  • LRM:

    Just out of curiosity, would both USD and Argentina Peso circulate in the economy at the same time right after the peg?
    When money was entering Argentina this would have been USD that went to the currency board that then held the USD in reserve and created the Peso of equal amount that then was issued as bonds and the like but denominated in Peso with interest in peso?
    Who were the main depositors that held USD in their deposit accounts?
    Traders, foreign banks? Would ordinary citizens have USD savings accounts?
    Just trying to figure out how to protect from these sorts of events and why more Greek and Portugal citizens would not be moving their money out to UK or Germany . I guess like most of us they may have Retirement accounts that are hard to move without costly losses known up front vs the unknown cost of “possible” conversion back to former currency

    • Yes, private citizens and companies also held both dollar and peso denominated accounts. After the currency board fell and the peso was devalued, the government eased the restrictions on withdrawals from peso accounts, but kept tight restrictions on dollar accounts in place.
      As to euro area peripherals, a flight of deposits from the ‘GIP’s to the core is in full swing – a lot of money is also flowing into Switzerland to get out of the euro altogether.
      For more details on the Argentinian situation, see Salerno’s very detailed account:
      http://mises.org/daily/890
      One possibility is of course also to buy gold and store it in a secure place (such as Zurich or Hong Kong, or one’s own safe).

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