"The Euro - Does it have a Future?"

Sydney M. Williams

Thought of the Day

“The Euro – Does it have a Future?”

May 11, 2011

“Before long, all Europe, save England, will have one money.” So wrote William Bagehot, editor of The Economist around 1870. At the time, the Latin Monetary Union, which had been forged in 1830 when Belgium gained its independence from the Dutch and adopted the French Franc, was being considered. Over the next several years, Switzerland, Italy, Greece and Bulgaria joined the LMU. In 1865, the Foundation Treaty (legitimizing the LMU) was signed in Paris. Unofficially, the French influence spread to eighteen countries. Unlike today’s Euro, each country maintained its own currency, but they were at parity with each other in terms of conversion into gold or silver. The extraordinary financing needs of World War I, and the lack of flexibility of the LMU, provided its death knell.

During the decade of the 1870s, the Scandinavian Monetary Union was formed between Sweden, Denmark and Norway. They accepted one another’s gold coins as legal tender within their territories. The union survived the dissolution of the union between Sweden and Norway in 1905, but during World War I Sweden abandoned its tie to gold; without fixed exchange rates, free circulation came to an end.

There are numerous other examples of monetary unions ranging from Ancient Greece to colonial America to Africa. The United States did not have a truly common currency until the Civil War when bank regulation distinguished between national and state-level banks. The National Bank Act of 1863 established the Comptroller of the Currency, in the office of the Treasury, and began issuing “Greenbacks” – the Dollar we know today, absent its convertibility to gold.

If the Euro is doomed, it is because countries like Greece, Italy, Portugal, Spain and Ireland did not practice fiscal prudence during the money-easy aughts. During the past decade the advent of the Euro created a situation that permitted the borrowing costs of profligate Greeks to be linked to credit worthiness of parsimonious Germans. As long as economies were growing and liquidity was present, all went well. But when the credit crisis hit and economies went into recession, the flaws in the system became obvious. A restructuring of Greek debt – extending maturities – would be preferable to defaulting on some, or all, of their debt, but still would be a cost to the holders. BNP Paribas analysts on Monday wrote: “The official line that Greece has a liquidity and not a solvency problem is showing its cracks.” The truth is Greece does have a solvency problem. So do Ireland, Portugal and possibly Spain. Mark Weisbrot, the co-director of the Center for Economic and Policy Research, wrote on Monday that the cost of remaining in the Eurozone is likely to involve, “many years of recession, stagnation and high unemployment.”

Illuminating and aggravating the problem, on Monday Standard & Poor cut the ratings on Greek debt from BB- to B. Yields on their Ten-Year bonds reached 16% and over 22% on their Two-Year notes. An inverted yield curve typically portends recession, as the cost of money for investment or consumption becomes prohibitive. As a member of the Eurozone, Greece no longer has the option of devaluing their currency – a traditional path for countries in trouble. Irwin Stelzer, writing in the Weekly Standard, notes that watching events unfold in Europe “is like watching a slow-motion train wreck.” Borrowing money for the purposes of extending the welfare state, as has been the case in many European countries, is a certain route to bankruptcy. (The U.S. should take note.)

In yesterday’s Wall Street Journal, Timo Soini, Chairman of the True Finn Party (the equivalent of the tea Party in the U.S.) in Finland, wrote: “Europe is suffering from the economic gangrene of insolvency – both public and private.” Thus far there has been little acknowledgement – on either side of the Atlantic – that the cure for excessive deficit spending will be painful. There is no easy way out. What these countries need is someone akin to Paul Martin who became Canada’s Finance Minister at the end of 1993. When he assumed the job, according to a profile in Investor’s Business Daily, “roughly $0.36 of every dollar in tax revenues went to pay interest on federal debt…The country was spiraling.” Three years later the country was in surplus. Mr. Martin had three guiding principals; they are not rocket science:

     1) A focus on cutting spending, not raising taxes – $7.00 in cuts for every $1.00 increase in revenues.

     2) A focus on short term goals. “They are the most effective – they keep your feet to the fire.” Five year plans (or, worse, twelve year plans) never meet their goals.

     3) Assume the low end of all economic forecasts.

From a financial perspective, the aughts will be long remembered for a time of easy money, asset inflation and irresponsibility on the part of almost everyone, from consumers to politicians.

Lucretia Hale, in her 1886 novel, The Peterkin Papers, has as her lead character, the “Lady from Philadelphia.” She was known for providing commonsensical solutions to what were simple, but to the Peterkin family seemingly impenetrable, enigmas. Should the lady from Philadelphia be presented the conundrum that is Greece, her solution would likely be, quit the Euro; reestablish the Drachma; deflate the currency; cut spending; set annual deficit targets. Of course that answer to Greece’s problem will worsen the situation in Germany and France. About €370 billion in sovereign and bank debt of Greece, Spain and Portugal sits in German and French banks. Nevertheless, default is going to happen. The only question is: what form will it take?

A unified Europe is a powerful ideal, a concept that emanated from centuries of internecine warfare, especially those of the century just passed. The elites of Europe felt that the prospect of a Euro to replace or complement the Dollar was a goal worth pursuing, if for no reason other than their antipathy to the United States. History suggests that to survive a unified currency must be preceded by a political superstructure – a stronger central government than now constitutes the European Union. As Mr. Stelzer writes, “The ‘European project’ won’t go quietly into the night. But it just might go noisily into the ashcan of history…”

Two years ago, Professor Martin Feldstein spoke at the American Economic Association meeting, which celebrated the 10th anniversary of the Euro. In that speech he alluded to the vast economic and financial differences between member states, suggesting the possibility of some sort of a future split. A comparison to America is not valid. Americans are more mobile than their European counterparts, and as wide as are the cultural differences between Texans and Californians, they are not as large as those between Greeks and Germans. It is hard to see a future in which the Euro, in its current form, survives. I hope this prognosis is wrong and that a way out is found, but I worry there is no easy exit.