As a former foreign exchange adviser and currency fund manager, I would like to contribute a slightly different slant on the ongoing EU crisis than what has been written to date, including its causes and the best long-term solution.
The fundamental problem with the euro is one of poor design. The euro was from the beginning an accident waiting to happen. A number of economists, including myself, warned more than ten years ago that there was a significant probability that the euro would run into big trouble.
Let me start by stating the most important design components for an independent sovereign state that wishes to have maximum control over its economy.
1. The right to issue the national currency.
International banker Mayer Amschel Rothschild once said, “Permit me to issue and control the money of a nation, and I care not who makes its laws”. And it is so, so true. Issuing your own currency is the most important component because it is a prerequisite for all the other components. Such a state can never be insolvent. It can never be forced to default any debt that is denominated in its own currency. (Foreign currency debt is a different matter).
2. An independent monetary policy
The ability to control interest rates and the money supply are vital for controlling an economy. Independence can be achieved in two ways, either with fixed exchange rates and capital controls or with floating rates and free capital flows.
3. The ability to devalue/revalue
If a country has a fixed exchange rate, it can devalue or revalue the currency in a crisis; but again, only if it issues its own currency.
4. Control of fiscal policy
An essential ingredient of the economic policy of a sovereign state is the ability to spend money into the economy and run a deficit without having to take up foreign currency loans. Once again, this is only possible if the country issues its own currency. This ability is especially important in periods of high unemployment and overcapacity in the industrial sector. Of course, one must keep an eye on inflation because the money supply is increased. But in a slow economy with excess capacity this is not normally a problem.
5. A floating exchange rate
In a mature and competitive industrial state, a floating exchange rate is normally the preferred currency regime because it is stabilizing and discourages speculation. Currencies tend to shift to reflect differences in inflation rates. So if a country with a floating rate is inflating faster than its trading partners, it will tend to lose competitiveness and run a deficit on its balance of trade. The resulting excess of its currency in foreign hands results in sales of the currency and hence downward pressure on the exchange rate. The lower exchange rate neutralizes the inflation differential and makes the country’s exports more competitive again, enabling an improvement in the balance of trade. Thus floating exchange rates are stabilizing.
The eurozone countries cannot issue their own currencies. Therefore they have none of the above-mentioned important components necessary for managing a sovereign state’s economy. In other words they have:
- No control over interest rates or the money supply (no independent monetary policy on account of fixed exchange rates and free capital flow)
- No possibility to devalue in a crisis
- No ability to run a deficit without foreign currency loans
- No stabilizing floating rate to correct for inflation differentials.
- Expensive foreign currency debt with the overhanging threat of default.
Thus the crisis was really not that difficult to predict, as no two markets can run in tandem indefinitely. The design corresponds to making a steam boiler with no safety valve. With such a setup, it was only a question of time until the pressures of different inflation rates and different trade balances within the eurozone became unbearable, especially with such major differences in economic strength and culture between Northern and Southern Europe.
I would like to add a few words here about fixed exchange rates, as there are widespread misunderstandings about this among politicians and economists. Generally speaking, fixing your exchange rate to another currency is not to be recommended, as it will almost always end with a speculative attack, either against the currency (when you issue your own) or against your foreign currency debt, if you are a member of a currency zone like the eurozone. Note that for eurozone countries, the euro is the equivalent of a foreign currency because currency issue is outside of the individual member’s control.
The large hedge funds are attracted like sharks to countries with exchange rates “pegged” to another currency when there is a sign of weakness, for example too high a rate of inflation relative to “big brother”. It is the central bank’s foreign currency reserves they are after when they attack a currency. If the country being attacked insists on defending an exchange rate which is too high, it will eventually lose all its currency reserves and then be forced to devalue. It happens time and time again. This is what happened to a number of Asian countries in 1997-1998.
Consider the opposite case of a floating currency that adjusts to the inflation differential automatically. There is no potential profit here for the hedge funds. Of course, a large hedge fund can force such a currency down if it wants to, but why would it bother? If the country refuses to use its currency reserves and instead “rolls with the punch”, letting the currency slide a little, the speculator will eventually give up and get out of its position in the only way possible, by buying up the currency again and forcing the exchange rate back up to where it was before. This is not an attractive use of time or capital for a hedge fund. Hedge funds are on the constant lookout for potential devaluation situations. But you can only devalue if you have something to devalue against, namely a “peg” to another currency or gold. And a currency is only interesting to a hedge fund if the central bank is prepared to use its foreign reserves to defend the unsustainable high exchange rate.
There are situations where a “peg” can be advisable, for example, in the case of a very small country, whose currency is too illiquid to trade internationally. A second case could be a country that has a reasonably liquid currency but has lost the confidence of the foreign markets due to undisciplined inflation with repeated devaluations. This was the situation in which Denmark found itself in 1982, when the new government publicly vowed to fight inflation seriously and to never again devalue its “peg” to the D-Mark, and later to the euro-come Hell or high water. Since then, confidence has been restored due to far greater discipline on fighting inflation. Now, thirty years later, the “peg” is no longer necessary and should be dropped while the krone is relatively strong. If the Danish kroner were to float today, it would probably increase a little relative to the euro because Denmark is in better shape than euroland.
The European Monetary System of 1979-1998 was another poorly designed fixed rate system and ran into several of the classical problems mentioned above. Differences in inflation rates among member countries were considerable, but rather than allowing the gradual exchange rate shifts to take place that would have been possible with floating rates, pressures were allowed to build up, political prestige got in the way, and a set of speculative attacks and delayed devaluations were the entirely predictable result. The EMS was actually superior in design to the eurozone. Although the EMS member states had no independent monetary policy because free capital movements were permitted, they did have the possibility of deficit financing without foreign currency loans and they could devalue in a crisis. Their problem was basically a lack of discipline on inflation combined with fixed exchange rates and too slow reactions to the pressures. Actually, the quietest period in the whole EMS period was after the total breakdown in 1993, when a 15% band of permitted fluctuations was introduced, which was in effect the equivalent of a floating currency regime. Speculation came to a sudden halt for a few years! If only they had stuck with that regime! But instead we got the fatal introduction of the euro in 1999, with the even worse problems we see today.
So what is the best way forward? It ought to be clear from the above what I recommend in the long term. Each sovereign EU country should have its own currency and they should all float freely. That gives maximum control to each sovereign state. If there are countries that want to stay in the euro, then they should form a new nation state with a single central government with the exclusive right to issue euros and a single central bank. Then the “euro state” will have all the prerequisites for a sovereign state in control of its economy. So will all those EU members that remain outside of the “euro state” with their own currencies. This is the ideal solution.
Any attempt to approximate this solution with the current eurozone setup, introducing an artificial central agency for dictating fiscal policy, with rules about submitting budgets for approval, applying penalties for non-compliance, etc. will, in my opinion, fail to deal with the fundamental design flaws, and will fail sooner or later. The Southern European countries’ competitiveness is so inferior to Germany’s after several years of higher inflation that it will continue to be cheaper for them to import German products than produce their own for many years, leading to a chronic German surplus on its balance of trade and a chronic deficit in the South, and thus to higher interest rates on Southern sovereign debt and further deterioration in their competitiveness in a vicious circle without end.
The eurozone was a mistake from the beginning and should be scrapped, the sooner the better. I would recommend the EU taking the bull by the horns and asking each member of the EU to make a choice: either accept a “eurostate” with the euro as currency or reject membership in the “eurostate” and issue your own currency. That is what the EU should have done in 1999. They should do it now; better late than never.
The least they can do now is to introduce the possibility of an orderly withdrawal from the euro if a member state so wishes. For those eurozone members that wish to maintain their independence, they should be allowed to withdraw, and if necessary, default on their foreign debt. I don’t think the Southern European citizens are going to stand for a decade of austerity as demanded by Germany-with historically high unemployment and a shrinking welfare state-without taking to the streets and demanding a withdrawal from the euro at some point. From their point of view, it feels like they are been asked to pay for the rescue of the international banks and the EU politicians that were the cause of the crisis in the first place. At some point, they may feel that they have nothing left to lose. In my opinion, they will be far better off in the long run if they take their hit as soon as possible and start afresh with a devalued but competitive currency. See, for example, how Iceland made a comeback in just three years after a 50% currency depreciation.
A common currency is not necessary for the EU. To the contrary, it is an unnecessary handicap. Cooperation among independent sovereign states, each having its own floating currency and with a minimum of outside interference-except for the ceding of sovereignty on ecological sustainability issues, which is an existential necessity-is, in my opinion, the structure that would give the greatest satisfaction to the greatest number of EU citizens. This is, indeed, my vision for a new post-crisis EU as outlined in Occupy World Street.
