“’Expletive deleted’ the lire” snarled President Richard Nixon, according to a Watergate tape transcript released in 1974. While the sophisticated sneered at Nixon’s crudity, young London bankers like myself admired his keen understanding of Italy’s importance in international finance. In any case, within the next year or so, citizens across the Euro zone, but particularly in Germany, will be saying “Expletive deleted” about a much more important currency — the euro.
When the euro was introduced, it was generally understood to be likely that, at some stage, its common exchange and interest rate across Europe would cause economic difficulties, either to countries like Spain, Ireland and now Greece for which the common euro interest rate was too low, or to those like Germany for which it was too high. It was perhaps less generally understood, and indeed hidden by the euro-hyping EU bureaucracy that, assuming the initial parities had been competently chosen, the difficulties would appear only after a period of years, as optimal exchange rates for different euro members diverged from their EU parity. The three-year trial period between the euro’s introduction in January 1999 and its replacement of national currencies in January 2002 was thus an unfair one; difficulties were never likely to become acute within so short a period.
Supporters of the euro have liked to claim that the single currency area covered by the euro is no larger than that of the United States, which has managed to maintain a single currency for two centuries. That is not quite correct. In the early years of the Republic, banks all over the United States issued their own bank notes. There was a huge shortage of specie — hard currency — so these bank notes circulated widely as a substitute. However, although the notes had the same nominal dollar value, they had nowhere near the same real value. A note from a good bank in Boston or New York, where exports and export services earned large quantities of hard currency, traded very close to its full nominal value against its gold or silver equivalent. A note from a small bank, or still more from a bank on the frontier, where hard currency was hard to come by, was exchangeable for hard currency or prime bank paper only at a substantial discount, of 20 percent or more. The process was facilitated initially by the well-capitalized first and second Bank of the United States, but by 1836, when the second Bank lost its charter, a thriving market in such notes, priced appropriately, operated nationwide.
Hence, whatever the nominal uniformity of the nation’s currency, dollars from St. Louis or Memphis were in practice worth less than dollars from New York or Boston, and by this means the appropriate differences in trade patterns and living standards were accommodated. Naturally, as the decades wore on, the frontier where bills were heavily discounted worked its way westwards, and the exchange rate of frontier money was greatly helped by the discovery of huge gold deposits in California in 1850. By 1862, when national “greenbacks” replaced the infinitely varied issues of private banknotes, a national currency was possible, after eight decades of monetary union. Even after this point, the scarcity of hard currency in the Midwest and South caused huge agrarian hardship and a major populist uprising in the early 1890s.
The fiscal system of the United States before the Civil War was in some respects similar to that of the EU today. The states were far more independent than they later became, and the great bulk of taxes were raised locally, with national taxation limited only to external customs and excise duties. Thus the ability of the national government to redistribute income between the states was insignificant. Labor mobility, limited in the EU by language barriers, was limited in the United States by poor communications.
A system like the pre-Civil War United States, in which the EU had no central bank, but local banks issued euros, might well allow the necessary degree of flexibility. Greek and Spanish banks would issue euros that could only be exchanged at a discount, and charge interest rates higher than elsewhere, while the best German banks would issue euros that could be exchanged close to par, and charge very low interest rates. Depositors would place their money accordingly, choosing German banks for stability or Spanish ones for high returns. Monetary policy would be expansionary in Germany, as in ante-bellum Boston, and contractionary in Spain, as in antebellum St. Louis.
However, with universal deposit insurance and a powerful European central bank, that is not the system that the Euro zone has chosen.
The euro has in many respects been unfortunate in the timing of its introduction. Had it been introduced in, say 1994, with elimination of the component currencies in 1997, the euro would have enjoyed several years of economic growth, during which national governments would have had time to pull their financial positions properly into order. Of course, peripheral regions such as Spain and Ireland would have seen a boom from the imposition of relatively low euro interest rates, but the deflationary effect on Germany, where euro interest rates are comparable with those in Deutschemarks, would have been much less. Moreover, as capital left the EU to invest in the booming U.S. stock market, the stimulative effect on the peripheral economies of a weak euro and excessive lending would have been mitigated.
Today, the position is very different from that in the bubble years. Over the past year, the flow of funds to the United States, needed to balance its $500 billion-per-annum payments deficit, appears to have reversed, with consequent weakening of the dollar. At the same time, there is little room for the yen to strengthen, because of the continuing recession in Japan.
Hence, the euro has strengthened, against both the dollar and the yen, and is likely to continue to do so. The outflow of funds from the U.S. stock and bond markets will for many months yet not be balanced by any great improvement in the U.S. trade position (the effect of currency movements on which is lagged) so it is likely that the euro/dollar exchange rate will overshoot, with the euro rising at least to the $1.20-$1.25 level against the dollar. Such a level would only reflect the level against the dollar of the euro’s major component currencies at moments of dollar weakness, in 1978 and the early 1990s.
Of course, a period of dollar weakness and strengthening exports, combined with euro strength and weakening Euro zone exports will have a simple effect: It will export the second dip of the U.S. recession, caused by the continuing “wealth effect” of declining U.S. asset values, to the Euro zone. Euro zone countries such as Germany, which are highly dependent on a strong export sector, will find their export performance weakening, and their domestic economy further deflated. It’s unfair, but that’s economics.
The economic deflation resulting from a strong euro will intensify imbalances that already exist in Germany. The supposed reinvention of the German economy of the late 1990s has been proved to be wholly a mirage — the Neuer Markt, Germany’s high-tech stock exchange, has undergone a downdraft spectacular even by Nasdaq standards; it is 96 percent off its all-time high, and due to be abolished shortly. This is actually pretty unsurprising; the major German banks during the 1990s spent a great deal of money acquiring some of the finest names in London merchant banking, but then proved unable either to manage the acquired businesses or to keep the staff they had inherited. It was thus to be expected that in the Neuer Markt’s new issue market, the level of aggression was greater, and of quality control, less, even than in the frenzied Wall Street of the late 1990s.
The economic outlook for Germany is thus pretty grim. A fifth of the country remains largely unemployed, because the “feel-good” currency unification at a 1-1 Deutschemark-ostmark parity with the former East Germany in 1990 priced east German labor out of the market, and prevented it from acquiring modern skills. The exorbitant German social costs, which already make German labor uncompetitive worldwide, will make it more so as the euro rises. The aging population will become a serious drain on the social security system from about 2010, which will cast its shadow on the market ahead of that date. The feeble German service sector, and the undercapitalized, low-skilled German banking sector will stagger under the financial burdens of the recession, and provide little relief from the deflation in manufacturing. In short, for Germany, it will be a very painful next few years.
There is an additional complicating factor. Incumbent Social Democrat Chancellor Gerhard Schroeder was re-elected after a fairly irresponsible populist campaign by the narrowest of margins last September. By taking some of the necessary steps to stabilize German finances (and meet the “Maastricht Criteria” which Germany itself had imposed on budget deficits when joining the euro), Schroeder has made his government deeply unpopular. The Social Democrats are running 17 points behind the opposition in opinion polls, and appear likely to lose February’s Land election in Lower Saxony, previously a Social Democrat stronghold. Yet it is nearly 4 years until the next German national election, and there is very little flexibility to call an election early, unless the governing coalition collapses entirely.
Seventy years ago, Germany had a government with a low level of popular support, faced by a deep recession for which it had few answers. That episode ended very badly indeed, for Germany and for Europe as a whole. Let us hope that, whatever the failings of the EU, it and the close relationship renewed last week between Germany and France will at least prevent a repetition or near-repetition of the disaster of the 1930s.
If the German people are gloomily echoing Nixon: “Expletive deleted — the euro,” they can hardly be blamed for such a view.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.