Home > Currency, Economic Musings, Economics, Economy, Financial Crisis, Gold, Money, Sovereign Debt, Speculation > Economic Musings II: The Euro as a Basket Case

Economic Musings II: The Euro as a Basket Case

How not to Introduce a New Currency

The Euro has been touted as something of a capstone of the European Unification project. Now it may well prove its stumbling block. How ironic. And at the same time how stupid and humiliating!

How (and why) has it all happened?

Once upon a time there was a man named Robert A. Mundell. He studied the optimum size or extension of currency areas. To CrisisMaven this may already be a false proposition, after all, we normally do not study the optimum area for, say, the distribution of bread. An old and late friend of mine, then working at the Irish Guinness brewery once told me “Guinness doesn’t travel”. That was to say, if you wanted to taste it at its best you should not have it sterilised. And if it wasn’t sterilised, it couldn’t be stored very long. Therefore there would be a natural “Guinness area” around a brewery, defined by the distance (and therefore time) Guinness would travel before deteriorating in taste. (Of course you could sterilise it but then the taste would not be the same, 90% of customers probably never know the difference as they’re outside the “optimum area”.) Now, with currencies consisting of coins or paper of excellent quality or even not being corporeal but existing as bits and bytes along a Moneygram or Western Union transfer line, the area a currency could potentially travel is probably the whole world. And indeed gold is (or was) a currency which, while it may have come in different denominations, still was considered the same all over the world*); one of the reasons gold was chosen over other valuables was its chemical stability, unlike Guinesse’s.

So, forgive this digression, but what CrisisMaven wanted to establish was the fact that Mundell’s research was probably valid only in the realm of artificial or “fiat” currencies. Once a currency were backed by gold, you’d be hard put to define an optimum currency area. Never mind, the ruse was born to introduce the Euro.

Maybe we should do away with another objection first: There’s a widespread fallacy that a wider currency area is good if for no other reason but that it saves on “currency exchange” costs. When you travel abroad on holidays you often seem to “loose” money when you change from one currency to the next. But is that so? When you go to a supermarket, you lose money because you don’t buy directly at the manufacturer. Aha. Why does the supermarket charge over and above the amount it buys for from the various manufacturers? Well, it stocks the wares there and you can come and go as you please. Wal-Mart doesn’t know when you will come, if you will come and what you’ll buy. It runs a risk that the bread may go stale as you decided to eat out and not call for another two days. Of course there’s a lot of other cost components that determine consumer prices, but this is one. Now, when a bank holds cash in foreign currency, it equally doesn’t know when, or if, you come, which currency you’ll want and how much. If it takes a bundle from you and holds it for two days till someone comes and wants to change in the opposite direction, the money may have fallen “in price” with the bank bearing the loss. And of course there’s storage and handling and insurance and checks against counterfeiting and so on and on. A few percent of the “fixing” is not bad for that service, hm?

But still, couldn’t we save us (and the banks) that trouble and the risk by deciding on a common currency for more than one country (= former national “currency zone”)?

Before we look at monetary reality, let CrisisMaven stress one obvious point: if all currencies were backed, e.g. by gold, of course, you could join several currency areas, no problem. If, say, the US dollar was $35/ounce of gold and the French Franc at the time was three hundred and fifty Francs per fine ounce and the Zimbabwean dollar three hundred and fifty billion per fine ounce, oh, no problem: Change existing old notes for one new, say, “wankor” which is meant to be one per fine ounce so that 35 US dollars became one wankor, 350 Francs one wankor and, hm, by the time CrisisMaven finishes the sentence the Zimbabwean dollar might have slipped a little. But you get the idea.

However, when you have free floating currencies, you cannot do this the same way, the same as you cannot rigidly tie two ocean tankers together without risking to sink both. Yes, one might say, just as tidal influences forbid to make ships bigger than a certain size so do free floating currencies (that are not backed by a common denominator such as gold) probably warrant a maximum size of distribution area. If the area became too large, then like with a ship that might break through the middle, so a currency area might, once too big, try and break up to establish an optimum smaller size. It is not for no reason we now hear talk of secession in the United States of America.

What happened in the case of the Euro? The Euro was introduced as a common currency in a geographic area that was quite diverse, culturally as well as economically, in terms of the “law of the land” and in many other aspects. (Not that the US are so much better – the United States consists of, believe it or not, 55,000 tax areas!)

What the geniuses at the helm of the European Union then decided was to combine a set of these currencies into one little hodge-podge, decree a certain relationship between the different to-be-amalgamated currencies, print new banknotes and tell everyone they now had to use those. The idea was that at the time of its introduction the Euro should be on par with the US dollar – not an idea that would be suggested by scientific reasoning, rather by posturing. Hubris is what made Icarus fall out of the sky. And immediately the Euro plummeted.

And here’s why: imagine you went to Radio Shack to get a new computer or LCD screen. In the far corner you see a special offer at 999 (of whatever your currency be). But as you proceed to the check-out, the shop assistant puts a cucumber, a toothbrush and some washing-up liquid into your shopping cart (or trolley). You get a bit upset but the shop assistant assures you they’re extra cheap and don’t they save you a stroll to the drug store in the bargain? Of course, the LCD screen now is not exactly 999 (of whatever your currency be) but 1,013, but you can always sell the cucumber if you liked. No, he’d insist, there’s no way are you going to leave the shop with the LCD screen only. You have to take the cucumber and the other stuff. So what can you do? Do you value the mandatory extra merchandise at 14 (of whatever your currency be)? Not really, you didn’t want it in the first place. You may dump it, give the cucumber to the petting zoo, put the toothbrush into your kid’s haversack for next summer camp but no way do you consider yourself 14 (of whatever your currency be) “richer“. That’s how our Euro zone trading partners must have felt when all of a sudden they didn’t have a choice to change dollars into Deutschmarks etc. but had to “buy” some coveted Italian Lira in the bargain as well. And they showed their initial disdain by flushing the lira out of their system, so that the Euro tanked and sold at 0.88 USD at some stage.

(Later the US dollar met with a similar destiny, but that was likely a reaction to the Vietnam-like Iraq adventure and ballooning fiscal deficits and inflation of the money supply, and low interest rates and all those other factors that also determine a currency’s value or exchange rate.)

Then – how to prudently implement a superseding new currency?

When you bought a new car and you traded in your old – was there a fixed relation between, say, a new Buick and, say, a seven year old Cadillac (or the other way around)? Not really.

Is there a fixed relationship between a new currency and an older one? Well, not really! Can there be a fixed relationship between six constituting national currencies and a new, superseding new currrency? Not at all!

Just follow CrisisMaven in this little thought experiment: let’s assume, you arrived in the “Euro” area-to-be with US dollar notes and you wanted to buy in the Deutschmark area. Would you have had any doubt as to the exchange rate? No. If the cashier would have accepted your US dollars, still he or she would have given you your change in Deutschmarks and at something closely resembling the current exchange rate. If you had then traveled to Italy and purchased goods there you might have not had enough Deutschmarks yet to pay for the full purchase so again you open your wallet and pay the remainder in dollars. Again, as there would have been an established rate for the Italian lira and the dollar you would have easily been able to calculate the value of each transaction and not have felt shortchanged.

However, if someone had now told you there was a different exchange rate for the lira than you deemed appropriate because someone had stubbornly fixed the Deutschmark-Lira exchange rate and wanted to force you to see the lira’s exchange rate in this “new light” you might have balked and insisted in either doing your transaction in dollars only or have asked for a reappraisal of the dollar-Deutschmark rate in light of the -in your opinion- unjustified lira rate.

So, by and large, that’s what happened. And it cost the Euro zone economies probably a lot more than they could ever have saved in “exchange losses” over the same time.

A Market Solution to the Euro Implementation

Now comes the simple part: If the Euro was really worth the trouble and using it had advantages and felt “superior” to using the old and embosomed currency (another “barbarous relic” in the eyes of the yuppie elite who never see a bubble until you can’t see it because it burst) , then it would have easily outrun the older incumbent currencies if it had honestly competed against them in the … marketplace. Marx and Engels said you cannot legislate against economic natural laws. Equally you cannot impose a currency on your own people nor esp. on your external trading partners without risking grave unintended consequences. We see those now and clearer by the day, but of course the professional deniers prefer other reasons that prove how it could have worked if only … well, if you don’t press the accelerator too much, then you need not repair a Toyota.

The Euro could have been introduced in the Euro zone countries by allowing it to be used side by side with the incumbent currencies. Not possible? Of course it is. That is exactly what happened! For several months shops were forced to accept both types of currency (the “dual currency phase“), all ATMs, all slot machines, all cash desks had to be changed at an enormous cost so the infrastructure was there in any case. There was absolutely no need nor ever any economic justification to introduce the Euro at a fixed artificial rate that was not even reflecting the individual currency’s other exchange rates prevailing in the currency markets at the time!

What they did to the Euro and with the Euro defies economic logic and now the bill is being presented. Oh, by the way, yes, it could have meant that to this day there would be a double or multiple currency regime or that the Euro would not have been able in this way to supersede the national currencies. And rightly so: the European Union has not yet decided that because, say, the French make better cheese, and the Germans better bread and the Greek better olive oil, that all the other members of the ECU (European Cheese Union) now have to phase out national cheeses in favour of the French variety, the European Bread Board has imposed German bread on the rest of the zone and olive oil cannot come from Portugal or Spain.

The Euro was a folly and will in a few years be the laughing stock of currency historians. Then talk about savings in foregone exchange transactions!

*) Actually Mundell later had a change of heart and moved closer to a gold standard than his epigones could have wished for.

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  1. 2010-03-04 at 08:13

    Thank you for all the great posts from last year! I look forward to reading your blog, because they are always full of information that I can put to use. Thank you again, and God bless you in 2010.

  2. 2010-03-04 at 01:56

    The Euro is a heavily artificially sustained currency. In a sense, it is the first meta-currency, a unit of wealth that doesn’t depend on itself and its relation to value at all, but on a complex set of inter-communicating appraisals of it. Money is money because we believe in it—the Euro is an example of this maxim taken to the extreme. The question is not whether it will continue, or rise or fall, but whether this means anything to anyone. Outside a very small group of financial agents, the answer is probably no. The EU, like the rest of the world of global capital, will continue, just continue, and get more and more rundown, more and more junk-filled and dysfunctional. There is no coming apocalypse (this is really an ideological belief continuous with the system, one more enticement to continue in spite of the brokedown state of things), but rather, a long slow slide into mountains of garbage, real and fiduciary, for a very long time to come.
    tog

    • 2010-03-04 at 02:35

      Thanks for commenting TOG – am always fascinated by your blog and the lady … and one of the few blogs so far I have to think twice or thrice to understand a sentence :-)

  3. 2010-02-26 at 12:58

    Its failure was programmed when a new world currency had – and has – to appear on world stange: Amero, necessary for Usa to spread its debts to and in the whole world…

    Euro is no more sufficient to make this job, that Eurozone did very well, maintaining debts, of Eurozone as of Usa, when American economy still functioned passably well…

  4. 2010-02-26 at 08:20

    We all know that the eurozone is not an optimal currency area. That’s why we need more integration not less or disintegration of the Euro.
    An immediate step would and strong signal to markets, particularly speculators would be a EU financial transaction tax which would raise a large sum of money painlessly (in the order of 100-200 Billions Euro), and would help to limit the sort of speculative attacks against the euro-zone. Moreover it would address the lack of regulation of foreign exchange markets. I prefer taxation to regulation of those.

    Moreover funds collected under a financial transaction tax (a kind of VAT at EU level with a Pigouvian character or own new own resource of the EU budget that is some 140 billions euro) could also, via a EU fund, cover the issuance of EU bonds. The common issuance of EU bonds would refinance gradually all the maturing debt of the PIGS. This would not only significantly reduce the cost of financing of PIGS debt, while creating a EU bond market, but it would replace any International Monetary Fund role and/or conditional loans.
    Too simple to happen? What’s wrong?

    http://mgiannini.blogspot.com/2010/02/too-little-to-fail-or-when-you-do-not.html

    • 2010-02-26 at 12:23

      Thanks for commenting, M.G. in Progress. What’s wrong in my humble opinion:
      a) We already have a regulated and subsidised EU agricultural policy (CAP) – and it has created the single most unprofitable agricultural region in the world. So doing similar things in the finance arena begs the question why, if the Common Agricultural Policy failed dismally, wouldn’t the “CFP”?
      b) Even Tobin, after whom, against all his protests, the general financial transaction tax was called, only advocated a currency transaction tax to stop (no: dampen!) short-term monetary speculation. To his death he has protested identifying him with an across-the-board Robin-Hood-Tax etc. It will, as all taxes, never be completely global, and lead to the demise of London and New York as financial hubs (unless, as with all taxes, you create enough incentive via subsidies to balance its negative effects – oh, haven’t we seen tons of that!).
      c) It should be left to the people, the sovereign (!) if they want more integration. Currently those who stand to gain because they wrecked themselves through financial improbity, may want it, those who’d end up net payers don’t. It is not democratic to first begin a terrible mess in finances then let everyone bail out the vabanque players. And it creates the exact same moral hazard that landed us in this mess in the first place. Indeed, all corrective actions proposed by the statists so far are of the “more of the same” manner. And none of them worked yet, not job creation, nor mortgage modification, nor “cash for clunkers” etc.
      d) Repackaging sovereign debt in the way you mentioned is, honestly, a process of mixing good with bad, a swipe-under-the-carpet operation. As I described with the adulteration process of the Euro where essentially Lira were forced upon Deutschmark buyers it will just as easily end in a “bond debasement” process. Why, doesn’t interest subsidy lie at the very heart of the mortgage crisis? Packaging bad with good homeowners spelt disaster there, now packaging bad bonds with good ones will spell future disaster here. Many US states and cities are in precisely the same mess as Greece because they could get bonds denominated in their “father”currency placed in the markets at below par rates!
      e) As for the transaction tax in b) there are other reasons: there is no serious economist who ever advocated tariffs – the tax has a strong semblance to tariffs. If anything got the Great Depression started after it was only a recession it was tariffs and the disruption of international trade.
      f) The argument hinges on the fallacy that speculation is bad, that there are two classes of financial transactions: good, “honest” ones and then bad “speculative” ones. As I have shown in Economic Fallacy II: Speculation is Harmful?, speculation is the only thing that REPAIRS the damages from other agents’ stupid behaviour. Without speculators markets would experience greater swings not lesser. Thus such a tax will likely have the opposite effect.
      g) However, the speculation “against” the “PIIGS” or “national” currency has a reason: if you create money out of thin air people will speculate “against” it. It has only started in earnest after the 1970s when Nixon debased the dollar! Go back to a state before that and no one needs a tax! Speculation in fiat currencies is a desperate way of trying to eke out value from what has no intrinsic value. That phenomenon would disappear over night if one would accept that money has to have value to “be of value”. The gold price would soar after that tax was implemented! Then you’d have to prohibit gold, creating new opportunities for organised crime. And so on and on on “the road to serfdom”.

  5. dearieme
    2010-02-24 at 11:36

    At the time of the folly, I tried to explain to a German chum why it was such a stupid idea. I gave up when he said “In the modern world exchange rates do not matter.” I know a religion when I see one.

  6. 2010-02-24 at 10:24

    The EURO is history.


    Its failure was programmed when this artificial currency was forced over so different economies such as the German and the Portuguese or the French and the Italian; during the last weeks there was not even the slightest hint that any or a certain group of the member states, the ECB or the EU is working on a plan to save the currency by installing measurements that would allow economies of different levels and needs (!) gather under the same currency roof.
    Not that I know all the answers and it very likely is long past 12 o’clock but obviously there are no solutions to heal the programme’s failures.

    To collect money in a Greek hat will see a number of other hats pop up, some larger, some smaller; the economies slipping almost on a global scale emphasising the battles for labour and commodities, also for weak currencies and low labour cost, this all inflamed by the banksters’ egoism will all but protect the EURO.

    So the question is: what’s next? Not so much a “how does this end?” but rather a “what will we be left with?” and a “how will we go on?”.

    Anyway, an awful end might shorten an awful time!

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