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.