The Future of the Euro

Difficulties with the construct pose real danger

BERNARD CONNOLLY, FOUNDER, CONNOLLY GLOBAL MACRO ADVISORS

Where should investors begin in thinking about the future of the euro? They should remember three things. First, the euro is, and always has been, a political project, not an economic one. Second, European Monetary Union has been the biggest credit bubble of them all. Third, depression, deflation and default – and perhaps political breakdown – are the near-inevitable fate of current-account deficit countries (CADS) in the area unless Germany assumes a perpetual burden similar to the Versailles war reparations.

The euro has a twofold political purpose. One is to allow Europe to play a more important role on the world stage. As a former member of the short-lived Monetary Policy Council of the Banque de France put it not long before the euro was introduced, the point of the euro was to suck capital out of the US, raise interest rates and unemployment there and, as he put it, force Washington to the negotiating table on the world socio-economic model. The economics of that ambition were debatable, but the politics were very clear. At about the same time, the Belgian Finance Minister, Philippe Maystadt, said very openly: “The purpose of the single currency is to prevent the encroachment of Anglo-Saxon values in Europe.” And forty years earlier Adenauer had told the French Foreign Minister, after France’s humiliations at Dien Ben Phu and then Suez, when it became clear that America would not support France’s global ambitions, “Europe will be your revenge” – against the Anglo-Saxons.

The second political purpose is, and always has been, to force countries into a bureaucratic, unaccountable political union. There is little need to elaborate this point given recent developments. But it is perhaps worth recalling that Romano Prodi, then president of the EU Commission, said in an interview in December 2001, a few days before the introduction of euro notes and coins, that the euro would create a crisis which would give “us” powers it would otherwise be politically unacceptable to claim – a prediction he approvingly saw, in an Financial Times article in May, as now being close to realisation.

Franco-German tension
These two purposes define common interests for what is the heart of the European project – the Franco-German “couple” (de Gaulle said in 1963 that, “Europe is France and Germany; the rest are just the trimmings”). But while there may be a shared determination to overturn an Anglo-Saxon global model, there is also an unending tension between France and Germany. Paradoxically, perhaps, it is this tension – about who really is the leader of Europe – that has contributed to keeping the euro area together – so far. The reason is that any withdrawals would face France with an intolerable dilemma: if there is a monetary split in Europe, does France stay with Germany and its consorts, thereby inevitably accepting subsidiary status, or does it split from Germany, putting at risk its perceived interest in using German muscle against the Anglo-Saxons?

The two political objectives we have discussed here also help make it clear why the politicians and bureaucrats involved in running the euro area are so fanatically attached to the project, even though it threatens to produce economic, financial, social and political chaos. This brings a serious risk that withdrawals, if they happen at all, might be forced from below – from political chaos and incipient political breakdown in the countries with vast full-employment current-account deficits. Argentina is a plausible template: its Convertibility regime did not break down because of a lack of official foreign lending; it broke down when the attempted implementation of Carvallo’s zero-deficit plan brought the mob into the grounds of the Finance Ministry.

A second implication is that law goes out of the window. The European Court of Justice has always been determined to destroy both national law and public international law, replacing them with “une certaine idée de l’Europe”. And the actions of euro-area governments since the EMU crisis began have made it very clear that arbitrary political will has indeed completely replaced law. There is now enormous political risk in the euro area: not just the all-too-obvious horrors of riots and political disorder but the risk that any asset price can be manipulated by the authorities, including the European Central Bank, and indeed that any asset, and not just sovereign debt, can be expropriated or adversely transformed and any activity prohibited or made unviable – with no recourse for the victims to anything resembling law. At all events, it is grimly obvious that whatever the outcome of the EMU crisis is, it will not be determined rationally or reasonably by governments, and no argument in terms of the massive damage that EMU is inflicting will make any difference whatsoever.

The EMU credit bubble

The second very important thing to remember is that EMU has been the biggest credit bubble of all. In the US, the bubble was a reflection of dynamic inefficiency, produced when Greenspan held back a rise in long real interest rates in the face of a marked increase in the anticipated rate of return – initially an increase fully justified by technological and entrepreneurial innovation in America – in the mid-1990s. The underlying delusion then was that the “New Paradigm” changed all the rules. At all events, it is a straightforward result in economics (though one studiously ignored by even the most celebrated economists) that dynamic inefficiency, bubbles and Ponzi games are essentially one and the same thing. In the US case, the bubble was most obvious in – though far from confined to – mortgage-related assets. Investors acted as though the credit of house buyers with no incomes, no jobs and no assets could be transformed by securitisation into rock-solid assets. In EMU, the equivalent delusion was that the single currency changed all the rules. Economists in central banks and the IMF claimed that current-account deficits did not matter in monetary union. In fact, of course, what monetary union did was to transform currency risk into something far more sinister – credit risk.

Current-account deficits are perfectly appropriate in a country with a high rate of return and correspondingly high real rates of interest and an appreciated currency: as the country subsequently catches up in productivity and as new capacity comes on-stream, the rate of return drifts back down to the world level and capex decreases, interest rates can come down and the exchange rate can depreciate, enabling both financial stability (the absence of bubbles and Ponzi games) and macroeconomic stability (the absence of big swings between available supply and available demand) to be preserved. But it is hard to think of a more inappropriate case of a large current-account deficit than that of Spain. That country, despite managing virtually no total factor productivity growth at all after the single currency began, had, for several years before the bust, the second-biggest current-account deficit in the world in absolute, dollar terms, and its external debt ratio rocketed. Its residential construction bubble was three or four times as intense, in relation to population, as that in the US. And its private non-financial-sector leverage ratio rose to a level, 220% of GDP, apparently unmatched in any developed country at any time in history and rendering it uniquely vulnerable should it suffer deflation. Its underlying budgetary situation was disastrous – as has nowbeen revealed by the bust, a bust from which there is no way back within monetary union. Yet investors credulously acted – applauded by governments, encouraged by ratings agencies which, incredibly, saw euro entry as reason for upgrading countries and approved by EU directives that said all euro-area government bonds should attract the same risk weighting – as though Spanish credits were as good as German credits.

Unrecognised CDO losses
Unhappily, the biggest credit bubble of all, EMU, will entail the biggest credit losses of all, with calamitous consequences for the financial sector in euro-area countries, at least, and possibly beyond, and with significant consequences for global growth. It is an open secret that many second-tier banks in core European countries have still not fully recognised losses on their US-referenced collateralised debt obligations. If in addition they have to suffer credit losses on their claims on governments, banks and derivatives counterparties in CAD countries, some – perhaps many – of them will be insolvent. There will have to be another round of taxpayer-financed bailouts. But this time taxpayers are almost certain to demand haircuts from banks and possibly nationalisation. The aid package agreed on May 9 was thus clearly intended to allow banks, pension funds, life insurers and other real-money asset managers to reduce their exposures by not rolling over maturing CAD bonds and by selling non-maturing bonds to the ECB. Obviously, it makes no difference to the probability of default and/or withdrawals. For the plain fact is that Greece, Portugal and Spain are insolvent within monetary union.

Why? National solvency requires a path for their current-account deficits implying massive trade-balance adjustment. That adjustment will have to come, and has indeed started coming, through sharp reductions in domestic demand. Within monetary union, this in turn crushes output and employment and will enforce a deflationary process. If everything held up, that deflation would eventually improve competitiveness. But CAD banking sectors cannot possibly hold up in a period of prolonged mass unemployment and deflation. And social and political systems might well not hold up either.

At all events, the problem of massive divergence in underlying current-account positions within the euro area makes the euro simply untenable – and it poses significant risks to anyone holding or trading in euro-area assets. No-one knows what a euro actually is. Is it a deutschmark? Or is it a drachma? Our calculations suggest it is more like a French franc or an Italian lira – but it could move rapidly in the direction either of a deutschmark or of a drachma if there were withdrawals from the area. Our calculations suggest that the short-run euro/dollar rate required to avoid deflation in Greece while ensuring external solvency through a reduction in Greek domestic demand is 31 cents; that for Spain is 34 cents. Yet for Germany to have an intertemporal equilibrium (in which Germans actually absorb, over time, the amount they produce) without inflation would require a euro/dollar rate of 2.35; for France the equilibrium rate is 1.11 and for Italy it is 1.25. (A caveat: all these calculations use the dollar rate as a proxy for the effective rate; this assumption will rarely be justified; but the numbers here give a valid indication of the enormous range between the equilibrium rates for CADs and for Germany). Talk of an equilibrium rate for the euro being around 1.10 (the purchasing power parity rate that is often quoted) is quite literally nonsense: there is no such thing as an equilibrium rate for the euro, because there is no such thing as euroland.

Germany as backstop
The implications of this enormous divergence for the currency’s future are radical. It is already becoming obvious that Germany will in effect have to guarantee the “guarantees” of other countries in the euro-area stabilisation fund. That is understandably already politically unpopular enough in Germany. But a transfer union would be hugely more costly than that fund. It would have to involve Germany in making enormous current transfers to CADs, every year from here to eternity, so as to avoid the need for trade adjustment in those countries. That will be politically impossible. Why? If it did happen, the cost to Germany would be financially crippling. The working of moral hazard would soon mean that just about every other euro-area country would want to benefit from German subsidies. Most important, France is a CAD – not in such a dire state as Spain, Portugal and Greece, but nonetheless qualitatively in the same boat as those countries. In a transfer union, France would be a recipient, and a very large one. Ultimately, we calculate, the cost to Germany could be at least as much as the full-employment trade deficits in all the present CADs – something like 8% of its GDP every year for ever. At a plausible real interest rate, the present value of that stream would be well over 200% of German GDP, similar to the intended burden (far greater than the actual burden) of the Versailles war reparations. That would produce financial ruin and dangerous political instability in Germany.

Absent that, keeping the area together would mean either rampaging inflation in Germany, if the euro became more like a drachma or a peseta, or depression, default and possibly complete political breakdown in the peripheral CADs even if the euro stayed at something like its present level and a fortiori if it became more like a deutschmark. Democracies would be hard put to survive that – and so would capitalism. If the CADs withdrew, the euro would become rather more like a deutschmark and would, given Germany’s current circumstances, appreciate substantially. But it is important to note that all the CADs – or at least all three of Greece, Portugal and Spain – and not just Greece, would have to withdraw for this to happen. If instead the German bloc (Germany and the other current-account surplus countries of the area) withdrew, the rump euro would rapidly become much more like a drachma or a peseta. But if one does not know what a euro is, it is very hard – impossible, in fact – to know how to value it.

Euro as anachronism
The elephant in the room, though, is what we began with: the ambition to overthrow an Anglo-Saxon global system and to ensure that as many decisions as possible are undemocratic and unaccountable. The euro is an anachronism. It might conceivably have worked in the 1950s and 1960s, when the private sector was weak, heavily regulated and, in effect, a tame beast. The beneficial changes in the world since the breakdown of Bretton Woods have unleashed private-sector energies (those energies have very obviously been misdirected as a result of the failure of monetary policy frameworks to adapt to those changes in the world, but that is a subject for another day). The euro, with its emphasis on the primacy of the state and of the corporatist “social partners”, is just not fit for the world. But the EU wants to change the world to make it fit for the euro: anti-market, anti-Anglo Saxon, anti-capitalist and anti-democratic. Markets, says the EU, must be brought under control. National parliaments must be subjected to the will of the unelected EU nomenklatura. Worst of all, private-sector behavior must be coordinated – in other words, the whole of the private sector, not just the financial sector, must be regulated – dictated by the state – to ensure that there are no disturbances to the serenity of the euro.

Do you believe that can work? If you do, you are looking at a currency worthy of a pre-emerging, pre-democratic third-world country, and one that should attract a corresponding political risk premium. If you don’t, you have to weigh the probabilities of three possible outcomes: initially no change, a weak euro to hold things together for a time (what France would like) but a very serious risk of ultimate economic, financial, social and politicalcollapse; CAD withdrawals, and a much stronger euro; German-bloc withdrawals and a much weaker euro. But, whatever happens, the second point we made remains intact: the world’s biggest credit bubble must produce the world’s biggest credit losses, with very negative consequences for the global financial system and for the world economy. The euro will be a danger to everyone as long as it exists and the reasons for its creation persist.

Bernard Connolly is the founder of Connolly Global Macro Advisors, a specialist macroeconomic and geopolitical consultancy providing financial market research to a global client base. Connolly is an economist and commentator, and author of the best selling book, The Rotten Heart of Europe: the Dirty War for Europe’s Money.