Saturday, June 11, 2005

Is the Euro just a Bull Market Phenomenon?

Marshall Auerback

“We lost a lot of our influence. We went too quickly on enlargement. It was a big mistake. The people voted against it last Sunday. Now we have lost our credibility too.”
– An unnamed French diplomat, quoted in London’s Sunday Times in the aftermath of the French EU constitutional referendum

The dual rejection of the European Union’s proposed constitution by the Netherlands and France has been described as a political earthquake. The analogy is appropriate: the underlying edifice holding together the EU has suffered serious structural damage, the extent of which is still unclear. And there is also the possibility of further aftershocks which may ultimately lead to nothing less than the demise of the euro itself.

The tea leaves for Europe’s policy makers have been evident for some time, if they only chose to read them. The EU and its attendant institutions have long been characterised by a huge democratic deficit, which has led to an increasing sense of political alienation of the part of much of the population. Even before the respective French and Dutch referendums, there had been enough hints by the electorates of various member states in a sufficiently large number of national elections to give Brussels a sense that something was amiss. Results across the continent repeatedly reflected the rise of populist, anti-EU parties and a concurrent sense of dissatisfaction with its existing leaders. All of this has occurred against an economic backdrop in which continental European living standards have plunged, national pension plans veer toward insolvency, unemployment remains in double digits and national pride is turning into embarrassment and even shame.

Even when things have apparently gone well, it has not redounded to Euroland’s credit. The appreciation of the euro over the past few years has been widely hailed by the continent’s policy makers as symptomatic of the currency’s growing credibility as a genuine store-of-value alternative to the dollar. But the ultimate impact of such appreciation has been to price European manufacturers out of global markets, if one is to judge by the wretched performance of the export-dependent Italian economy (now in recession), as one significant example. This is a particularly worrisome trend, since EU-wide exports were widely deemed responsible for last year’s economic recovery, given the persistent sluggishness of domestic consumer demand.

Amazingly, the underlying problems have continued to be ignored by the European Union’s leading officials, which in turn has stored up additional trouble for the future. No change in the Commission’s operating procedures have ever taken place in spite of numerous political warnings. Euroland, as a consequence, has continued to function in a huge political vacuum. Indeed, the whole “European project” is increasingly characterised by growing institutional inflexibility, policy paralysis, and tenuous political legitimacy. Today, the whole movement toward an “ever closer union” appears dead and the notion of a “United States of Europe”, standing as a serious political counterweight to the US, risible.

The more relevant question might be: is the euro itself salvageable? The FT’s Lex column lays out the stark alternatives ahead for Euroland:

“[M]arkets are leaning toward the belief that a vicious cycle is taking hold. This will see a weaker euro on the back of a worsening eurozone economy, political uncertainty and higher US interest rates. The European Central Bank, convinced that economic weakness has structural rather than monetary causes, will refuse to lower rates as imported inflation rises. Fiscal laxity as governments try to placate electorates could actually result in rate rises, depressing growth.

But those searching for a chink in the clouds could paint a much sunnier scenario. Elections in Germany this autumn, and the discrediting of the lame-duck French government, could result in a more pro-reform core Europe, which would work more harmoniously with the UK. Italy’s economic meltdown would continue, its debt burden finally forcing it out of the euro. A few years down the line, a leaner, meaner EU, focused on trade rather than political and social integration and expansion, could drive through aggressive structural reform and set the region on the high growth low unemployment path. An EU that regained the characteristics of a free-trade zone, focussing on competition and financial regulation, could more comfortably accommodate Turkey and other new members.”

As the paper concedes, this latter scenario appears unlikely, especially in light of the immediate response to the results in France and the Netherlands. It is worth noting that these two countries are core founding members of the European Union, not traditionally euro-sceptical nations existing at its periphery such as the United Kingdom or the newly accepted nations of Eastern Europe. And the latter are feeling fairly aggrieved at this juncture because the No votes were said to be fuelled by fears over jobs being lost to cheap workers from the east and immigration. Resentment is, therefore, building in the new members that they have been made scapegoats for the economic and social ills of old Europe.

So does “Old Europe” get it? Even before the results of the French referendum were official, Jean-Claude Juncker, the Luxembourg Prime Minister, insisted that the ratification process for the constitution continue until all countries delivered the “right” answer, which is essentially what was tried following the Danish referendum on the euro and the Irish rejection of the Treaty of Nice.

Jean Luc Dehaene, a former Belgian PM, exhibited comparable contempt for popular opinion: In a BBC interview last Monday, Mr Dehaene made the extraordinary remark that the results in France were meaningless because the electorate was not voting against the constitution, but against the French government. Common sense suggests that on the contrary, they were voting precisely against the constitution, a project of politicians such as Dehaene who are determined to pursue an unpopular agenda with or without popular consent. This notion also appears to be confirmed by the British newsmagazine, The Economist, which noted that five of the top 10 best-selling non-fiction books in France were about the Constitution. Millions of people watched television shows discussing it. A huge percentage of respondents in public opinion polls were familiar with its content. There was huge voter turnout (70 per cent) and people had a very good idea of what the issues were.

This obliviousness to public opinion has been the flaw at the heart of the whole "European Project" right from the start. It is scarcely remembered now that France only barely ratified the introduction of the euro in a vote so tight that its adoption by a few tenths of a percentage point gives lie to the word, “democracy" that lifts so carelessly off the lips of the most undemocratic of politicians.

But have France, let alone the rest of the EU, taken on board the message? In the immediate aftermath of the French Non, President Chirac announced a new and strong impetus to government policies, but chose his “political son”, Dominique de Villepin, to be France’s new Prime Minister, rather than someone identified closely with further economic reform, such as Nicolas Sarkozy. De Villepin (best known to Americans for his outspoken opposition to the US-led invasion of Iraq when he was France’s Foreign Minister) is viewed by the markets as fundamentally hostile to “Anglo-Saxon liberalism”, and determined to retain France’s unique “social model”.

“He’s got class and he can recite poetry,” said Jean-Louis Martin, a 59-year-old engineer who lost his job in 2003 when the local metal smelting factory shut down. “But I don’t see what hope it brings us. The people voted for a change — not a return of the nobility, the old regime. This is a joke.” This quote from the London Sunday Times reflects a commonly expressed sentiment. The euro lost a cent against the dollar in the immediate aftermath of the announcement of De Villepin being named French Prime Minister because the markets interpreted his appointment as a sign that France has set its face not just against the European project but against further economic liberalisation and reform. This is not euro bullish.

On the plus side, the contradictory impulse toward both widening and deepening the European Union (and, ultimately, the euro zone), has been demonstrably established as futile. The British belief that more widening of the EU would mean less deepening has essentially been vindicated.

There is little question that for a monetary union to operate successfully, there has to be a high degree of economic and political convergence. But this runs up against the tide of history: Pooled political sovereignty and a concomitantly more cohesive supra-national fiscal policy are far more difficult to implement in a larger currency zone with countries at disparate stages of economic development and correspondingly different political/historical traditions.

Most single-currency zones involve a central or federal government with a tax and public expenditure program of substantial size relative to national GDP and the ability to run significant deficits. A tax and public expenditure program generally involves redistribution from richer regions to poorer ones, whether as an automatic consequence of a progressive tax and social security system or as specific policy acts. The redistribution also has to be sufficiently large in scope to act as a stabilizer with negative shocks, leading to lower taxation and higher social security payments in the region that is adversely affected. The EU’s current budget is a pittance and there is little inclination for member states to pool further fiscal resources in the current political climate. But there is a need for the development of a larger EU tax base and redistribution of tax revenue from richer regions to poorer ones in order to have a genuinely proper functioning fiscal policy at the supra-national level. This is clearly more feasible with a smaller zone of nations with common economic and political philosophies.

In the absence of such a mechanism, it could be expected that economies would adjust to differential shocks and uneven economic performance through a variety of other routes, such as currency devaluation.

With the existence of the euro, that is not an option, but even that is coming into question: In the aftermath of the recent referendum results, issues hitherto considered politically sacrosanct, such as the actual withdrawal from the euro zone, have begun to creep into the public domain. This must surely constitute the ultimate Pandora’s Box for euro enthusiasts.

Of course talk of withdrawing from the euro zone is dismissed as completely unrealistic by EU officialdom. But recall that when the first stirrings of doubt were expressed by Germany back in 2001 about the Stability and Growth Pact, this too was met by a hail of denial. Just four years later, the Stability Pact is all but dead, denuded of any kind of meaningful enforcement mechanisms in the face of persistent violations.

The issue of euro withdrawal has been broached in Italy, of all countries. Ironic, because Rome has effectively had a free ride in the eurozone’s integrated bond markets for years, obtaining Germanic levels of interest rates (as a consequence of Germany’s historic record of fiscal prudence), despite maintaining historically retaining profligate levels of public sector expenditure and debt to GDP ratios well in excess of most of the other founding member states in the monetary union.

In spite of its low cost of capital, the country’s Welfare Minister, Roberto Maroni, told La Repubblica daily Italy should hold a referendum to decide whether to return to the lira, at least temporarily. He also said European Central Bank President Jean-Claude Trichet was one of those chiefly responsible for the “disaster of the euro”: The euro “has proved inadequate in the face of the economic slowdown, the loss of competitiveness and the job crisis,” Maroni said.

In this situation, Maroni contended that the answer was to give the government greater power to defend national industry from foreign competition and “to give control over the exchange rate back to the government”, and specifically cited Britain as a virtuous example of a country whose economy “grows and develops, maintaining control over its currency.”

The dirty little secret of European Monetary Union is that there has never been a proper debate on the pros and cons of the single currency union within the member states. Like so much else in regard to the EU, it was imposed from above. Yet this is a debate that must occur because the European Monetary Union and its attendant institutions, such as the European Central Bank, ultimately cannot succeed in the absence of open, public discussion and acceptance, in lieu of bureaucratic imposition.

It is said that politicians in particular and the democratic process in general cannot be trusted with economic policy formulation because they lead to decisions that have stimulating short-term effects (for example, reducing unemployment via higher government spending) but are detrimental in the longer term (a notable example is a rise in inflation). But comprehensive rejection of the constitution has proved to be an outlet for discontent extending well beyond this particular issue; French and Dutch voters have now shown us the limits of pure technocratic economic management in an environment divorced from political reality.

On the other hand, to debate the appropriateness of a single currency union at this juncture may engender unintended results. It is extraordinary to consider, for example, that the German people never had the opportunity to express their views in a referendum as to whether they ought to abandon one of the most successful post-war monetary regimes in favour of an untried and untested currency. Even if one makes allowances for Germany’s traditional post-war phobia of being perceived as “bad Europeans”, it is almost certain that most would have voted to retain the D-mark, had they been given the opportunity to express themselves in a proper democratic forum.

Already, there are stirrings of euro discontent emerging at the margins in Germany as well as Italy. The referendum results in France and the Netherlands appear to have lit a match on a tinder box of huge continent-wide disenchantment. Consider what is happening to the now discredited EU constitution in the wake of the French and Dutch referendum results: Four separate polls in Denmark and a survey in the Czech Republic indicated the two countries could both vote No in referendums on the constitution. Bild, a leading German tabloid, showed overwhelming hostility in Germany to the constitution. Of the 390,694 readers who responded, 96.9% said they would vote no if a referendum were held there. Now imagine if this discontent were to extend to the monetary union itself.

Increasingly, the euro appears to be nothing more than a bull market phenomenon. Its enthusiasts have over promised and under delivered. In the words of London Times’ correspondent, Anatole Kaletsky:

“The relative economic decline of ‘old’ Europe since the early 1990s - especially of Germany and Italy, but also of France - has been a disaster almost unparalleled in modern History. While Britain and Japan certainly suffered some massive economic dislocations, in the early 1980s and the mid-1990s respectively, they never experienced the same sort of permanent transformation from thriving full-employment economies to stagnant societies where mass unemployment and falling living standards are accepted as permanent facts of life. In Britain, for example, unemployment more than doubled from 1980 to 1984, but conditions then quickly improved. By the late 1980s, Britain was enjoying a boom, the economy was growing by 4% and unemployment had halved. In continental Europe, by contrast, unemployment has been stuck between 8% and 11% since 1991 and growth has reached 3% only once in those 14 years.”

Could the euro, therefore, suffer from the same sort of conflagration of discontent, as is now manifesting in the constitutional ratification process?

How would one re-establish national currencies, given that there exists no mechanism to re-establish them in lieu of the euro (at least none that have been publicly disseminated, for obvious reasons)? Indeed, France and Germany have only recently issued 50-year euro-denominated bonds. The euro itself is becoming an increasingly large component in the reserve portfolios of other central banks, particularly Asia. The prospect of chaos in the bond markets, and consequent severe economic dislocation, cannot be ruled out if this movement to restore national currencies were to gain sufficient political momentum on the back of this current outbreak of anti-EU populism.

What to do in that sort of context? In the past we have described the problems of the US economy ad nauseum. We have also highlighted the problems of the yen and the structural problems inherent in the existing European Monetary Union. Although the euro zone as a whole suffers less from the debt disease prevalent in both the US and Japan, it has largely “earned” its spurs on the foreign exchange markets as a consequence of being the least bad major paper currency alternative. Its acceptance has, until recently, continued unabated, largely by virtue of not being the dollar, as opposed to any intrinsic merits.

Generally speaking, most currency choices faced by market practitioners today are comparable to Keynes’s notion of market speculation: to paraphrase Keynes, one is not seeking to adjudge the most beautiful currency in absolute terms, but merely seeking to guess what the market’s will judge to have the best relative merits . In other words, paper currencies are only “relatively” attractive vis a vis each other and not genuinely attractive as ultimate stores of value. The current problems of the euro (as well as the longstanding problems of the dollar) illustrate that phenomenon.

This points the way toward a potential major paradigm shift in relation to gold, long viewed simply as another variant of the “anti-dollar” theme. Symptomatic of this shift in thinking is the Financial Times, a publication which has usually been viscerally hostile to gold as a legitimate reserve currency asset. In an editorial last April, however, the FT came to a fairly stunning conclusion:

“In truth, there are good reasons for selling all three of the world's main currencies. But could they all fall? Yes, against either gold or the Chinese renminbi. In recent years, gold has been a useful hedge against the dollar, but not against the euro or yen. Meanwhile, the U.S., Japan, and the EU would all like to see the renminbi revalue, but so far, the Chinese are not playing."

The current travails of the euro may change the perception of gold as a barbarous relic from a bygone era For the FT, which has been known as a very anti-gold publication, to come to this conclusion means that many people who have long viewed bullion as economically irrelevant are likely reassessing their viewpoint. This could well point the way forward for gold, notwithstanding the many travails its holders have experienced over the past two decades. Often, seismic shifts in thinking unfold in slow-motion, and are often masked by other “noisier” events, such as the French and Dutch referendums. The “noisier events”, however, could well be catalysing a far more profound change in financial thinking. The rejection of the EU’s constitution in France and the Netherlands, therefore, may well have initiated something well beyond the control of today’s paper currency custodians, much to their ultimate horror no doubt.

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