There is probably no single experiment in modern economics that is more interesting than the EMU. The Euro has quickly grown to become a near reserve currency and prior to this crisis was viewed as a viable alternative to the US dollar, however, the credit crisis has done considerable harm to the currency and in my opinion has exposed it as being fundamentally flawed and unable to survive in its current format.
I have previously described why single currency systems are destined to fail (see here) and how the Euro actually reflects the gold standard in many ways. I am not alone in my beliefs. In a recent note UBS analysts eloquently described why a single currency system such as the EMU must make dramatic changes or perish.
The primary problem with a single currency system is that it causes inherent imbalances across the system. UBS elaborates:
Persistent imbalances in the EMU
At the center of the current crisis of the euro are fiscal deficits, especially in Greece, Portugal, Spain and Ireland. However, these fiscal deficits are just symptoms, but not the cause of the malaise. The fiscal accounts must not be looked at in isolation. Besides the fiscal or public sector financial accounts there are also the private (i.e. firms and private households) sector financial accounts and the foreign sector financial accounts. To approximate the latter, we can look at the so called “current account”. We can think of a country’s current account as roughly the same as our own private bank current accounts. If we spend more than we earn, the account will be in deficit and vice versa.
Thus, if the private sector (firms and households) and the government spend more than they earn, the country’s current account will be in deficit. The deficit will be necessarily be financed by the import of capital from abroad, i.e. from countries that save more than they spend. Thus, if there are deficit countries there must also be surplus countries. As the EMU is a fairly closed economy, where about 75% of all external trade takes place among EMU countries, the surpluses of one country or group of countries are to a large extent the deficits of others.
Figure 1 provides evidence for persistently rising current account imbalances between two polar country groups, that we call “core” (Austria, Finland, Germany and Netherlands) and periphery (Greece, Ireland, Portugal and Spain). Please note that this distinction is made on purely statistical grounds and not based on political consideration. Something is causing the core group to spend less than they earn, while the periphery group spends in excess. The evolution of the current account balances in the two groups are nearly mirror images suggesting that the core group of net savers is financing the peripheral group of net borrowers.
So, we can see from this simple description that the EMU is easiest to understand if you think of it as a closed system. Someone’s surplus is someone else’s deficit. It can be no other way. But what is the problem with this format and what makes the EMU unique in this regard? UBS examines the ensuing problems in such a scenario:
“Peripheral countries accumulate foreign debt
As mentioned above the gap between spending and savings is financed by foreign capital. Thus, every year’s current account deficit adds to the country’s public and private aggregate foreign debt. Thus, running a current account deficit means accumulating foreign debt. Figure 7 shows that both the core and the periphery started out with similar debt positions in the early 1990s. Since 2000, however, differences in current account patterns begin to materialize. Core countries continuously reduced their foreign indebtedness to close to zero. For the peripheral countries, rising current account deficits led to the accumulation of net foreign debt of close to 80% of GDP. This debt needs to be serviced out of current income. The peripheral countries have to pay an increasingly larger share of their income to service their foreign debt, which has become a serious burden for the current account.”
Unlike a nation such as the USA, which has monetary sovereignty in a floating exchange system, the Euro members are forced to take on foreign denominated debt in order to finance their spending. This involves a beggar they neighbor strategy as we currently see in Greece and in several other nations. Because there is no floating exchange market forces cannot help right this sinking ship. Austerity is self defeating as it only further weakens the economy. Ireland is exhibit A here and Greece appears to be following in their footsteps. Much of this response is self defeating and in fact exacerbates the deflationary spiral. UBS expands on the problems:
“If nominal currency devaluation is not available, countries can go for a so called “real devaluation”, by cutting prices and wages. This would help restore the trade balance of indebted countries. However, it would have no beneficial effect on the net foreign debt positions. Germany adopted such a policy in the early 2000s to restore price competitiveness after joining EMU at an overvalued exchange rate. Germany is currently advocating such a policy for the indebted countries at the periphery of the EMU. Can it work? The short answer is – no, at least not for every country, given the political obstacles. Ireland, which is very export oriented and flexible, may be able to implement such a policy successfully, but for Greece, Spain or Portugal the chances are slim.
We think there are two reasons for this. Firstly, running a public sector surplus within a monetary union is easier said than done. We have mentioned earlier that the current account balance is the sum of the private sector financial balance and the public sector financial balance. Thus, it follows that a country that cannot avoid running a current account deficit, but wants to run a public sector surplus, must persuade its private sector to pile on debt at a rate that is higher, in absolute terms, than the public sector surplus. For Spain, where the private sector is already highly indebted this would be a daunting prospect. Importantly, the EMU is a fairly closed economy, where most of the foreign trade takes place within the union. This means, if Spain or any of the other deficit-countries want to run a current account surplus, Germany, which accounts for 25% of the EMU would have to switch its current account balance from surplus to deficit. As Germany has just announced a public sector savings program which will tend to push Germany’s current account up again, this looks like an unlikely prospect.
The second reason why real devaluation is not likely to work for all countries is the fact that it is a very painful policy. Latvia is using real devaluation to solve its debt problems, as it wants to keep its currency peg to the euro. As a result, the unemployment rate shot up to 20% from around 5% in a matter of two years. If several countries in the same region with close trading links pursue a policy of real devaluation the negative effects on economic production and employment will be compounded further. GDP growth would therefore be very low or even negative for a prolonged period of time. As such, real devaluation risks weakening the economies to a point where the debt-to-GDP ratios continue to rise despite the governments’ best efforts.
So we can see that there are very real inherent problems within the EMU. What can be done about these inherent flaws? As I’ve stated before there are no good answers here. I still believe the ECB’s bailout plan is merely kicking the can down the road while they construct some sort of long-term solution. But even then, the real solutions are difficult and perhaps impossible to apply. The most obvious solution is that these nations require true unity – a United States of Europe if you will. But like UBS, I believe the odds of this occurring are extremely low. The hurdles that must be overcome in order to create one rule of law, one treasury and one central bank all under the same umbrella would be staggering:
“A fiscal union may be the way to go
We believe the only sustainable solution for the EMU is a transition to a full-fledged fiscal union or fiscal federation, complete with a system of fiscal transfers and proper political institutions that bind member states. The consequences of such a move would be truly ‘historic’. Such a setup would practically transform the EMU into the ‘United States of Europe’. Individual member states would have to relinquish much of their fiscal and economic policy sovereignty to a new supra-union authority, which would raise its own tax revenue and allocated spending across the member states.
The chances for such a European super-state are slim we think. Firstly, getting a large number of sovereign states to peacefully and voluntarily relinquish much of their sovereignty will be extremely difficult, if not impossible. Indeed, the haggling over comparatively minor changes to national fiscal policies has already caused some disagreement. Secondly, the time of great visions for European integration seems to be coming to an end. Finally, such a fiscal union may not even be desirable. A fiscal union basically cements the imbalances of the EMU, which in time is likely to breed disharmony among the member countries. As new, lower-income countries join the EMU; these political challenges become even more difficult.”
Like UBS, I believe the EMU is simply not sustainable in its current format:
“ Unsurprisingly, our analysis confirms that in its current form, the EMU is not sustainable. The methods and approaches that policy-makers are currently proposing to solve the problem will, in our view, not fully resolve these tensions. Yet, we acknowledge, that much of the current proposals are short-term crisis management. The longer-run reform of the EMU governance may look different. Hence, to assess the long-run prospects of the euro, it will be very important for investors to watch out for what direction the reform efforts take in future. If measures are taken to improve labor and price flexibility, and especially to ensure the proper pricing of risk, these would be encouraging signs for the euro’s long-term outlook. However, ultimately we think the EMU would have to evolve into a full-fledged fiscal and social union, not unlike the US dollar union, if the euro is to be put on a sustainable basis. Failing this, our base case has to be that the euro will not survive in the long-run – at least not in its current shape and form. However, taking a view of what will happen is often a far cry from knowing when it will happen.
Unfortunately for many of the nations in Europe there is too much political will invested in the Euro to simply accept that it is flawed and dissolve it. This likely means we will muddle through a period of economic hardship in Europe until something pushes them to act. I fear the markets will not sit by idly while the situation deteriorates across the region. UBS agrees:
“The EMU is essentially a political undertaking and political will could potentially keep the common currency alive for many years. Such a muddling through may at times even look like a sustainable solution. On the other hand, if financial markets start to discount a bad outcome a quick and disorderly unraveling of the EUR can also not be entirely excluded. Our main assumption, however, is that the euro will survive the next three to five years when policy-makers will try everything to keep the project alive, not least for a lack of alternatives. Policy makers currently seem more inclined to create partial fiscal coordination, presenting moral hazard risks without fully ensuring a fiscal union. It will take some time before such alternatives become clearer and their costs more calculable. Also, if the economic and financial conditions seem less fragile, governments may be more inclined to pursue alternative solutions, especially if costs of EMU membership continue to rise in coming years. It should not come as a surprise that forecasting such events is beset with great uncertainty. In addition, anticipating the eventual demise of the common currency does not mean it is unwise to have EUR-investments, as arguably the price of the currency already reflects such risks and the residual currencies would have value. However, at this point we find it very difficult to be optimistic about the long-term prospects for the euro.”
Excellent thoughts. The history of single currency systems is not good. Such systems have generally only been dissolved once periods of extreme economic depression occur. Europe has bought itself some time and hopefully I have overlooked a viable solution or misjudged the severity of the conditions. Europe is a vital component of the global economy and no one wins if they suffer further economic hardship. Because of this I sincerely hope I am wrong, however, history is not on the side of the EMU. Not unless they can overcome some incredible historical hurdles of their own and form a truly united currency union. Unfortunately, that just doesn’t appear realistic at present….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.