Mises Daily Articles
Whither the Euro?
On January 1, some 300 million Europeans entered a new financial era. They surrendered their own currencies in exchange for a common currency: the euro. Commercial banks and financial institutions had used it as a common medium since January 1, 1999; the distribution of euro banknotes and coins merely completed the conversion. It was another step toward a united, integrated Europe that began soon after World War II as a coal-and-steel trading arrangement and expanded to a Common Market and the present European Community of fifteen countries.
At a meeting in Maastricht, The Netherlands, in December 1991, the members decided to form a currency union with certain participation criteria--namely, national budget deficits of no more than 3 percent of gross domestic product (GDP) and public debt of no more than 60 percent of GDP. The governments confirmed the requirements by signing a Stability and Growth Pact in June 1997. The treaty itself was ratified by each country, either by parliament or by popular referendum. Community members Britain, Denmark, and Sweden chose to keep their own currencies.
The driving force of this European movement toward union is both political and economic. Many European leaders hope to emulate the American experience and forge a United States of Europe. Many long and strive for political and economic cooperation and cohesion which promise economic benefits for all. A common currency in particular brings greater cost and price transparency throughout the union, reduces transaction costs, abolishes currency risk, and, above all, leads to greater economic and financial integration. In euro-area bond markets, the yield differences among government bonds, which used to be more than five percentage points, have practically disappeared. The distribution of euro notes and coins, finally, displays the advantages of a common currency to consumers also.
For many Germans, the coming of the euro and the departure of the German mark are a painful and needless experience. They are proud of their mark which, throughout the decades since its inception in 1948, had become one of the most stable currencies in the world. Trusted and accepted in all money markets, it had risen to an important reserve currency surpassed only by the U.S. dollar. Yet, the German government decided to surrender the mark and join the Monetary Union, which chose Frankfort, the seat of the Bundesbank, also to be the seat of the European Central Bank.
Twelve more countries are eager to join the Economic Community, seeking stability and prosperity in a unified Europe. But they must meet a number of political and economic membership conditions. They must be prepared to adhere to the aims of political unification and to show proof of "the stability of institutions guaranteeing democracy, the rule of law, human rights, and the protection of minorities." Moreover, admission requires "the existence of a functioning market economy as well as the capacity to cope with competing pressures and market forces within the EU." Ten countries may actually qualify to join as early as 2004: the three Baltic nations of Estonia, Latvia and Lithuania; five central and Eastern European countries, including Poland, Hungary, the Czech Republic, the Slovak Republic, and Slovenia; and the two Mediterranean islands of Cypress and Malta.
In Search of Stability
We cannot foresee the future by the past. But we do know that monetary policy can be no better than monetary thought and that today's thought may become tomorrow's policy--for better or for worse. It is clearly visible in the mandate to the new European Central Bank (ECB) to maintain price stability, which is defined as an increase in consumer prices of less than 2 percent a year. No mention is made of a permissible 2-percent decline in prices, which apparently would violate the ECB mandate.
The euro definition of stability reflects the common experience of inflation and currency depreciation far in excess of 2 percent, which makes a 2-percent inflation appear as true stability. After half a century of rampant inflation and currency depreciation throughout many parts of Europe, a mere 2-percent annual rise in consumer prices has become tolerable and even respectable. The ECB is to manage money and credit in order to assure this kind of stability also during economic booms and recessions. Although the treaty does not call for ECB contracyclical policies, the express function of price stability with a 2-percent upper price margin envisions such a policy. A stable euro would allow goods prices to decline due to rising productivity. Unfortunately, throughout the long history of central banking, no central bank has ever managed to achieve the illusive goal of price stability. It is unlikely that ECB will be more successful.
Since its inception on January 1, 1999, the euro already has lost some 6 percent in purchasing power and more than 25 percent versus the U.S. dollar. It made its appearance at U.S. $1.18 and soon fell to less than $.90, where it has been hovering ever since. The purchasing-power loss of only 6 percent in three years reflects the general trend of fiat money, including the U.S. dollar, which lost a similar amount. The shocking loss of some 25 percent versus the U.S. dollar, which itself is greatly overextended as the reserve currency of the world, is unique and may be a temporary phenomenon precipitated by the very nature of the currency exchange.
Panic at the Swiss Border
A simple exchange conducted over a long period of time would have inflicted minor costs and inconvenience on the population. Unfortunately, the governments of the euro area did not just opt for a simple exchange; to them, the exchange was an exceptional opportunity to strike a crushing blow at the underground economy, to collect many billions of tax revenues and fines on untaxed savings, and to criminalize thousands of businessmen. They made the euro exchange a major search-capture-and-seizure operation employing an army of bank informers, border guards, and internal revenue sleuths combing the euro area. Many thousands of Europeans lost their savings. But the primary victim of the search-and-destroy campaign has been the euro; its exchange rate fell significantly.
The magnitude of the operation tells the story. The euro-zone underground economy is estimated to produce some 16 percent of official gross domestic product (GDP), using some 20 percent of banknotes in circulation. All these funds, amounting to many billions of German marks, French franks, Italian lire, and other area currencies, will soon become worthless unless they are exchanged promptly into new euros or U.S. dollars. The deadline is February 28, 2002.
In Germany, for instance, the black market is estimated to use some 170 billion marks. The lion's share already managed to escape into accounts in Switzerland and Liechtenstein, foreign life insurance, or even Swiss or Spanish real estate. Smaller amounts sought refuge in new Porsche and Mercedes cars, expensive diamonds, and various art objects. Yet the approaching deadline of February 28 is causing a panic among many black-market holdouts who face the choice of either confessing, repenting, and paying income taxes with interest and penalty--or braving the border guards and customs officials on the way to Switzerland. If caught in the possession of their untaxed savings, they are stripped of the amount of taxes owed plus 6 percent interest and a fine of 50 percent, which usually amounts to total confiscation. Government officials like to call it "the justice of the new euro"; for economists, it is just another costly disruption of the market order.
The search-and-seize operation, which visibly depressed the euro exchange rate before and during the note and coin exchange, will leave a void that the euro is likely to fill in the coming months. The underground economy--which springs naturally from regulatory distortions and maladjustments by permits and licenses, price and wage controls, and confiscatory taxation--urgently needs cash replacement. The lifeblood of black markets is instant cash. And untaxed savings continue to accumulate. Surely, the U.S. dollar serves as the universal medium of exchange also in black markets. But in Europe, it may gradually give way to the new euro which, unlike the dollar, has legal-tender quality in all legal markets.
Since its launch, the euro has imposed incalculable conversion costs but also has brought some benefits to government and business alike. Interest rates on public and corporate obligations have fallen, as they were converted into euro obligations with lower currency risk and, consequently, lower interest costs. The euro brought greater price and cost transparency to business, eliminated undesirable currency exchange-rate charges, and simplified international payments. It even nourished the hope of greater price stability. But we must not forget that the ECB is just another central bank, a political creation with an innate disposition to inflate and depreciate its currency. Surely, it may have the laudable intention of relative price stability, but so did all others that, soon after their inauguration, yielded to powerful political pressures and embarked upon their natural course of currency depreciation. The ECB may be no exception to the rule.
Central bankers seem to have an obsession about avoiding the collapse of a major institution, fearing that such collapse may lead to a general financial panic. They may be mindful of the history of banking, which is a long record of crises. The news of failure of a bank always terrified financial circles, when call loan rates soared, stock markets collapsed, bank loans contracted, and depositors questioning the solvency of their banks withdrew their deposits and hoarded gold and silver. Such crises always took a heavy toll in the business world.
A recession is a time of trial for all financial institutions that have managed poorly during the euphoria of the preceding boom. In pursuit of great profits, they took great risks, or, flush with profits, incurred high costs which threaten to crush them during the decline. Forced to cut costs drastically, they now discharge thousands of workers, who swell the unemployment rolls. They may have to retrench and restructure, causing uncertainty and fear, which become the primary concern of the central bank. It is forced to come to the rescue.
If central bankers live in constant fear of the collapse of a single financial institution, ECB managers must be concerned about the solvency of numerous institutions in twelve member countries. They must especially be troubled by the possibility of failure of one or several of the member banking systems. A single bank failure may quickly spread throughout the country system and then affect others. The national systems differ substantially, having developed separately in different financial and legal systems in different periods of time. They differ especially in their relations with their central banks, which exercise the public duty of influencing the behavior of banks and other financial intermediaries by regulation and persuasion. In the past, the national central banks always stood by and, on rare crisis occasions, saved the banking system from collapse. But the new euro system denies them this power by withholding their power to create credit. It will be the task of the ECB to come to the rescue. If it does, it may soon violate its mandate of price stability. If it refuses to save a failing institution, it soon will face the failure of a national system, which would cast doubt on the solvency of the euro system. Therefore, the ECB is bound to ride to the rescue of any important financial institution in the euro area. It has no choice but to inflate.
Competition of Systems
The euro is unlikely to create a homogeneous European price-and-income structure. But it will strengthen the European market and increase competition, which will be most beneficial for consumers. As competition intensifies, so does the pressure on business to improve efficiency and productivity. Many businesses will prosper and grow; others are bound to fail. But the greatest pressure will be on the governments of the member states that provide the institutional framework for business to compete. Business law and labor law that constitute the basic institutional structure differ substantially throughout the Community, distorting the markets to various degrees, benefiting some producers and harming others. In short, the euro is bound to intensify not only business competition but also the tension and friction of the national institutional systems. It may prove to be a powerful structure-reform activator.
The 300 million people of the euro area are estimated to have an average per-capita annual production of some 20,000 euros, with governments taxing and consuming some 50 percent. There are considerable differences among the member countries, differences caused by a great variety of cultural, political, and economic factors. Whatever they may be, the differences constitute a powerful incentive for labor to move from less productive to more productive areas, moves which will be opposed vehemently, if not violently, by the workers of the more productive countries. Moreover, as capital tends to move from low-yielding areas to more profitable areas, capital is likely to prefer low labor-cost to high labor-cost areas, which is bound to aggravate the political situation throughout the euro area. Labor strife and upheaval will tell the story.
In the coming years when several small countries with low labor productivity may be permitted to join the Community, it will encounter growing political strains and tensions. In the more prosperous member countries, such as Germany, France, and Italy, powerful political parties will demand government protection from "unfair foreign competition" and "foreign invasion." The old watchwords of economic nationalism and welfarism will be heard in the centers of stagnation and unemployment, which then may turn nationalistic and socialistic. The innate antagonism among welfare states--which in pre-Community days was visible in import duties and export subsidies, in competitive currency depreciation and devaluation--will now be audible in the political halls and courts of the Community. It may question its very existence.
The old catchwords of Keynesian economic thought, too, will be heard, especially during periods of economic decline and rising unemployment. Governments are expected to conduct effective contracyclical policies through monetary and fiscal means. In the Community, this thought finds expression in the demand for "cooperation" and "coordination" and for "proper policy mix." ECB monetary policy is to be coordinated with the fiscal policies of the Community members. Keynesians are chagrined that the Stability Pact set a narrow limit of just 3 percent of GDP to a country's new budget deficits. It is ironic that Germany insisted in this deficit limitation and, in 2002, will be coming close to violating it. Coordination is also the password of the Community bureaucracy in Brussels, which is busily turning market adjustment and coordination into a complex system of "guidelines" and "processes," "action plans," and "reports." Always pointing at "market failures," it does not miss a single field of economic activity, expanding continuously and assuming ever more functions. It is laying a heavy blanket on economic activity throughout the Community but is giving life to black markets.
We must expect the forces of statism to plead for "harmonization" of wages and social standards throughout the union. They mean to "harmonize" working conditions, that is, to equalize wage rates and welfare costs by legislation and regulation. In labor markets with equal labor productivity, unhampered competition tends to harmonize working conditions. In various labor markets with widely diverging labor productivity, any attempt at harmonization by force is bound to be disastrous. It would cast the poor countries into deep depression and great dependency on the charity of the more productive members. It is unlikely that such a union would survive for long.
Although the European Central Bank is to be independent from and immune to all political machinations and pressures, it is a creature of politics, which tends to be tantamount to being unpredictable, crafty, and cunning. The ECB has two managing bodies consisting of government appointees: the six-strong Executive Board, headed by Dutch banker Wim Duisenberg, and the Governing Council, composed of the Executive Board and the twelve presidents of the national central banks. They shape monetary policy by majority vote; the rule is "one person, one vote," regardless of the size of a country's population. The ECB president is appointed by unanimous vote of the EU Council of Ministers.
The ECB Governing Council has little say on who is appointed to its membership; the member governments appoint the heads of their central banks and thus the members of the Governing Council. They tend to select and appoint politicians in good standing who reflect the monetary thought of the party in power. Although the principal objective of the ECB is to maintain price stability, most euro-area governments, when faced with recession and mass unemployment, are eager to relax fiscal policy and spend their way out of trouble. Significantly, public opinion in Germany, France, and Italy has already shifted away from stability to public spending which, according to old Keynesian thought, will boost demand. Socialist or social democratic parties now lead or participate in thirteen of the fifteen EU member governments.
The supremacy of politics and ideology was clearly visible in the appointment of the ECB president. At the May 1998 summit meeting of the European Union, French President Jacques Chirac took the meeting to the brink of breakdown on the major issue of ECB leadership. He succeeded in forcing the Dutch ECB president eventually to step down early in favor of Jean-Claude Trichet, governor of the Bank of France, who would serve a full eight-year term as head of the bank. This kind of row, which led to a cooling of relations throughout the Union, is likely to recur in years to come.
There are heated arguments about whether politicians or bankers should be in charge of running monetary policy in the euro zone. The euro reached its high of $1.1899 just four days after its launch. It dropped steadily thereafter when, in a public battle, many politicians led by the German finance minister put pressure on ECB to lower its interest rates, calling into question the bank's promised independence. When the ECB ignored the calls, politicians turned their guns on the ECB managers themselves, criticizing the "faceless bankers" for their lack of political accountability. In the world of politics, accountability obviously conveys low interest rates and bountiful money. The "faceless bankers" must brace for more such demands and denunciation.
Unmanageable Supply and Demand
The ECB mandate to manage the euro and maintain its purchasing power is a mammoth task which no committee of political appointees can ever discharge satisfactorily. It is bound to create serious economic, social, and political pressures that will becloud the future of the euro as well as the monetary union itself. The euro is fiat money with legal-tender quality; it is not backed by gold, silver, or any other substance. Yet it has value because it is scarce and people need and accept it. Economists search for its value in its demand and supply, which embodies some of the most difficult problems of economics.
The ECB is the sole bank of euro issue endowed with all the powers of a central bank; yet its power over the supply of euros in the broader sense is rather limited, as is the power of all central banks. They find it difficult to identify particular claims as money, near money, or a store of future money. Surely, an excess of money relative to output is the very nature of inflation. But what specifically constitutes money is eluding economic analysis and, therefore, rational policymaking.
The ECB distinguishes between three components of supply--M1, M2, and M3--which it seeks to influence primarily through changes in its interest rates. M1 consists of currency in circulation and overnight deposits. M2 consists of M1 plus deposits with an agreed maturity of up to two years, deposits redeemable at notice of up to three months, and repurchase agreements. M3 embodies M1 and M2 plus money market funds or units and money market paper and debt securities issued with a maturity of up to two years.
The ECB may seek to manage M3 by raising or lowering the reserves that banks are required to maintain and by changing three basic interest rates: the minimum bid rate on the main refinancing operations, the marginal lending facility, and the deposit facility. In December 2001, the rates stood at 3.25 percent, 4.25 percent, and 2.25 percent, respectively (ECB, Monthly Bulletin, December 2001, p. 89). The ECB's Governing Council determines the key interest rates on the basis of information about two pillars of monetary policy strategy.First, it continuously and thoroughly analyzes variations of M3 and uses it as reference value. At the present, the medium-term reference value for annual M3 growth that is believed to assure price stability stands at 4½ percent.
The second pillar of ECB monetary strategy is GDP growth. With the growth close to zero, the Governing Council finds no decisive evidence of measurable and lasting increases in productivity growth in the euro area in the foreseeable future. Structural reforms are needed, according to the council, "aimed at providing the proper incentives for economic agents and at fostering an environment more conducive to innovation." "Major further steps need to be taken, particularly as regards the labour and goods markets." In the fiscal area the Council urges its member governments to hasten "determined structural expenditure reform in order to create room for further tax cuts and for absorbing the fiscal costs from the ageing of populations. Such reforms, the Council believes, would enhance the effectiveness of fiscal policies in supporting employment, investment and economic dynamism" (Ibid., p.7).
Committed to price stability, the Governing Council may want to squeeze out any inflationary excess created by various financial institutions. But serious efforts toward "disinflation" nearly always cause grievous economic, social, and political consequences in the form of rising unemployment, soaring deficit spending, and political upheavals. During the 1990s, several European countries suffered the consequences; the United States was spared such pressures on account of the concurrence of three factors: (1) the remarkable boost to labor productivity due to a new information technology; (2) the balance and even surpluses in the federal budget, which increased the pool of investment capital; and (3) the position of the U.S. dollar as the reserve currency of the world, which greatly enhanced the demand for dollars.
While the supply of euro money may be a vague concept that presents great difficulties of analysis, the demand for euros may even be indeterminate. It involves the whole range of human knowledge and emotions and, at times, may surpass in importance the supply of money. The ECB may affect the supply and influence the demand, but it cannot control the demand, which depends on the attitude of millions of money holders toward their cash holdings. Some economists speak of the people's preference for cash holdings; others, guided by the science of matter and energy, call it "velocity." They seek to determine the speed at which the money changes hands. High velocity signifies low demand for cash holdings, and low velocity means great demand. An increase in velocity tends to raise goods prices and depreciate the currency; a decrease in velocity tends to lower goods prices and boost the value of money.
In short, changes in the demand for money may conjoin with changes in the stock of money or may offset them. The effects of an increase in the stock of money can be enhanced and even multiplied by an increase in velocity, or be mitigated or even offset by a decrease in velocity. Unlike the supply of money, which tends to increase rather slowly, the demand can change overnight and affect the value of money and goods prices drastically. It is rather unreliable as a guidepost for ECB policy.
The Euro in the New Economy
Central bank money has constituted the foundation of modern monetary systems ever since the abandonment of the gold standard. It is the institutional settlement asset in exchange, anchored in law and regulation and managed by numerous central banks that have given us an age of inflation. Their sad record of managing the supply and demand of money, which modern information and communication technology renders even more difficult, casts doubt on the future of central banking.
The technological changes in the "new economy" are altering the economic landscape--giving rise to new businesses and industries and transforming old ones. But they are not abolishing the basic principles of supply and demand; they are merely continuing the dynamic processes of the market order. In the new economy of telecommunications and technology, new payments media are enlarging the stock of money. New technologies provide nonpaper substitutes for conventional cash, such as electronic purses holding and transferring digital balances, lodged in microchips in computers, mobile phones, and plastic cards. Efficient and convenient electronic media of payment are likely to become ever more economical and popular and thus reduce the demand for traditional means of payment. In the European Union, currency cards may soon become more popular than ECB notes.
High-tech substitutes for euro notes obviously will generate new inflation pressures. To safeguard monetary stability, ECB will have to reduce its own stock of money, which would shrink its revenue base and be rather unpopular with ECB officials and politicians. EU commissioners or member governments may be tempted to hamper or even outlaw the development and use of electronic money, but such efforts are likely to be rather ineffective in a community of twelve countries as diverse as the European. Advances in information and communications technology tend to undermine all efforts at restriction and control. The ease of money transfers by phone, fax, and Internet renders them rather ineffective.
It may deprive the European Central Bank of its central position as "lender of last resort." Commercial banks do not need such a lender if they are free to organize their own safeguards against potential crises. Facing an unexpected loss of reserves, they may turn to a strong euro-area market for short-term interbank loans. They may organize self-help arrangements through their clearinghouse associations. They may affiliate or merge with strong banks throughout the euro area. Some may rely on their offshore subsidiaries gathering deposits from heavily regulated and taxed areas. They may even tap the vast U.S. dollar market that drives the legal and illegal markets of the world.
The growing volume of electronic money and the declining demand for euro notes are likely to render the financial markets ever more vulnerable to unexpected shocks. Any factor that would reduce the demand, such as political upheavals casting doubt on the currency union or a sudden decline in underground demand for cash holdings, could have unfavorable consequences for the euro. The danger tends to grow with the rising volume of electronic media and the proportional decline in ECB money.
All signs point toward growing inflationary pressures and financial instability throughout the euro area, which are bound to unleash powerful political forces of criticism and condemnation. The ECB will have to justify its existence by its own ability to defend itself and the euro. It is easy to foresee the consequences if it should fail.
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What then can the European Central Bank do to confront and mitigate the political and financial pressures? It would be a fatal error to yield to the natural temptation to mandate and legislate stability; whatever needs to be maintained by force is doomed. Economists would react differently; they would abandon mandatory monetary policy altogether and seek stability in the marketplace. For instance, they would select an exchange rate to the U.S. dollar, preferably the market rate, and peg the euro to the dollar, always standing ready to buy and sell the euro on fixed terms against the dollar. In other words, the ECB may hitch a ride with the Federal Reserve System, which hopefully will cope with the problems of electronic money. Unfortunately, European pride and self-esteem will not allow such a simple solution, although the ECB probably will always keep a watchful eye on Fed policies.
Some economists would fix the value of the euro to a basket of commodities, which hopefully would ensure more stable prices. But such a policy would immediately breed dissent about the size and content of the basket. It is unlikely that the eighteen members of the ECB Governing Council from twelve different countries will readily agree on the commodity basket. And even if they should agree, they would have to manage the basket continusouly as the commodities tend to change in utility and importance.
Other economists would use a combination of what they believe to be "reliable indicators" to steer a stable monetary course. They would be guided by the euro-dollar exchange rate, by commodity prices, especially of inflation-sensitive goods, and by interest rates. But such a combination surely would breed much disagreement among the councilmen. The euro-dollar exchange rate as a guide obviously leaves basic policy decisions to the Federal Reserve Board of Governors. Commodity prices as a guide may give ambiguous and erroneous signals. And interest rates as guide are rather volatile and subject to numerous disruptions and misinterpretations. Rising rates, for instance, may signal rising inflation, greater debtor risk, and tighter central bank policy. It is unlikely that the ECB councilmen would readily agree to steer the euro ship by such guides.
A few economists even remember the gold standard, which used to give the world a measure of monetary stability. It evolved spontaneously with the universal use of silver and gold for the coinage of money, thereby creating a fixed tie between the currencies of the trading countries and establishing, in effect, an international monetary system. The classical gold standard had its beginning in 1816 when England based its monetary system on the gold sovereign and limited the legal tender of silver coins. Most countries soon followed suit, making the maintenance of the gold value of the currency the primary objective of economic policy.
The classical gold standard came to an end with World War I, when gold coins were withdrawn from circulation and hoarded in the central banks. The United States maintained redemption of currency into gold coins until 1933. It devalued the dollar in 1934 and thereafter used gold only for international settlements. During the 1920s, most countries adopted the gold-exchange standard which allowed them to hold foreign exchange as monetary reserves. They pegged their exchange rates to gold standard currencies--primarily the U.S. dollar.
When in 1971, after many years of rampant inflation, the United States government finally defaulted to redeem its currency in gold, it gave rise to the present monetary order: the fiat dollar standard. It depends entirely on the decisions of the Federal Reserve Board which is a creation of the United States Government. American preponderance in the world capital markets and international trade affords the dollar such an eminent position.
The launch of the European economic and currency union is changing the political and economic landscape of Europe and may affect other parts of the financial world. In time, it may even modify the world dollar standard and give rise to a bicentric dollar-euro standard, which is the hope and dream of most Europeans. And the ambitious among them may even long for a euro alliance with gold. It would lift the euro above all others.