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How a Fragile Euro May Not Survive the Next Crisis

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11/23/2018

A big US monetary inflation bang brought the euro into existence. Here’s a prediction: It’s death will occur in response to a different type of US monetary bang — the sudden emergence of a “deflationary interlude.” And this could come sooner than many expect.

The explanation of this sphynx-like puzzle starts with Paul Volcker’s abandonment of the road to sound money in 1985/6. The defining moment came when the then Fed Chief joined with President Reagan’s new Treasury Secretary, James Baker, in a campaign to devalue the dollar. The so-called “Plaza Accord”  of 1985 launched the offensive.

Volcker, the once notorious devaluation warrior of the Nixon Administration (as its Treasury under-secretary), never changed his spots, seeing large US trade deficits as dangerous. The alternative diagnosis — that in the early mid-1980s these were a transitory counterpart to increased US economic dynamism and a resurgent global demand for a now apparently hard dollar — just did not register with this top official.

Hence the opportunity to restore sound money. But this comes very rarely in history — only in fact, where high inflation has induced general political revulsion (as for example after the Civil War) — was inflation snuffed out. In the European context this meant the end of the brief hard-Deutsche-mark (DM) era and the birth of the soft euro.

The run-up of the DM in 1985-7 against other European currencies, as provoked by the US re-launch of monetary inflation, tipped the balance of political power inside Germany in favor of the European Monetary Union (EMU) project. The big exporting companies, the backbone of the ruling Christian Democrat Union (CDU) under Chancellor Kohl, won the day. The hard DM, an evident threat to their profits, had to go. The monetarist regime in Germany tottered towards a final collapse.

Around the globe, there was the inevitable run-up of inflation in the aftermath of the Plaza Accord and Volcker’s capitulation, given that many countries (crucially Japan) sought to limit the dollar’s fall against their own countries by following the US monetary lead. The inflation was evident in asset markets and good markets. Out of that new monetary chaos come an onward journey to the next stabilization experiment on both sides of the Atlantic: the “2 percent inflation standard”.

Volcker in the pre-launch publicity for his new book (Keeping At It: The Quest for Sound Money and Good Government) now criticizes the Federal Reserve and leading foreign central banks for pursuing a 2 percent inflation target. One must wonder where he has been the last 20 years. It seems that as a monetary bureaucrat he follows the timeless rule of not in any way blaming himself for the emergence of subsequent trouble, in this case the deeply flawed 2 percent regime.

Yes, the real evil genius behind the new standard may well have been Stanley Fischer, the intellectual leader of the neo-Keynesian assault, perfectly politically timed, on monetarism. But Volcker provided the opportunity.

Birth of the ECB

At the European Central Bank (ECB), which opened its doors in late 1998, it was ex-Bundesbank official, Professor Otmar Issing, who steered Europe towards adopting the new 2 percent standard. German monetary exceptionalism came to an end; or some would say that Germany abdicated as the hard money sovereign of Europe. Under its monetary rule much of Western Europe had enjoyed considerable monetary independence from the US at least in the heydays of the mid 1970s when Arthur Burns had embarked on a second great monetary inflation.

By contrast, under the 2 percent regime, the euro zone, including Germany, aligned itself to the US monetary cycle, sharing in all the ups and downs of US inflation. And in the European context, asset inflation meant vast mal-investment most obvious in the enfeebling of Italy’s once dynamic economy and a bloating of Northern Europe’s export sector (reflecting an undervalued euro).

A Test for the Euro

In these two distortions we find the existential vulnerability of the euro and the next US monetary shock will present the severest test yet. The shock is most likely to take the form of a sudden arrival of a “deflationary interlude” in a long and likely intensifying monetary inflation over the long-run beyond.

Specifically, as the virulent asset inflation stoked up in the present global monetary cycle (as always led by the Federal Reserve) proceeds into the final stage of unwind (asset deflation) and recession, there will be a period of overall credit contraction. This will be reflected most likely in the broad money aggregates. Prices and wages could come under some downward pressure, though this is not in itself evidence of monetary deflation.

In this asset deflation phase, accompanied by global slowdown or recession, Europe would be in a particularly dangerous situation. The vastly over-extended export sectors of Northern Europe are vulnerable, not least to the emerging market credit bubble turning to bust. Weak banks and sovereigns across Europe would descend into an insolvency zone. The weak euro and market share boosting measures of the big northern European exporters are likely to attract Trumpian ire.

There would be zero tolerance in Washington for continued or new-style monetary radicalism in Europe. If this is what holding the euro together requires, meaning that currency’s perpetual weakness, then it should not be held together.

A New, Smaller Euro Zone?

Hence the big German export companies would face a Day of Reckoning. The axis which joins the Berlin Chancellery to the ECB (at present the Merkel-Draghi axis) would no longer be able to support them (via a cheap euro). Under these changed circumstances, the euro falling apart may be their most promising road to future success. Yes, a re-incarnated DM would press down on export profit margins; but the menace of US-German or US-EU trade war would recede.

The CDU could have new scope to move towards the right and away from the prevailing euro-centrism of the Merkel era, so winning back voters from the parties on the far right while also gaining some middle-class support from savers long disgruntled with the soft euro and negative interest rate euro. The feared descent of Germany into Weimar-style political chaos as could occur if the CDU remains frozen in euro-centrism (eventually joining up with the Greens in coalition and thereby fanning support for the extreme parties) could be aborted.

Yes, Italy would fall out of the euro-zone. The potential for sound money renaissance in Europe, possibly with France, Holland and Germany getting together in a new monetary union, would be real. Europe’s monetary future would no longer hang on a US thread. This possible window of opportunity might be short, given the potential danger of a US inflation storm further ahead as stemming from devastatingly weak public finances.

Brendan Brown is the Head of Economic Research at Mitsubishi UFJ Securities International.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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