First, a little history. We’ve had a Europe-wide currency system before: it was introduced by the Romans in about the year 880, then expanded by Charlemagne, and brought to Britain by William the Conqueror. Throughout Europe we used to have the pound (librium) – the lira in Italy and the livre tournoise in France.
In the 15th century the Italians invented the modern banking system based on double-entry accounting. This led to a rapid growth in bills of exchange. The banks, or rather traders, from different countries would get together at fairs known as assiuntos to settle up. It was one of the world’s first clearing systems. But sadly, in spring 1570, when they got together in France to exchange their pieces of paper and settle in real money – gold – they found that all they had was Italian debt! This caused a collapse of the settlements process. The French abandoned the livre tournoise and introduced a new currency, the ecu au soleil. As you can see, we’ve been here before.
Over the last few hundred years, there have been many periods of floating exchange rates as well as fixed exchange rates. The French floated briefly in the 1920s. The reason for the Bretton Woods fixed exchange-rate agreement in 1944 was the poor experience in the earlier floating exchange-rate periods. (Floating exchange rates became unstable because of so called “hot money” flows.)
The theory of the optimal currency area states that it must fulfil three conditions:
First: free flow of knowledge. For Europe this condition is just about fulfilled .
Second: free flow of capital. In practice this is not the case in Europe because of all the local banking, insurance and investment regulations designed to maintain local employment and patronage systems. While there is fairly free flow of free capital across Europe, there are still severe restrictions on pre-existing stocks of capital. Thus, until recently, there was the currency-matching requirement on insurance and pension investment. This forced many continental European institutional investors to be 80% invested in local-currency assets. In addition there are still banks supported by government credit. Such support is in violation of the European directives. These barriers will not vanish quickly. Even in the US there is still pressure on the boards of individual state pension funds to keep the money in the state. The politicians argue with the pension funds that the money should be used to support the local economy. We can expect to have even more vociferous arguments about this in Europe. In particular the politicians will soon start complaining about their inability to tax free-flowing capital.
Third: free flow of labour. Labour flow is the crux of the European problem. The European populace is neither mobile, nor does it welcome the arrival of foreigners. Yet cheap labour wants to enter Europe from all around its borders. Labour is not mobile, and labour costs are certainly not flexible downwards. If labour does not move then capital, and then jobs, will move. The capital will move to the environment with the lowest costs and government charges (in terms of taxes and hidden social charges).
Call to arms
The euro will give France a wake-up call, because Europe is the battleground of two polar economic ideologies: the Anglo-Saxon free-market approach and the alternative model of government planification – which puts social goals ahead of free financial market forces. The French government is trying to address unemployment by reducing the working week from 39 hours to 35 hours. Europe has very high unemployment. While it is now falling, unemployment rates are still over 10%.
You see small companies in France registering themselves as British companies to minimize the French social charges and taxation. It is perfectly legal and completely enforceable under European directives, but of course they will find some French rule that says you can’t do it. Irish GDP is growing at a rate of 8%. House prices are up 95% over two years and interest rates are still 3% above German rates. By contrast, in the east German Land of Saxony-Anhalt the unemployment rate is close to 20%, and is much higher still for the young. The ultra right party, DVU, achieved a startling 12% of the local vote with its electoral slogan “throw out the criminal foreigners”. This is rather surprising given that Saxony-Anhalt has only a tiny percentage of foreigners.
These new political pressures are behind the very rapid change in the European political agenda – and the sudden re-emergence of the term “subsidiarity” in the French and German political vocabulary. Putting in government “wedges” to stop these labour employment flows will simply create faster capital flows.
There will be acute regional imbalances. We have monetary union but we do not have fiscal union or budgetary union or social policy union.
The debate at the moment within Europe is still about countries. Politicians and technocrats are still talking about what these developments mean for Germany or France. But the individual country, as a unit to discuss, will become much less important. Emu is the beginning of the end of the European nation states. We are going to see a replacement of countries by cities and regions. London, for example, is booming. But it’s not the British economy that is responsible for this – or even the British.
The impact of information technology is more important than that of the euro. If we get innovations such as open architecture Mondex cards and Visa Electronic purses and retail global electronic transfer, then why be concerned about currency denomination? It doesn’t matter. In other words, everyone is making a huge fuss about the introduction of the euro, but it is merely a unit of account. Once we’ve got good electronic communication and transfers, who cares?
There are over 4,000 banks in Germany alone. There are over 10,000 in Europe. How many banks does Europe need now that there will be just one currency? Does Europe even need any banks? Banks intermediate interest rates, liquidity and credit risks. We can strip all these out and, provided we have got good IT we don’t need banks as we know them today. Between investment funds and companies that need capital there are expensive intermediaries: investment banks which originate paper and take 10% to 15%, then there are the stockbrokers who take 2%, then there are the fund managers. Won’t these intermediaries sooner or later be cut out? This won’t happen in the short run, but there are certainly too many costly financial intermediaries.
Why are there so many banks? Because of regulation. But with electronic banking, it is impossible to protect these oligopolies. Look at the growth of internet share trading in the US. Internet retail brokerage in the US is three years old. Today 17% of all retail share trading in the US goes through the Internet. Technology is driving this rapid change. In this new era of finance it’s impossible to cross-subsidize. So the European banking shake-out will be rapid. Computers will indeed give more leisure time, but for many that leisure time will come in the form of unemployment.
Running the stops
Will the markets see increased volatility in the run-up to Emu? Obviously traders would like to get larger bonuses. This is impossible if there is smooth, event-free convergence of markets. So we are going to have some attempts by the traders to “run the stops”. The central banks will be able to counter any currency speculation between Emu members. However, there could be very sharp movements in differential country spreads in the bond markets. From an investor’s perspective, the uncertainty that was reflected in the different currency and bond markets will now land in the market for bond credit spreads.
There will be rapid cumulative financial flows. And as equilibrium will not happen with labour moving, it will happen with investors moving their capital. It will force rapid unbundling of European companies. Continental Europe hasn’t yet been through this. As they say in the US: “No pain, no gain.”
Which banks will have the cheapest euro funding? Initially there will still be country credit spreads. The European Central Bank will have the lowest borrowing cost. Then private banks will have borrowing spreads above the European Central Bank. These spreads will be based, initially, on the bank’s country and credit rating. This means that German and Dutch banks will be those that have the cheapest marginal funding.
This has strong implications for European financial intermediaries. First, we have far too many banks in Europe. Their average cost level is too high. There will be rapid consolidation, but also fall-out of failing institutions. Second, there will be an explosive growth in the European direct corporate borrowing market. This means Euro commercial paper, MTNs, corporate bonds, high-yield debt and credit derivatives.
In the US there has been dramatic corporate downsizing. The junk bond predators were widely criticized for their attacks on large, cost-bloated corporations: dramatic layoffs ensued. However, an economic miracle has occurred in the US: the capital has been recycled into new, small, start-up companies. The real employment growth and incremental wealth creation is occurring in the new small companies in the US (and indeed worldwide). The same will be true in Europe. There will be an explosion in the growth of these small companies. There will be a vibrant growth in merchant banking, which will also lead to the floating of privately held companies, as well as the non-core divisions of corporate giants.
Once union is completed, continental European investors will have one bond market and one equity market. The bond markets are already highly correlated: the country diversification has already gone. The equity markets have correlations of return of over 0.7 – and that is rising.
So, simply to diversify, funds must invest outside continental Europe aggressively. If you undertake a strategic asset allocation analysis, the optimal allocation is 40% outside continental Europe (including the UK as outside). Very few funds will go there rapidly, but all continental European funds will go in this direction. In continental Europe we have an intrinsically unstable system. The Europe-wide economy will become more like the new US economy: certain areas (and industries) will boom, while other areas are in terminal recession. While aggregate European unemployment will rise as the state protected corporate giants downsize, there will also be areas of strong growth. So the European Central Bank will not give in to the inflationist, political, pressures easily. This implies that the external value of the euro, versus the US dollar and the yen, will take the strain.
Optimists on the role of the euro point to the size of foreign reserve holdings of euro and the percentage of trade in euro. These are accounting facts, but the real issue is the depth of the underlying money markets. This is going to take several years to develop. So the euro will be a competitor to the US dollar as a leading reserve currency, but not straight away.
Ronald Layard-Liesching is a partner and director of research at Pareto Partners. This article contains extracts from a speech given to the editorial panel of Treasury Management International
