Europe sleepwalks into dangerous territory

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Next year, when the sun-loving Germans travel to the Italian Riviera they'll still have to change their Deutschmarks into lire - or will they? Although the lira will be the only legal tender in Italy for a further three years some economists predict that Italian shopkeepers will soon prefer to be paid in Deutschmarks and bank those, even though the lira and the Deutschmark will be components of the same mighty euro.

Why? Because of the slim chance that Italy will default and/or European economic and monetary union (Emu) will fail in its first three years. If it does, so the thinking goes - you would be better off in Deutschmarks than in lire.

What effect would a pro-Deutschmark bias have, apart from forcing national mints to print more Deutschmarks and fewer lire? None, say some. Others fear it will open up first an interest-rate and then an exchange-rate differential. Nobody quite knows, and a lot of people refuse to talk about it, because they don't want to appear anti-euro, or even euro-curious, at this delicate stage of Emu.

"Thinking the unthinkable" is the title of several recent writings on Emu that dare to explore the unknown. "Sinking the unsinkable" is the title of our cover story, which seeks to test Emu to breaking-point and beyond, because we believe not enough hard questions have been asked. Eleven countries now appear to be sleep-walking into a theatre potentially as apocalyptic as the Great War. The UK, as current EU president, has nothing to say and would not be listened to if it did.

Enough economists are warning that the euro-zone is not an optimal currency area, that countries are at different stages of the economic cycle, and that inability to adjust interest rates regionally will lead to localized boom and bust. So what? Once in, these countries can't get out, so eventually they'll settle down like a United States of Europe. But if they don't? What if the strains get so great that a country exercises its sovereign right to leave? Shut up, says the European Commission.

Ironically, by being so indecisive, London could turn out the biggest winner as the jurisdiction of choice for contracts in euro, for writing, booking and trading, just as it is for the Eurodollar. Who knows what will happen legally to onshore euro contracts if a country pulls out of Emu and invents a new currency.

Emu's most vital weapon is credibility. This means that it should be intellectually robust enough to withstand any amount of devil's advocacy. Without that it is less a market-driven economic system, more a religious faith. Is that what eleven scientifically mature countries are subscribing to at the end of the 20th century?

And a word about the Pfandbrief. Apparently many German mortgage banks are buying state debt and using it to back their jumbo Pfandbrief issues because their own rating isn't good enough. In their single-minded pursuit of euro-wide benchmarks they appear to be putting the cart before the horse - taking on assets for the sake of building bigger and better liabilities. How many other distortions have been created in anticipation of the new euro market?