The Euro: Sick men of euroland

The debate continues as experts give their counterarguments:
Avinash Persaud, global head of research for State Street bankGraham Bishop, advisor on European financial affairs at Salomon Smith Barney

Why has the euro fallen so much since its birth? The euro, of course, is a bad currency: it is structurally incapable of providing stable economic conditions in its area as a whole, and still less so in each of its member economies simultaneously.

The structural faults in its architecture, combined with the imperialistic political motives that underlie the idea of "Europe", will within a few years create a financial crisis that will allow its progenitors to push for the creation of a European financial area run by democratically unaccountable bureaucratic agencies, such as a beefed-up Euro-11 Council. But that is not why the euro has been weak this year. The reasons for this year's relatively benign weakness, as opposed to the malignant weakness its structure will make inevitable, are to be found in the past, not the future. But the link between the past and the future can be discerned, by those who look closely enough, in the travails of the German economy.

On May 2 1998, the European Council took the formal decision to institute a single currency, the euro, in 11 EU countries as of January 1 1999. Commenting on the decision that day, the leader of the main German opposition party, Gerhard Schröder (now chancellor), said that the euro was coming too soon and would cost Germany jobs. What did he mean? And how does his comment throw light on the weakness of the euro since its inception?

Germany is a structurally uncompetitive country with high unemployment, high costs and sclerotic markets. Everyone knows that, and most people have known it for the past 15 years. Worse, German reunification, by reducing the average productivity and real-income levels of the Deutschmark zone, depreciated the long-run equilibrium exchange rate. But the demand consequences of the eastern, transfer-financed bonanza meant that the short-term equilibrium rate had to appreciate. There was nothing wrong or problematic about this short-term/long-term divergence in itself. But the perversities of the exchange rate mechanism (ERM) and of the drive to economic & monetary union (Emu) meant that movements in the Deutschmark were of intense political significance. It was made almost impossible for the Deutschmark to be "right" for the German economy, either in the short term or long term.

By 1995, the Deutschmark was hopelessly overvalued. It subsequently retraced part, but only part, of its appreciation against the Anglo-Saxon and European peripheral countries. But it remained far too strong. The response of Helmut Kohl's government, which was essentially to shift the distribution of income away from labour and towards capital, did quite a lot for the DAX stock index but nothing for the economy. In part, it was that contrast that led to Kohl's downfall last September.

Former Bundesbank president Karl-Otto Pöhl said about a year ago that Emu would be run not by the German government but by German firms. It certainly seems, in the wake of the Lafontaine debacle (the forced resignation of finance minister Oskar Lafontaine in March this year), that Germany is not run by the German government but by big business: Lafontaine was proposing fresh taxes and the linking of wages to productivity; he also tried to force rate cuts on the supposedly independent ECB.

The pressures of globalization, as they impinge on Germany, have so far meant mergers and acquisitions, outsourcing of operations overseas, and falling employment at home. No-one would be pessimistic enough to say that the rate of return on capital employed within Germany will never improve, appreciating the equilibrium real exchange rate with it. But, certainly as viewed from May 1998, it would have been wildly optimistic to think it was going to improve soon enough and significantly enough to help Germany's employment problem. And if it was not going to happen soon enough to help employment, it would also be too late to avoid difficult dilemmas on government spending, on the pension system and on taxation. This did not paint a pretty picture for an incoming government.

When the Schröder/Lafontaine team took office, the need was to get the Deutschmark down. But they faced a double problem.

The first aspect of it was historical. Ever since about September 1997, when it finally became clear that the single currency was going to go ahead on schedule - that had been very much in doubt during the summer of 1997 - and that 11 countries would be in it, exchange rates among the 11 were set firmly on the "Emu glidepath", determined by expectations of the euro conversion rate and by short-term interest rate differentials. For most countries, since differentials were by then very small, exchange rates were close to the expected conversion rate. But for Ireland, Italy, Spain and Portugal, the glidepath actually implied currency depreciation. So Germany was faced not only with essentially fixed exchange rates against its nearest neighbours, but with a worsening of its competitiveness - at least in the short term - against four other countries, of which Spain and Italy were far from insignificant trading partners. From September 1997 onwards, this had been a worrying prospect for the Kohl government, which, with support from Bundesbank president Hans Tietmeyer, began lobbying for realignments within the ERM.

The initial target was Ireland. Why? The country was totally insignificant in German trade. Part of the answer was that the Irish pound was, in late 1997, trading far above its ERM central rate and the economy was booming. A plausible economic case for an Irish realignment could thus be made, one the Irish central bank would be intellectually, if not politically, happy to support. More important, it was thought, Ireland had no political weight in Europe and, unlike Italy and Spain, could be forced into a realignment even if it didn't want one. Once Ireland had been dealt with, the markets might smell further realignments, pushing up the value of the peseta and the lira within their ERM bands and providing an excuse for Germany to ask for those currencies, too, to be revalued before it was too late.

Bundesbank retreats

But the Irish government was unwilling to play ball. It had gained office in an election campaign in which it had promised the influential farming lobby that there would be no revaluation. It refused to accept the German instruction. Instead, it pointed out that on the Bundesbank's favoured competitiveness indicators, as opposed to internal balance indicators, it was the Dutch guilder that stood out as most undervalued. But a revaluation within the "hard core" was politically unthinkable; the Bundesbank withdrew from the fray. The German government was frustrated and angry: if Ireland was able to resist on this occasion, what might happen within the European Central Bank (ECB) council when it was formed? Germany had to be seen, at least within official circles, to be able to get its way. Finance minister Theo Waigel eventually turned to his French counterpart, Dominique Strauss-Kahn, for support: if the Franco-German axis could not prevail now, against little Ireland, the political consequences might be very troublesome. Strauss-Kahn, though not particularly interested in the exchange rate of the Irish pound, was swayed by the Realpolitik argument. As soon as the Irish saw the French and the Germans lined up together against them, they knew they could resist no longer: they would realign, they said, but only by 3%, not by the 10% the Bundesbank had originally suggested. And the other countries - Spain and Italy to the fore - said they could accept an Irish revaluation, but only if it were made clear that there would be no other realignments.

A deal was thus struck. It had no economic rationale whatsoever, but Franco-German honour, if that is the right word, was satisfied. The Irish authorities even accepted a communiqué wording that claimed the revaluation was at the request of the Irish authorities. But this diplomatic triumph was a total failure in terms of producing a significant devaluation of the Deutschmark. From the time of the Irish revaluation, exchange rates among the euro-11 were even more firmly locked onto the euro glidepath.

To make things worse, the euro snake-oil salesmen in Brussels, anxious for gloire and ever concerned to do anything that, in their eyes, would harm the US, were touring the world telling their hapless listeners that the euro was quickly going to take over the dollar's role as the world's leading reserve currency and was bound to leap in value. A lot of investors believed them. Money flowed into the Ecu. When Schröder had expressed his warning on May 2, the dollar/Deutschmark rate stood at 1.80; by December 31 the Deutschmark had been forced up to 1.68, at the end of a quarter when German GDP had actually been falling. The on-track approach of the euro was indeed costing Germany jobs.

Faced with this unhappy state of affairs, the SPD (social democrat)-led government pondered what to do. They could try to initiate structural reform in a way that would boost "animal spirits" in Germany. But this was strictly ruled out by Lafontaine. They could try to improve Germany's relative position by using the EU machinery to impose additional cost and regulatory burdens on Germany's more dynamic competitors in euroland. This had clearly been foreshadowed in Schröder's comments the previous May. Lafontaine set the wheels in motion, but this was going to be no short-term solution. They could follow the route mapped out in France by the ineffable Banque de France governor Jean-Claude Trichet - that of "competitive disinflation". But Lafontaine's much-maligned - and usually unfairly maligned - state secretary, the economist Heiner Flassbeck, rightly regarded such sado-masochistic practices with unfeigned horror: "no way, Trichet" was the response to any such proposition, wherever it came from. So there was only one thing left: German competitiveness would have to be improved by a plunge in the value of the euro against the rest of the world. And, because Germany could no longer devalue against its major trading partners in euroland, the fall in the euro would have to be a big one to achieve the required improvement in trade-weighted competitiveness.

Missing the target-zone

The new German government had already reacted by publicly campaigning for target zones and by attempting to pressure the ECB into rate cuts. The target-zone initiative was given short shrift by the US, but the first fruits of pressure on the central banks were seen when the Bundesbank led euroland rates down in December. At the same time, an informal deal was struck by the ECB with the German government: lay off us, keep quiet, allow us to preserve the myth that we are independent and in charge, and we'll cut rates again in February.

The February cut never came. The cover for ECB tardiness was that by then the euro was weakening. Most of those who had in late-1998 bought into the story of the euro's immediate ascension into superstar status had shot their wads. When the euro started drifting in January the initial impulse was not so much that there was major selling, more that there was hardly anyone buying But it also soon became evident that forex markets were reacting not only to strong US output news but also to weak German output news, something they had rarely if ever done during the Bundesbank's heyday, when Germany had a currency of its own. While over the years most people had taken the view that Emu was a plot by France to get its hands on the Bundesbank, the market seemed to have decided in January that what Emu really did was to allow the German government to get its hands on monetary policy for the whole of Europe.

This was not something likely to please the central bankers. They were additionally aghast when the German finance ministry team (Lafontaine, Flassbeck and international department chief Stefan Collignon) circulated a paper to euroland governments effectively saying that Bundesbank policy had been throttling the European economy for the past 18 years. Tietmeyer in particular recognized the significance of the timeframe: in 1981, 18 years earlier, the Bundesbank had savagely tightened policy, a move that the SPD regarded as intended to unseat the socialist-led coalition under Helmut Schmidt. Tietmeyer himself became a part of SPD daemonology the following year, when, as state secretary in the economics ministry, he was widely believed by the left to have persuaded his boss, Otto Graf Lambsdorff, leader of the FDP, to ditch his coalition partner, Schmidt, and throw in his lot with Kohl. Now, to rub salt in the wounds, Lafontaine began telling other governments he would ensure that Flassbeck became Bundesbank president when Tietmeyer retired. The rest, as it is said, is history.

With Lafontaine and, effectively, Flassbeck out of the way, the ECB could, after a decent interval, cut rates as it had planned to do in February. But the April cut, widely expected to boost the euro by improving growth prospects, failed in that aim. By then, the US economy, and with it the dollar, had taken wing. This was helpful to everyone connected with euroland monetary policy. It improved German competitiveness, and by doing so helped get the politicians off the ECB's back.

More recently, however, politicians and bankers have been finding that one can have too much of a good thing. They definitely do not want the euro to fall below parity with the dollar. In part this is just a question of face. But they also worry that a euro below parity would destroy the belief of many investors that the euro was any time soon going to become a viable reserve currency. And they worry that any further slide could cause a generalized crisis of confidence in euroland financial markets, leading to a nasty recession. And the German government worries because the man in the Haupstrasse, not understanding how deep a hole his country's economy had fallen into, believes the Deutschmark has been dragged down by the euro, to the detriment of his savings, rather than the other way round.

The hope of the euroland authorities, expressed many times a day, is that the German economy will pick up sufficiently, relative to current market expectations, to hold the euro: currencies go up and down with the cycle, they say, and it is the nature of cycles to go up and down. And the central bankers in particular claim that because the treaty commitment to price stability is irrevocable (at least until the next in the line of increasingly frequent treaty revisions), the euro must logically become, in the medium term, the strongest currency in the world. Vanity of vanities!

Yes, currencies go up and down with cycles. But what drives the euro is not the euroland cycle. Indeed, "euroland" is not even a Metternichian geographical expression: it is simply a fiction. It has 11 countries and several cycles. The problem is, as long as there are 11 sovereign countries, among which "solidarity" is a sick, hypocritical joke, there will be a tendency for the ECB to have to target the cycle in whichever country happens to be weakest.

How strong that tendency is in a concrete instance will depend on two things: how politically important the economically weak country happens to be; and how big a mess it is in. As the events of the past eight months have proven, in the case of the most politically important country, Germany, the economy need be in only a moderately bad mess, one that might lead to crisis if left untreated.

But at all events, while periods in which the ECB can pursue the aim of price stability in euroland as a whole will indeed occur - there may even be one this year - they will be rather rare and brief. For most of the time, the ECB will have to be bending to tend one sick patient or another. Like stiff-skirted nurses in British hospitals, it will constantly be concerned about preserving its dignity - and in particular about making sure it covers its backside. And to think that the central bankers believed that they would be wearing the trousers in euroland.

Bernard Connolly is an executive director of AIG International

The debate continues as experts give their counterarguments:

Avinash Persaud, global head of research for State Street bank.

Graham Bishop, advisor on European financial affairs at Salomon Smith Barney.