Recent events make more likely a "soft" Emu incorporating Spain and Italy. But this will make it more vulnerable to currency speculation during the transitional period 1999-2001by Walter Eltis / July 20, 1997 / Leave a comment
Published in July 1997 issue of Prospect Magazine
The political turmoil surrounding European monetary union-following the victory of the French socialists and Chancellor Kohl’s rebuff from the Bundesbank-makes all prediction about the future of Emu dangerous. But whether the destination is a hard or a soft euro, the political will to start on time remains overwhelming. As has been pointed out before, Emu is primarily a political project. It has survived the covert undermining of the Maastricht criteria (through various forms of creative accounting) and it will now probably withstand the overt undermining of the criteria. Dominique Strauss-Kahn, the French finance minister, has already called Maastricht’s 3 per cent budget deficit limit “a bit ridiculous.” And it is hard to see how either France or Germany can now qualify for Emu under the original terms. This laying bare of the political heart of Emu should not, however, preclude drawing attention to some of the practical difficulties for the three year transitional period (1st January 1999 to 31st December 2001) during which the Emu member currencies will be “irrevocably” fixed against one another but still remain legal tender. Indeed, the further politicisation of Emu may make it economically unsustainable during this transitional period. A broad Emu, which is likely to include some of Europe’s most financially vulnerable economies, will generate some furious political rows at the European central bank. Some of the weaker economies are likely to find their definitively fixed exchange rates unsustainably high and will start to run large budget deficits, crowding-in resources from others with sounder finance. The financial markets will be watching all this very closely. In theory, Emu cannot be broken by speculators between 1999 and 2002 because each national cur-rency will be an irrevocable part of the euro-a euro-DM, a euro-lira, a euro-peseta and so on. But those who hold lira denominated bonds (and Italy’s debt to GDP ratio is more than twice Maastricht’s permitted 60 per cent so there are plenty of them) may well prefer to switch to euro-DMs, just in case of a breakdown. Again, in theory this should cause no difficulty. If savers prefer to hold euro-DMs to euro-liras or euro-pesetas, the Bundesbank is obliged under the Maastricht treaty to simply print more Deutschmarks. If the Bundesbank is willing to be an unlimited buyer of liras or pesetas and issuer of Deutschmarks, then the irrevocably fixed exchange rate will be sustained. All the liras and pesetas and Deutschmarks will simply become euros in 2002 and there will be no problem. But this is where politics is likely to intervene once more. For a massive printing of Deutschmarks will leave most Germans, not least the directors of the Bundesbank, more than unhappy. The situation would be containable if the European central bank gave an exchange rate guarantee to all holders of liras and pesetas, including the Bundesbank, that in 2002 these would unquestionably be exchangeable for euros at the irrevocably fixed exchange rates. Tim Congdon has pointed out that this guarantee has not been offered and it can only be offered by Europe’s governments. Only they have the resources to back up a guarantee that in the event of an Italian or Spanish departure from Emu, all liras and pesetas will be convertible at the previously agreed exchange rates. In the absence of such a guarantee, Germany and the Bundesbank acting on its behalf may be unwilling to flood the world with Deutschmarks in exchange for liras or pesetas. A withdrawal from Emu during the three years in which national currencies remain legal tender will create an opening for banks and hedge funds to profit hugely at the expense of participating governments. Is it likely? Three years is a long time in the life of a government and Europe’s unemployment is high and rising. Spanish unemployment exceeds 21 per cent. French and Italian unemployment exceed 12 per cent. There will be elections in various countries in 1999, 2000 and 2001 and electorates are desperately concerned to contain unemployment. European governments are bound to wish to introduce job-creating strategies which cost public money, and if they have gained entry to Emu through creative accounting, there will be little resistance to its use afterwards. It is therefore highly likely that some budgets will move even more strongly into deficit. Those with the strongest budgets will resent this, but there will not be a majority of directors on Europe’s new central bank to prevent it. With confused accounting those continuing to run sound budgets will not even be able to establish the existence of anything untoward. Meanwhile the weaker economies will also be suffering the effects of high exchange rates. France will support the admission of Italy and Spain into Emu but it will exact the price of high initial exchange rates for the lira and the peseta to restore some of its lost competitiveness. Italy and Spain will accept that price to gain admission, but their exporting sector will then suffer as Britain’s did from 1990 to 1992. Hence with mediterranean budgets deteriorating, and either the lira or the peseta or probably both overvalued, strains will emerge within Europe. The old safety valve was devaluation, but that solution will no longer be available. The mechanism for redistributing employment within a single currency area such as the US is falling pay in regions where jobs are lost, and rising pay where labour is scarce. Such developments have produced great internal migrations. That will not happen in Europe because it lacks a common language and governments pay sufficient unemployment benefits to pers-uade those who lack jobs to remain where they are. But will this not simply mean a further “debauching” of the qualifying criteria and subsequent stability pact, rather than a political breakdown? This is where the financial markets and the Bundesbank come back into play. As budget deficits mount in several countries, investors are likely to flood into the Deutschmark. At the irrevocably fixed exchange rates, there will be no penalty in switching lira deposits into Deutschmarks. Even if the option of switching into euros exists and the euro is available as money before 2002, most will opt for Deutschmarks. Those who switch from lira to Deutschmark-denominated bonds will sacrifice some interest. It is worth recalling that Canada has a single currency, and oil rich Alberta pays 0.6 per cent less interest than the resource-poor maritime provinces and more heavily indebted Quebec. If French Canada can be required to pay more interest than English Canada, more interest can also be required from Italian Europe than from German Europe if it follows less disciplined policies. As I mentioned above, in principle the vast monetary movement could be contained by an equivalent creation of Deutschmarks. But political forces are likely to resist this, especially if Chancellor Kohl has retired or been defeated in next year’s election. Even if Kohl is still in office the Bundesbank may overrule him as it has just done over the revaluation of gold reserves. As soon as the possibility of the departure of one or more countries from Emu between 1999 and 2002 is recognised, movement towards the Deutschmark will not be confined to those who are exposed to weaker currencies through trade or holdings of debt still denominated in their former currency. There will be staggering opportunities for profit at the expense of those who, like the British government in 1992, seek to hang on to exchange rates they cannot sustain. George Soros will be there. He has already written in Foreign Affairs: “In all likelihood the euro will be introduced in 1999 as specified in the timetable. People will direct all their anger and resentment over unemployment at the single currency. There may well be a political revolt-particularly in France, notorious for such rebellions-and it would likely take a nationalistic anti-European direction… Mounting popular discontent would sweep away present policies, including the single currency.” It is to be hoped that the warning from Soros and others will alert Europe’s leaders to what they are walking towards before it is too late. Many have warned that the project will end in disaster if the entry conditions are politically manipulated, as they are now bound to be if Emu is to go ahead. The Duke of Wellington remarked nearly two centuries ago that “Any one can get 10,000 men into a square but it needs a real general to get them out again.” Does Europe have the generals it will need to march France and Germany out of Maastricht?