Justin Pugsley - Justin has over 20 years experience writing about markets, economics and finance. He has worked for a number of leading media organisations such as Agence France Presse (AFP), Dow Jones, Wall Street Journal, Thomson-Reuters, British Sky Broadcasting and McGrawHill.
Justin Pugsley
Justin has over 20 years experience writing about markets, economics and finance. He has worked for a number of leading media organisations such as Agence France Presse (AFP), Dow Jones, Wall Street Journal, Thomson-Reuters, British Sky Broadcasting and McGrawHill.
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The trouble with monetary unions and the EUR

The EUR is probably the most ambitious currency union ever undertaken, and certainly so in the modern era of fiat money (currency based on supply and demand) as opposed to being backed by assets such as gold or silver.

However, currency unions have a chequered history – most failed eventually – and the long-term outlook for the EUR is not encouraging.

Greece is a major test for the EUR and if it departs it will potentially open a can of worms for the architects of the Eurozone. It will set a precedent that despite all the brave words of the single currency being irreversible (there's no prescribed exit mechanism) it is possible for members to leave after all.

 

Can the EUR survive?
Why currency unions tend to fail

The single currency was launched with hubris with little attention paid to the forces of economics. It's always been about politics first and foremost – an attempt led by France, to keep Europe at the forefront of global politics and to create a rival currency to the USD.

But history is replete with failed monetary unions, which included attempts in early US history between some states, which eventually disintegrated. Then there's been the Latin Monetary Union (LMU), the Scandinavian Monetary Union (SMU), East Africa and many more.

They usually failed either for political reasons (SMU: Sweden fell out with Norway and Denmark), lack of centralised control (LMU among others) or lack of discipline (ie some members pursued inflationary policies or borrowed too much and needed to devalue to stay competitive).

A notable success story from Africa

Nonetheless, one notable modern currency union survives, despite little political and economic integration and no fiscal transfer mechanisms between its members. It's the CFA franc, established in 1945, for former French West African colonies and is pegged to the EUR (before it was the French Franc). It's had its fair share of criticism and has been devalued several times.

Reasons why the CFA has probably worked is because it's backed by France (a powerful outside influence), which also imposes a degree of monetary discipline and often provides financial assistance. France's support has conferred some monetary stability to CFA members, which they may not enjoy with their own currencies.

But back to the EUR. It was launched Jan 1, 1999 and was preceded by numerous attempts to peg European currencies to each other, such as the snake, the European Monetary System and the European Exchange Rate Mechanisms (the UK was famously ejected from it and a number of other countries such as Italy were almost thrown out). All three were prone to instability.

The EUR at least does have a centralised control via the European Central Bank, which controls the money supply for all its members. Meanwhile, it's narrow mandate has recently been expanded so it can more readily deal with crises. But central banks can't do everything.

 

The ECB – a monument to hubris and folly?
More centralisation needed, but...

What the Eurozone lacks is fiscal control. Though there are rules about debt issuance and budget deficits etc .. they've been routinely flouted by just about every member – even by Germany and France at various times.

Long-term survival of the EUR requires centralised control of taxation policies and bigger fiscal transfers and much more power to Eurozone institutions over national ones. Possibly even a central treasury, which issues debt collectively for the Eurozone and thereby harmonises interest costs and credit ratings for everyone.

Weaker members are directly propped up by stronger ones. The US, for example, has this kind of set-up with a Federal government and Federal Reserve and hence there are never existential questions posed over the USD.

But this is all fine in theory for the Eurozone. The problem is that political integration of that level is difficult to foresee. There is no real strong sense of European identity in the same way there is for US, Chinese and Russian citizens.

Nonetheless, European authorities never let a good crisis go to waste and have been adept at pursuing their integration agenda every time there is a wobble. No doubt the Eurozone architects – if they ever thought about it at all – knew full well that a fiscal union pre-EUR would have been politically impossible. They 'may' have banked on it emerging later.

…support for more political integration reaching its limits

However, moves towards further political integration appear to be reaching their limits. For a start Euroscepticism is hardly just a UK phenomenon now – it's becoming more widespread in other European countries.

The richer northern countries, particularly Germany, are sick of bailing out weaker members. Meanwhile, those being bailed out are growing increasingly resentful of being told how to run themselves by their creditors and of suffering never ending austerity programmes.

There are now growing anti-austerity movements across the Eurozone – Greece's ruling Syriza party is one manifestation and is writing the latest chapter of the Euroizone crisis. The fear for the Germans is that the ECB will end up simply printing money to directly finance weaker countries leading to a debasing of the EUR. The recent quantitative easing programme by the ECB is unpopular in some parts of Germany's political and financial establishment.

Germany has been a huge beneficiary of the EUR, which is undervalued for Germany's much more productive industry. It has led to booming exports and to outperforming Eurozone rivals, which cannot devalue to keep up and either have to match German productivity or go bust.

However, it's very unlikely that citizens of the Eurozone's richer countries will willingly pay higher taxes to fund their poorer southern counterparts via large fiscal transfers. Many northerners consider their southern counterparts to be profligate and resent paying for them. There simply isn't a strong enough common European identity to justify such sacrifices.

One-size fits all created economic divergence rather than convergence

The one-size fits all approach of the EUR ended up accentuating the strengths of some countries and the weaknesses of others. Rather than via currency devaluation economic adjustment happens through output and employment levels instead, which can trigger social unrest and instability when it goes in the wrong direction.

Meanwhile, the EUR, seen by some as a pseudo-Deutsche Mark, enabled countries with poor governance and poorly run institutions to borrow unsustainably and far more than they should have or could have if they still had their old currencies. Greece is a case in point.

Unsustainable debt levels of some members have probably sounded the death knell for the EUR, but it's likely that politics and social unrest will eventually finish it off. The lesson of Grexit – if it happens – is how to somehow unwind the Eurozone in an orderly way without causing a financial disaster for the rest of the world, should it ever come to that.

The trials and tribulations of the EUR will favour JPY, USD and if it becomes really out of control then gold as well. The losers on the crosses will be GBP and certainly the commodity currencies such as AUD and NZD.

 

By Justin Pugsley, Markets Analyst MahiFX

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