Is it viable and can it survive?

There are lots of things happening in the Eurozone right now and some are questioning whether the € itself will survive, so the question is – is it fundamentally sound? In order to consider that, we need first to work through how currencies function.

So how does a currency work?

Conventionally each country has its own currency so let’s start there. Importantly, each has a government of one sort or another and that government determines all the financial matters for the whole country – not parts of it. It is said to have fiscal control which means it sets all the rates of national income and expenditure. All of them, including taxation; state pensions; retirement, and all services from state education through health, defence, business, energy, environment, food and agriculture, transport – everything.

In any country, some areas generate more wealth than others so some need support and these areas change over time (sometimes as a result of government policy). The government transfers wealth in many forms from the stronger regions to the weaker ones, but essentially the wealthier areas pay more tax which goes as support to the less wealthy ones. It will always be that way.

Only by way of example, in the UK the North East is now in need of support because its major industries have moved mostly abroad, and the Welsh Valleys are equally smitten with the demise of the coal industry. But go back 100 years and these were the wealth generators supporting much of the country along with the Black Country north and west of Birmingham. Things change over time.

Developments in Transport have always hugely moved production, so around 1800 industry was where the canals where, but by 1850 it was important to be where the raw materials were so steel was in Sheffield and the North East, where also the shipbuilding industry was the pride of the world. We had moved from the canals to the railways, so where the railways went industry followed.

With the advent of the container ‘industry’ (around 1960) and the construction of monster ships, the cost of long distance transport shrank, so production moved to the cheapest regions of the world. The areas with the lowest labour cost became the production centres which moved production wealth from what is glibly called the developed world to the developing world. As far as we in Europe are concerned, in our hunger for ever cheaper goods – we exported production to Asia but there is something else to consider. Exchange rates. Countries with low value currencies have an exporting advantage while those with high values have an export impediment, and governments impact on their exchange rates!

The Balance of Trade

One thing a currency area has to do is to ‘balance its books’ – its total imports and exports (including services) need to be similar. If imports exceed exports the currency loses value, and as the value drops the cost of exports drops so exports rise. Similarly the cost of imports rises so imports drop. The books balance for some rate of exchange for the currency. So the strength of the currency ultimately depends on how the currency area performs which is of course hugely important for the Eurozone.

What is required for a Country (sorry Member State) to join the €?

The Eurozone currently consists of 16 countries (17 tomorrow as Estonia is joining) – interestingly called ‘Member States’ rather than countries, which maybe a clue to the original political intent.

For the countries to work in harmony with the same currency they must be economically similar or ‘extremely similar’ so there are 4 ‘Convergence Rules’ defined by the infamous Maastricht Treaty, (now transferred into The Lisbon Treaty) to define if a country is ready to join:

  1. Inflation – must not be more than 1.5% over the average of the 3 best performing countries.
  2. Govt Deficit – must not be more than 3% above GDP and:
    Govt Debt – must be less than 60% of GDP.
  3. Interest – long term interest must be less than 2% above the average of the 3 best performing countries.
  4. Exchange Rate -the currency must be ‘stable’.

The Notion of ‘Convergence’

By definition, that word means the incoming economy is not similar enough or it wouldn’t need to converge, and anyway the economies of countries are different. Each applicant economy must therefore be modified until it is similar enough. But it is also a treaty requirement that when the economy of a country not in the Eurozone but in the EU meets the convergence criteria – it must join the €!

And not illogically, if it had to ‘converge’ then it was highly likely later to ‘diverge’. We cannot make the North East like London. But there are three ways to arrive at ‘convergence’:

  1. Wait until it happens
  2. Encourage it to happen
  3. Fudge convergence

I would argue there are at least 3 distinct, and distinctly different, economic groups in Europe – the Northern, Southern and Eastern Europeans (ex USSR). Some are industrial or semi industrial, some have big financial institutions; some strong business systems, some substantial agriculture; some are very tourist dependent. Some are ‘laid back’ (the southern countries); some have a lot more domestic property than their population needs, and some are coming from a long way back in economic terms. Some countries expect to retire at 50; some at 65 to 70. Some follow rules; some don’t, and in some bribery and corruption are endemic. Those who have travelled widely and not kept to the tourist trails will know this and I have several personal experiences to prove it.

So let’s consider the probabilities of subsequent ‘divergence’ and note the word is probability not possibility. We will take just 3 examples but there are almost as many as EU countries.

The Cross Over

 

The green plot starting higher could represent France while the brown one might be Poland. Clearly Poland had some catching up to do.

Given that countries with economic differentials need to ‘converge’, why should the rate of economic change close once the € has been adopted? If the economic growth rates continue they must diverge. To avoid that either the faster growing economy must slow down or the slower one speed up.

The Hiccough – or pseudo convergence

 

The green plot could represent Germany and the brown plot Greece. It seems clear Greece wasn’t honestly converged and it has rather slumped in comparison.

The convergence criteria were surely sometimes fudged which ensured a rapid divergence when the reality could no longer be concealed.

[Some European Politicians have focussed on growing the EU at almost any cost even to the extent of being undemocratic. Take the recent Lisbon Treaty. Negotiations started in 2001 though it didn’t take effect until 1st December 2009 – just one year ago and already in need of revision due to this financial crisis. The central EU politicians wanting the Treaty had become very frustrated as it was taking too long for each country to ratify it. Some countries parliaments voted on it; some had referenda, and some governments just approved it, but let’s focus on those having referenda.

If the population voted against the Treaty, that result wasn’t fundamentally accepted as they were then asked to hold another referendum. If democracy was king, countries that had voted against it would have remained against it and the result would have stood. And if (undemocratically) they were asked to vote again then countries having already agreed should have been able to vote again and maybe now vote against – but that was not allowed. The EU is fundamentally undemocratic and a one way ticket to a centralised State.]

The Fall Away

 

And here the green plot could represent Denmark and the brown one Spain. Clearly Spain is struggling.

Just as Tyneside prospered and then its power house failed, so it has to be with some countries. We cannot all prosper at the same growth rates for ever as independent countries, so when a country loses some of its economic strength its economy must necessarily diverge from the rest. It isn’t rocket science – just logic.

What is required to stop countries failing if diverging?

In order to stabilise those countries that diverge, wealth must be moved from the stronger to the weaker just as we already do inside every country. But this is not going to make the population in the stronger countries happy, and if the population isn’t happy the politicians will be in difficulty. If we therefore remain as separate individual countries, ultimately the must fail as continuing to transfer wealth is going to be unacceptable – but this sentence did start with an ‘IF’.

So there are only two real and permanent solutions which allow the € to survive:

The United States of Europe or

The Federal States of Europe

(so long as fiscal authority is central)

There would have to be one Government; one Central Bank; one Chancellor of the Exchequer; one President – one fiscal authority. The ‘Member States’ [and now we know why they were called that] using the € would have to form this single ‘State’. It would be run from Brussels – like it or not – and the central government would have to effectively subsidise the weaker regions. All Member States would lose their national identities and governments, though they could have devolved governments for minor matters (the Federal Option).

Countries not yet in either the EU or the Eurozone are generally weaker than those in, so it is not surprising they fight hard to gain entry as they expect to receive not to give. And if that United States of Europe were formed with the existing Eurozone countries it would have an interesting external border which would be even more interesting if Turkey were to join.

So there we have it. Having separate and disparate countries using one currency is a system designed to fail.

It is a constant surprise that those at Maastricht didn’t seem to understand this, but the Eurozone is where it is and we all have to pay the penalty of that mistake.

So what is actually happening?

May I start with an observation that might be useful when considering events? The Euro came into being on Jan 1st1999 but the actual notes and coins only on 1stJan 2002. That means the € has only been a currency for nearly 12 years, and the notes for 9 years. A microcosm of time for a currency. By comparison the £ was founded before 797AD – or it has exceeded 1,200 years.

During 2010 the first cracks became too obvious to hide, and Greece foundered economically, but the EU and Eurozone were found wanting. It caught them by surprise and there were frantic, not to say frenetic meetings trying to decide what to do. Effectively the country was and is bankrupt, and it would surely have gone bust had it not been in the Eurozone.

Now countries work financially just as we do as individuals, so there are two main worries: the total amount of debt and the annual deficit or surplus which shows which way the total debt is moving and how quickly. Convergence rule 2 required the annual deficit to be not more than 3% of GDP yet the figure for Greece was 15.4%; total debt had to be less than 60% of GDP yet is 127%. So the debt is dreadful and getting worse at breakneck speed which means Greece is a really bad credit risk.

The rate at which countries borrow is called ‘The Bond Rate‘, and the bond rate for Greece was reaching 15% which is unimaginably high especially when you compare it with the rate for Germany which is about 2½%. And at 15% effectively the total Greek debt was likely to rise for ever – or the country is bust.

There were 3 options for the EU and Eurozone:

  1. Greece is lent the money at ‘affordable’ rates.
  2. Greece ‘re-structures’ its debt – which means to you and I that it makes an arrangement with the people it has borrowed from to pay them maybe only ½ what it owes. Not a lot of happy bunny lenders with that one.
  3. Greece is expelled from the Eurozone.

Option 3 was a bit interesting as Greece only joined in 2001 when its economy had apparently ‘converged’. Strange that just 9 years later it had diverged so much it could be thrown out. A bit of egg on a few faces with this one then and not likely to be the solution EU leaders could face. It also begs the question of the professionalism of the Due Diligence carried out by the EU before allowing Greece to join. Clearly a hiccough convergence.

Option 2 would have taken financial credibility away from the Eurozone and the EU, and would have hugely increased market pressure on other Eurozone countries in similar positions to Greece. Who is going to lend if what is borrowed won’t be repaid?

Option 1 had to be the route chosen being the only plausible one, so Europe set up an Emergency Bailout Fund to help failing economies (note this is in the plural)! And Greece has been or is being lent €110B at 5%.

That is a very serious situation, but Greece was not and is not the only country pinned against the wall financially. Next came Ireland with similar problems if with a different cause. Measuring their situation is complex as their Banks (yes banks again) are in a big mess and don’t seem to yet know how big the mess is. So Ireland’s annual deficit is seemingly 32% (against the 3% required) and their total debt about 100%. Yet again an almost impossible situation and their Bond Rate was and is about 8½%. Net result – the Bailout Fund was used again with €85B being made available to Ireland. With a second country clearly having diverged in so few years, we must question the fundamentals of the currency, but Ireland is an interesting case.

Ireland needed to gain strength to remain ‘converged’ so the Eurozone propelled growth just as it did in a number of other countries. The ECB (European Central Bank) provided a lot of funds to Ireland. Unfortunately much of it financed a building boom, which resulted in perhaps the fastest growing property values anywhere, so right now there are huge numbers of empty houses which some say is over 100,000 (and one analyst giving it as 300,000). Whatever it is it is a big number and a problem. In China this number would not be significant, but Ireland only has about 1,200,000 houses. The result was the property price collapse which has seen prices fall around 50% from their highs, and this has collapsed the asset value held by the banks.

So Europe piled money in; which created a boom; which created a bust; which means they must now pour more money in.

[All over the world economies grow on the back of increasing property values yet this is a pseudo valuation. We shouldn't lose sight of the fact that a property has a base value which is all we can rely on. This is the cost of building it + a profit margin for the builder + the basic cost of the land which in many cases is zero. Land to build on only has superior value because we are allowed to build on it and cannot build everywhere. If the economy collapses, the land itself is probably worthless as it would cost a lot to return it to other (agricultural) use, so the value we attach to houses is transient and simply the result of supply and demand. But values cannot fall below that base value for long].

Are there any more cracks appearing?

With two countries in deep trouble, attention has turned to others in difficulty with Portugal and Spain now under pressure (31/12/10) but Italy and Belgium have similar national debts and annual deficits. So out of the 16 countries, 2 have been bailed out and 4 more are in difficulty. Now even if Portugal needs support next, by then only 1/15th of the EU (by money) would be involved, but Spain on its own is almost twice that and Italy almost three times that. So the notion that the remaining ‘stronger’ countries could bail that lot out is implausible. They couldn’t, but even if they tried we can be certain the populations of the supporting countries would revolt.

A further problem is that with the economic woes around Europe, it is very unlikely the supported economies can grow at the rates required for the Bail Out Funds already allocated to suffice – so we can expect Greece and Ireland to need a further tranche! And the other countries given above can also not grow at predicted rates – and nor surely will we.

But weren’t there rules to avoid this?

Certainly – they were the convergence rules given above but we did also mention that some countries follow rules and some don’t, and the conglomerate that is the EU doesn’t seem to be among those that follow rules too closely. So let’s just see how some Member States are doing:

Member State National Debt Annual deficit Interest rate
Rule: Less than 60% Less than 3% Less than 4.16%
Greece 144% 15.4% 11.5%
Ireland 100% 12% – 32% 8.2%
Italy 126% 11% 4.2%
Spain 77% 11.4% 4.7%
Portugal 85% 10%+ 6.9%
Belgium 99% 11.9% 3.72%

The debt figures are all growing at the moment, and the above should represent the current situation at the end of 2010, but all the EU countries seem to be breaking the rules – even Germany whose total government debt will be about 87% now. It isn’t as if the variances from the rules were minor as they are not, nor is it that a single State has broken them. And it was intended that deviation from the rules incurred a heavy financial penalty – but if the country is in deep trouble and we are trying to pull them through, adding to the problem would be bizarre.

Conclusions

This currency has only been around for 12 years and already there is what can only be described as ‘currency mayhem’. A fundamentally stable currency wouldn’t do this. It isn’t fundamentally sound.

Member States have diverged and are diverging, and while Europe is not controlled as a fiscal unit, this must continue to happen. The Euro as a currency has no long term future with this EU format.

Bringing the ‘Member States’ together as in The United States of Europe would solve these problems but is undoubtedly unacceptable to the peoples in the various Member States so that proposition would be unacceptable.

Whether the Euro collapses during 2011 or 2012 or manages to hang for a while longer, it is destined to fail, and the quicker it does so probably the lower the consequences for all involved. The ramifications are awful, but this outcome was predictable and responsibility lies with those who set up the Eurozone.

Postscript 1.1

There is a matter of huge significance that never seems to be appreciated by World leaders and economists and it is this. The world’s resources are finite, and the notion that we can have never ending growth is absurd. It cannot happen, and the faster the global population grows, and the faster the non-consuming peoples start to consume at our levels – the faster resource depletion will occur. An ever growing global economy is nothing more than a ‘Ponzi’ or ‘Pyramid selling’ scheme. It has to fall off the cliff. The only question is – When?

For the first time in the history of the Planet we are exhausting all resources on it and in it simultaneously. For those in doubt, a check on the global prices for most things will show they are all rising – the economic signal that demand now exceeds supply. Europe is arriving at this time with massive debts which require that economic growth to continue for decades at least. Unfortunately, that time frame is no longer available.

Postscript 1.2

I separated this one out as it is globally crucial and I am referring to the cost of energy. While the recession we are trying to recover from is mostly put down in the media to the Banks, the reality is it was triggered by the price spike in oil. The gambling Banks then turned a huge problem into a crisis, but the trigger was the oil price. With a $100 rise in the price of a barrel of oil, the US economy had more than $1T per year taken out of it, and the oil price had risen from the $30′s to peak at $147. The US economy is not designed to be frugal on energy (they use 25% of world production on their own), so the less well-off started defaulting on their mortgages. And the pack of cards came down.

While the US economy has been floundering, the Tiger economies have continued growing and at break neck speed, so oil demand is again about to exceed maximum supply. The price of oil today is $90 which is hurting already, so the world is about to receive another energy shock which will radically curtail the growth figures being assumed in the EU and elsewhere.

Postscript 2

There is a second matter of huge significance; well discussed but the ramifications are seemingly ignored or at least action deferred to coming generations. It is the changing climate – and at this point it doesn’t matter if it is man made or natural.

We will progress the work in this field in other Papers to be published, but the implications are also enormous and this will impact hugely on economic performance. To assume we have decades of high levels of growth, even if there was no resource depletion, is bizarre.