Will This Wounded Bird Fly?
Almost every issue of the Financial News, the Financial Times, the Economist, and other European papers carries an article about the euro, the trans-European currency due to be born on January first, 1999, to take the place of most of the currencies of Europe, including the mark, French franc, guilder, lira, and at least seven others.
However, little press about the euro has appeared in the United States. Indeed, whenever I bring it up, I'm asked by Americans, "Why should we care? What difference does to make to us what the Europeans use for money?"
A single European currency was a great concept, important both to Europe and to global trade. To realize what a disadvantage the current situation is, imagine the chaos in our country if each of our 15 major regions issued its own currency. What a nightmare General Motors--with 100,000 parts in inventory--would have selling and pricing Chevys if it had to account for its inventory and its sales in 15 separate U. S. currencies. We would become a nation of currency traders, as it would be a full-time job to keep up with how the South Central piece-of-eight was faring against the New England guilder and the Southwestern peso. While we'd still have the advantage of a single language, workers wouldn't be as quick to move to another region if they weren't sure of the new region's currency. Who'd want to earn a Pacific Northwest rial to send back to his mother in Appalachia if it couldn't be relied upon?
For Europe, the advantages of a single currency are numerous. Every time a transaction occurs--and the manufacture of, say, an automobile involves thousands of transactions--a currency trade is likely to occur. With the creation of the euro, millions, billions, of points of expense in European commercial life will ease. Tens of thousands of currency traders, bond traders, bankers, accountants, lawyers, etc. will be put out of work, all of which will combine to turn Europe into a more competitive force. As any owner of a business will tell you, a few extra points of profit makes all the difference in how well a business hums.
Today's European politicians are eager to establish this new currency. They feel it will extinguish any lingering chance of war in Europe, which twice this century has been torn apart by war. The euro's chief architect, Chancellor Kohl of Germany, has strongly pushed the establishment of the new currency as a means of establishing his lasting place in history. In addition to cutting costs in European trade, the euro will make it easier for Europeans to embrace a single political identity. Thus the euro is important for political, economic, historic, and sociological--as well as egotistical--reasons.
However, the important questions are: Can the euro be formed, and will it be formed on time?
Countries can share a currency only if their fundamentals have much in common. Imagine if Zaire and Switzerland decided to issue a common currency called the Z-franc. First, the Z-franc would have to be managed by the Swiss or nobody would want to hold it. Second, anyone who now owned Swiss francs would assume that the Z-franc would be inferior to the Swiss franc no matter who managed it, and current holders of Swiss francs would rush to exchange them into, say, German marks before the Z-franc took their place.
The key background fact in any discussion of a European currency is Germany's devastating experience with its currency during the twentieth century--that their mark was twice destroyed, once after World War I and again after World War II. Imagine our dollar becoming worthless twice in our century -- your family's net worth twice being wiped out -- and you can understand why the German central bank, the Bundesbank, was formed in 1948 with only one mandate -- to establish and maintain a sound currency. Most other central banks in Europe have no mandate at all. In this country the Fed has more than one mandate, not only to maintain a sound currency but to insure full employment, one reason the dollar isn't as strong as the mark. In fact, the Bundesbank is one of the world's few independent central banks, so it can maintain strict monetary discipline.
The advantages of a sound currency? A country with a sound currency pays lower interest rates, as investors are willing to lend money at cheaper rates if they're sure they'll be repaid with currency of the same value as they lent. This is why the Italians pay such high interest rates: Who wants to own lira for five years? Investors have to be bribed with high rates to hold it. As well, a sound currency promotes stability, attracting the kind of investors willing to wait twenty years for a return on their money.
If the euro is to have any credibility, Germany, with its large economy and sound currency, must be included, and the Germans must have a strong hand in running it. Unfortunately, Germany still does not meet the strict debt and deficit requirements it insisted upon back in 1992. German authorities argue that this overage stems from several exceptional problems: the staggering cost of rebuilding East Germany, the liabilities the government assumed this year from the state railroad, and the recent surge in unemployment. However, argue the Italians, Greeks, and Portuguese, if an exception is made for Germany, why not one for us?
Without Germany no euro is likely to be formed. No one will believe that Italy, Portugal, and Greece will run a sound currency, not after decades of printing and borrowing money in an undisciplined way whenever they have fiscal problems. (Not that small, profligate countries can't establish a sound currency. For decades Chile was the model of a spendthrift nation; today it is a model of sound money, its currency sometimes even advancing against the U. S. dollar.)
Thus when currencies of differing strengths are yoked together--such as the Deutschemark and the Italian lira--something has to give. Either the Germans' currency weakens or the Italian economy is put under more fiscal discipline--less welfare, less government spending, and more taxes--than the Italians are politically and socially willing to bear, or both happen to some extent.
On Jan. 1, 1999, the Deutschemark, French franc, Italian lira, and eight other European currencies are scheduled to be phased out over a three-year period. Banks, merchants, and manufacturers will need at least this much time to prepare for the complex transition, which will include new bookkeeping systems and new computer programs, not to speak of new coins and new paper money. Automatic teller machines and vending machines will have to be retrofitted. Loan agreements, insurance contracts, and mortgages must be restated. Bond issues and share prices must be repriced to their holders' satisfaction, and some of these instruments use fractions, not decimals. Big banks will lose up to 10% of their income as European currency trading ends. Across Europe there are 58 separate bank holidays; payment deadlines and the scheduling of receipts will have to be adjusted in some fashion. Pension funds will have to be restated; the Italian pensioner who now receives hundreds of thousands of lira will have to be persuaded that hundreds of euros is a true equivalent. I can imagine tens of thousands of lawsuits in the wake of the euro's formation. And on and on and on--the transition won't be easy.
Conventional wisdom has it that the creation of the euro will happen on schedule and that it will work. Most of the 15 political leaders of the EMU say they want the euro, even though by treaty and agreement Britain, Denmark, Sweden, and Greece will not be in the first round. This is why the lira's value has been rising, along with Italian bonds. Italian interest rates have been heading lower, as if the Mediterranean lira's association with the Deutschemark has put it on a diet of Teutonic steroids.
How could all this turmoil affect us, 3,000 miles away? Remember the dollar is the world's reserve currency. It's also the world's medium of exchange; commodities worldwide are priced in dollars -- oil, wheat, timber, cotton, what have you.
This is a tremendous and often unrecognized advantage for us over other countries. As a result of our status as a reserve currency, we're able to print money whenever we need to, and we're able to borrow easily. We can run gigantic deficits for decades with little penalty, which for example Italy cannot do, much as they yearn to ape our carefree fiscal style.
We continue to flood the world with dollars, which causes the most astute to invest in other currencies. Luckily for us, at the present time the world doesn't have many places to park large amounts of spare cash, as there aren't enough Swiss francs, yen, and German marks to go around.
But if the euro comes to exist, there will finally be a rival to the dollar, a rival large and possibly strong enough to be a serious threat to our hegemony. If 11 countries of Europe pool their currencies, that will be a large pile of money. Remember that both Europe's population and its GNP are larger than ours. The European Community, as a whole runs, a trade surplus, while the U. S. has run a trade deficit for decades. And if the Germans run the euro as they've run the mark -- as indeed they plan to -- the euro's liable to be not only larger but more soundly managed than the dollar. Which would you rather put into your retirement account: the mismanaged dollar -- which has declined 70% against the mark over the last three decades -- or a trans-European currency managed by the same folks who have managed the German mark? And certainly the Germans have shown discipline; with unemployment at 12.2% and their current desperate need to stimulate their economy, if their discipline hasn't broken under such pressure it's hard to believe it will later on.
A large, successful euro will not only put the dollar under stress, it could challenge the dollar as the world's reserve currency. Should the euro succeed we may find our position to be more like Italy's -- with higher inflation, higher interest rates, and as little desire on the part of others to hold our dollars as there is for us to hold liras. Our weak currency will mean we won't do as much trading with the rest of the world, which will mean our economy will lose some of its luster and robustness.
On the other hand, if the euro is formed and is weak, then items such as French wines, German cars, and Scandinavian furniture will be less expensive and more competitive, which will also give our businesses fits.
However, in my opinion the euro will not be formed as negotiated, even though I'm not sure that its failure is better for us. As the global economy is a vast cooperative organism, we want healthy trading partners, even strong, competitive partners. We want them as consumers so we can purchase products at the best possible price, and as a nation we want strong trading partners so that the community of nations is economically vibrant.
I would remind you the European have tried to join their currencies several times in the past 3 decades -- all without success. This attempt is far from certain success.
So why won't the euro be successful this time? Within the next couple of years, there will be several elections in Europe. It's more than just possible that the short-term pain of fiscal discipline will create new European political constituencies who will elect politicians to oppose the euro. Germany itself -- the engine driving the creation of the euro -- will have an election before 1999, and while Chancellor Kohl is the most influential politician in Europe and the father of the euro, he could either lose the election or find himself facing a new constituency. As well, he may not run again: he's been in office a long, long time; his health is worsening; and he's getting on in years.
Thus for political reasons the euro may not come into existence. That is, meeting the euro's strict criteria may continue to lead to a painful economic slowdown, and if voters won't accept the short-term pain it takes to create a sound currency, there won't be one, as the formation of a currency needs the consent of politicians elected by voters.
The currency and bond markets have been so certain that the euro would be formed that they have raised the prices of several weak European currencies and bonds. Traders jumped on the momentum bandwagon, driving the prices still higher, but lately the markets appear to be taking a second look.
Nor is it a small point to the markets that some countries are cooking their books in order to meet the Maastricht criteria. The French stunned everyone, even the Italians -- who rightly assumed no one was as brazen at cooking books as they -- by selling off assets of state pension funds and declaring this as income.
Not to be outdone, this year the Italians have passed a special euro tax of 1%, which the government has promised to give back next year. You and I would call this a loan, but the Italians call it income.
As an aside, the best investment to appear in this situation are the special coins commemorating the creation of the euro. The coins, minted in limited editions, stand an excellent chance of being worth a great deal more than their nominal value in the future whether the euro succeeds and especially if it fails.
Actually, the markets sense something is amiss, that European currencies and bonds have gotten ahead of themselves. Even now the smart money is edging toward the door. If the markets won't play along with the politicians' efforts to cook the books, the game is over. Remember, the markets have more money than the central banks, and in time the markets always get it right -- which in this case means eventually abandoning or renegotiating the weak euro. No matter how hard the central banks fight to support the new currency, if the markets won't accept it, it's dead.
But suppose the politicians are able to defy the markets in the short run and Kohl is able to will the euro into existence.
Then the entire world could have a major problem. A third of the economic world will be committed to a currency -- in this scenario there will no longer be any lira, pounds, Deutschemarks, French francs, etc. -- with Bundesbank types running it. No extra euros will be printed by the stern central bank. For Portugal or Italy to raise the extra euros they believe they desperately need they will have to cut spending, borrow them, or raise taxes, none of which suits their cultures as well as printing money.
Suppose in 2002 Portugal is over-extended, needs relief from the restrictive Maastricht criteria, and yet is told by the new central bank, "You must be more competitive. Tighten your belt. Borrow what you need."
Portugal replies, "We can't afford to borrow," but reluctantly agrees to try it. After paying the necessarily high interest, the situation worsens.
Opposition Portuguese politicians spy a once-in-a-lifetime opportunity to advance their careers. In fact these firebrands are elected with a mandate to change the situation. They return to the Euro Central Bank with this message: "Give our people a special break or we're out of this stifling union."
What will the Eurocrats do? Send in Panzer divisions? Yet if they lower their standards and give in to the Portuguese, the Swedes and the Greeks will bleat, "What about us?"
If the Greeks and Swedes aren't catered to, rabblerousers may then be elected by them, and not only might the euro collapse, but the Common Market stands a good chance of being brought down. Former tariffs will possibly be reinstated. The newly elected firebrands will print new currencies -- new lira, new pesos, etc. For a little while these new currencies might sustain their value, but with the return of skyrocketing inflation the banking and trading systems of many European nations would fall apart, plunging these countries into far worse economic straits than they are in now.
If the Common Market falls apart, all trade with Europe will suffer, including ours. We won't sell Europe as much wheat and computers, which means we won't be able to buy as much wine, cars, and furniture from Europe as now. We like to imagine we're not dependant on trade with other countries, but the truth is we're very dependant on it. Some 11% of our GNP is composed of foreign trade, and if a only few points of this are lost, we could enter a recession--or worse.
Back in the 30s, beggar-thy-neighbor trade policies engaged in by all nations contributed to the worldwide depression. Today it's beggar-thy-currency policies which may lead to the same problems. After all, how can we sell to others if they don't have a sound currency with which to buy our products? As an extreme example, we don't ship much to the Congo, as its currency is worthless.
If the euro is delayed beyond any of its scheduled starting points, then its formation may never happen, as even more politicians come into power who will heed the local constituencies that want to lessen the pain of austerity. The entire Maastricht treaty would have to be renegotiated, a political, economic, and social nightmare, as bad for the rhythms of politics, banking, and business as it would be for ball clubs if the World Series were put off three months.
For the sake of Europe and the world the euro should be created, but it won't happen as planned. However, if through a miracle it does happen and then falls apart, it's going to be yet more disruptive. Some European currencies will lose much of their value, and their economies--and likely the rest of the world's--will then slow; many financial firms will go broke, causing havoc in the debt markets; and all the investment in creating the euro will be lost.
While there's too much ego and politics for the rational to occur, there are actually two ways that the euro could be successful. Both involve starting small, so that if the project causes problems, they will be small problems, not large ones--always a useful rule for new projects.
One, the Germans might merge their currency with only the Dutch, as their two economies are already closely tied together, in a pilot project by two countries who have been in the Common Market since it was formed in the 50s. The two could easily meet the deadline of January first, 1999, so that the euro is formed on schedule, creating confidence in the enterprise. Countries like Italy and France wouldn't become bent out of shape, as the Netherlands is too small to pose an economic threat. (The merger of the powerful French and German currencies would be too much of an economic and political threat to the rest of Europe.) Over the next five to ten years the other countries of Europe could gradually join this new union as the kinks are ironed out.
The second plan would be for the four sound small countries to join together in a currency union: Finland, Denmark, Ireland, and Luxembourg, all of whom actually meet the Maastricht criteria. This marriage could also be used to iron out the wrinkles that are inevitable in such a step, and this union could then take in other countries as time and circumstances permit.
Both these plans would allow the euro to happen on time and reduce uncertainty. However, due to all the political ego and national pride involved, I have no faith that such a rational approach will be tried.
In summary, the euro will be tried and might work, leading to huge ramifications for us and for Asians. The world will have a large, powerful new competitor, changing forever the dynamics of the dollar and world trade.
However, it's probable that the euro will crumble over the next several months and never occur, staving off the problems of its formation but leading to other problems for us all.
With worst luck, however, it will in fact come into existence, and sometime in the early 21st century it will collapse, leading to a European recession at best and a worldwide panic at worst.
For these reasons over the next five years the euro situation could well be the world's single most important event.
Even though we live 3,000 miles away and have the isolationist belief that nothing over the waters much affects us, we're wrong. We should make sure our various financial houses are in order, those we live in at the family level as well as those on the national level. Among other considerations, we'd be wise not to load up on too much debt, both personally and nationally, in case a crisis strikes, not advice Americans like to hear.
We won't like it, but we'll very much be affected by the euro whether it comes into being or not, and we should follow news of its pregnancy and birth with great attention.
Updates are available at www.jimrogers.com.