Tuesday, April 04, 2017

Is Brexit the euro's first major blow to the EU?

Published by New Direction (p25)

In his book "The Euro: The Politics of the New Global Currency", David Marsh shows that the drive to forge a common currency in Europe was animated by the traumatic experience of the break-up of the Bretton Woods agreement in 1971, when the US declared it would default on its obligation to exchange the dollar reserves of European nations for gold.

At the beginning of the 1990s, a system of fixed exchange rates was in place in Europe, in preparation for this planned common currency. In 1992, investor George Soros made a lot of money as his speculation forced the British government to pull the pound from the European Exchange Rate Mechanism (ERM). Soros understood Germany would not be willing take extreme measures to keep Britain in the ERM, an insight lost on many in the City of London.

Similarly to the euro crisis that would come later, this humiliating chain of events did not stop the big project from proceeding. The 10 year borrowing costs of struggling European countries such as Italy, Spain or Belgium (see figure) continued to stay high over the next few years. No half-hearted budget cuts, gold sales or tax hikes succeeded in bringing them down. The only measure that lowered borrowing costs was the decision to create a common currency. In 1995, investors became convinced that the common currency would be a reality and that Italy and other weaker European economies would become members. This is evidenced by the fact that this was the last peak before which borrowing rates dropped off precipitously. For each of the eurozone’s member states, the prospect of entering the common currency zone resulted in a drastic reduction in borrowing rates.

Why does this matter? It matters because it explains how the euro was not born as a result of positive experiences with fixed exchange rates or of some ideological consensus. There were many opponents, not least in Germany, but also in France, where almost half of the population voted against the Maastricht Treaty, which provided the euro’s framework. Rather, the euro emerged because it allowed politicians to postpone painful decisions and in some cases even outright state defaults. When politicians were desperately scrambling for ways not to have to cut spending in the 1990s, they eventually discovered that deciding to create a common currency allowed them to kick the can down the road. As the US Dollar has proven for decades, a large currency zone affords more mismanagement, in terms of loose budgetary or monetary policy, than a small currency zone.

Just as the euro was pushed through despite the opposition of a large part of the political class, it has now given rise to a transfer union, despite the reluctance of both Northern European politicians, who had to defend to the system of transfers to their taxpayers, and Southern European politicians, who had to accept the conditions and foreign interference linked to the transfers.

Just as the common currency emerged unintentionally, also Eurozone protectionism, which endangers the whole EU project, may emerge as a result of events. When Spanish banks got in trouble in 2012 and frightened Northern European politicians provided Spain with a 100 billion euro bailout, they could only get away with this move, politically, by ensuring that the bailout had strings attached. In this case, the strings amounted to a concession that a Eurozone framework for financial supervision would be created, parallel to the EU framework, to supervise Spanish and other eurozone banks. The ECB was entrusted with this task, and thereby directly ended up in direct competition with an existing EU banking watchdog, the “European Banking Authority” (EBA) in London.

One can imagine that after yet another round of bailouts and further, stricter prescriptions for banks, eurozone banks may start to lobby to exclude competitors who enjoy market access in the Eurozone without having to comply with ECB rules. In short: common eurozone rules might easily serve as an excuse for keeping out external non-eurozone competition in the future. The aftermath of the Brexit vote and the many warnings from the continent about Britain losing its single market access hint at the underlying desire to kill off competition from outside the eurozone.

The ECB has proved not to be immune for the protectionist virus. Already a few years ago, it tried to force clearing houses to relocate to the Eurozone if they wanted to continue clearing in euros. This attempt at grabbing business from London failed and the ECB had to back down, thanks to Britain’s EU membership, which allowed the UK government to exert some pressure.

As Britain leaves the European Union, further, more aggressive, attempts will likely be made to export Eurozone rules outside of the common currency zone. This in turn will likely boost anti-EU sentiment in Denmark, Sweden and Poland, which may have their financial institutions barred from the eurozone market. Once the EU’s free movement of capital is damaged, it is only matter of time before the freedom of movement of services, persons and goods comes under fire.

Still the differences within “old Europe” are quite material and this itself may be the reason for a hypothetical future EU break up. It is unlikely that the far right in France or the populist left in Italy will manage to convince the citizens of those countries to leave the euro by referenda, because of fears that savings would be ruined in ensuing banking crises. If the euro does blow up, it will likely be the result of some financial event, not a political one. Such a scenario would force the German government to make a choice: will it only bail out its own banking system or will it bail out the banking systems of the Benelux, Austria, France and Italy as well? The German government would not have more than a few hours to make this choice. Perhaps on the next two occasions when it has to make this choice, it will again decide to bail out the whole of Europe. Perhaps the German government will go much further than anyone can now imagine—but at some point, enough will be enough.

Why would there be financial crises forcing the German government to make such a choice? The answer to this question is not just about the euro. It is related to the nature of our fractional reserve banking system, whereby banks are allowed to only keep a fraction of the funds they owe to their clients in reserve. This is a means by which the total amount of money in circulation can be expanded, which drives down the price of money, also known as the interest rate. This in turn allows governments to refinance their old loans more cheaply, so they can avoid raising taxes. The unsustainable investment following excessive creation of money produces investment bubbles and financial crises. When these appear in Japan or the United States, the odds are high that the respective governments will bail out the whole currency zone, even when this means they have to impose significant financial repression. In Europe, this is more difficult, given that the burden wouldn’t be suffered evenly across the monetary union. Nationalism would pop up as violently as it did in Greece, where anti-German sentiment was rife during the eurocrisis, which even led to a Greek Parliamentary investigation aimed at pushing for German World War II reparation payments.

Why should the EU break up when the euro collapses? There is no reason that it should, but politicians like Angela Merkel have linked the two together, in order to get away with Eurozone bailouts. In 2011, she said: 'If the euro falls, Europe falls'. One can only hope people understand that to have a common currency is different than to have a treaty whereby countries promise not to impose trade barriers upon each other. When banks close and people lose considerable parts of their savings that message may be a hard sell and human folly may rule the day.

Still, one shouldn’t be overly pessimistic. Already now, many have understood that to have savings in the bank is a risky undertaking, and that it’s probably a good idea to shift a part of one’s wealth into hard assets like real estate, stocks and physical gold and silver, despite the fact that also these investments come with great volatility and risks. Today in 2016, only a tiny part of services are compensated in private “cryptocurrencies”, of which Bitcoin is the most popular, but this will only grow. This kind of currencies have proven to be very volatile and risky, but at the same time they have proven to be a very effective way to avoid capital controls, while the technology behind bitcoin, blockchain, has now been adopted by major banks. If in 20 years time, one third of transactions would be in private currency, a breakdown of the public money system in Europe may be much less traumatic than it would be today.

Another alternative is of course that we could just see the German government effectively allowing the full erosion of savings in the Eurozone in order to save the euro-project, but this isn’t likely, given the current German hostility against such payments. Some may think that common Eurozone joint debt issuance may save the Eurozone, but this overlooks the fact that the ECB has been the crucial actor in propping up the currency zone, precisely because there was no political support for doing bailouts in a more transparent manner, through the eurozone’s lending schemes, such as ESM and EFSF. According to prominent German economist Hans-Werner Sinn, the ECB has provided for about 75% of the bailouts in the Eurozone.

Alternatively, we could see moves towards a world currency, in the framework of the IMF’s “Special Drawing Rights” (SDR). In the same way that the decision to create the euro effectively bailed out struggling European welfare states, the debt-crippled industrial nations of today may get a few decades respite as a result of beefing up the SDR system. US economist Jim Rickards suggests that the world’s bad debt could be rolled up the into the Special Drawing Rights (SDR), which he thinks is also why China has been buying SDRs on the market.

Of course, there are two sides to this coin, and savers would pay the price for such a move. Perhaps there may simultaneously be moves to reboot the system. There may be “bail-ins” or operations to recapitalize banks through the shrinking of the money supply, similar to what happened right after World War II.

Britons had a lot of reasons to vote to leave the EU. What they most certainly did not like, was that the club which was supposed to be about scrapping trade barriers turned out to be a club mostly centred around a common currency helping to boost an ever-centralising bureaucracy and helping to prop up virtually bankrupt European welfare states. Without the eurocrisis, which gave the EU such a bad reputation, the British may well have voted to stay, despite concerns about freedom of movement. Brexit is just the first big blow the euro has inflicted on the European Union.

At the moment, elites in Berlin, Paris and Rome still believe they will manage to save the euro project through a “transfer union”, despite the fact that the large eurozone transfers since 2010 (and before, through the ECB) have done little to mitigate the crisis. Given the series of euro crises that will continue into the future, and which eventually may lead to its demise, it is now crucial to make the case for an arrangement in Europe that secures the right to do business and move cross-border, and make sure this great part of EU cooperation isn’t tainted by the failure of the euro. Otherwise, the enemies of free and open trade will happily seize the occasion to kill the EU, alongside with the euro.

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