Problems Facing the Euro: Eurotrash

Justice Litle tells us of Problems Facing the Euro, and why the Euro is not going to replace the dollar as the world’s reserve currenct anytime soon.

“Rumors of my death have been greatly exaggerated.”
— Mark Twain

IN THESE DARK days for the dollar, it is oft suggested, or at least implied, that the greenback’s status as world reserve currency is coming to an end. Supposedly, it’s only a matter of time before the world’s central banks and international crime syndicates diversify a substantial portion of their reserves…and thus, slowly but surely render the dollar’s hegemon status null and void.

In elementary school, we used to play a game called “king of the mountain.” It was an exceedingly simple game. You found a small hill or a large pile of dirt, climbed on top and declared yourself king of the mountain. If someone succeeded in pulling or wrestling you down, you were dethroned — in which case, the challenger claimed the crown, or the throne stood empty.

So which currency is supposed to dethrone the dollar? The euro?

Beginning to look doubtful.

The euro is a wonderful idea, floated by a charming group of countries. Many thought it would never happen, that it couldn’t be pulled off even if it did happen, that the transition would be a nightmare.

Problems Facing the Euro: One serious, One Potentially Fatal

Thanks to Europe’s political will — and willingness to gamble — all those fears were proven incorrect. But now, just as the dollar should be sinking into the muck and the euro rising triumphant, there is just one problem. The euro’s greatest champions — France and Germany — are on course to destroy it.

Not intentionally, of course. But intentions don’t count. Actions do. There are two problems the euro must deal with: one of them serious, but not life threatening; the other potentially fatal.

The first problem is the demise of the Stability and Growth Pact, which would be more aptly named the Profligacy and Hypocrisy Pact. The pact has existed in one form or another since 1997, and was created at the insistence of “responsible” countries like France and Germany. The basic concern was that smaller countries with a history of lax budgets, like Italy and Portugal, might take advantage of monetary union by going on a spending binge, knowing that they would not be fiscally punished for their imprudence.

When countries share a currency, it is a bit like business partners sharing a mutual credit rating: Your good credit will be of benefit to your partner, but his bad credit may tarnish yours — especially if he continues to make bad decisions.

Of course, things didn’t work out as planned. France and Germany, the supposedly responsible parties, turned out to be the biggest hypocrites. They have broken the rules of the pact for three years running and completely ignored the penalties they were so insistent on creating. Their lead by example has been inspirational to the smaller countries: Greece, for one, has merrily let its fiscal policies go to hell in a handbasket.

At this point, the Stability and Growth Pact is a bit like a lame watchdog that has had its teeth pulled. Better for it to be retired or put to sleep. But France and Germany continue to pretend it still has meaning. Rather than admit the pact has been trashed, they have shot it full of holes with “exemptions” and “special exceptions” to explain away their dubious overspending.

This utter lack of fiscal discipline has not been penalized yet, but it will be an albatross around the euro’s neck when the next downturn comes. If Europe is having trouble reining in spending now, just imagine what will happen in the next global liquidity crunch. Keynesian spending instincts are ever present for politicians; when things go from bad to worse, the instinct only gets stronger. With the demographic time bomb factored in, Europe’s overgenerous welfare and social programs are not remotely sustainable.

Similar fiscal discipline issues apply to the dollar, but with important differences.

First off, the dollar is already established as the world’s reserve currency, with a long history of political stability and the proven resilience of the U.S. economy behind it. In contrast, the euro is still an infant — and thus still susceptible to crib death — backed by a far less flexible group of economies.

Secondly, the dollar is issued by a single sovereign entity and subject to the decisions of a single government. This makes it far easier to take extreme measures in the event of a financial crisis. The euro, however, is essentially an unproven social experiment, the result of union between a dozen (soon to be more) sovereign governments. There is no guarantee that France, Germany, Italy, Ireland, Portugal, etc. could agree firmly on ANYTHING in a time of financial crisis.

The euro’s utter lack of fiscal discipline is a serious, but not fatal, problem, as the dollar has fiscal issues of its own. In this regard, the poor balance sheets may largely cancel each other out, with an important caveat (the dollar likely withstanding a major financial crisis, the euro likely not).

Problems Facing the Euro: The Political Will of France

The second problem the euro faces is much more grave. It is rooted in the political will of France, and to a lesser extent, the lack of political will in Germany. To understand the root of this problem, it is necessary to take a look at the reasons why France found the European Union — and monetary union — attractive in the first place. As The Economist explains in a March 26 article covering “the rise of a new Euroskepticism” in France and the potential for a “no” vote on the EU constitution:

 “From a tender age, French voters are taught the virtues of Europe. For political leaders, on left and right alike, Europe has been the means of preserving and projecting French power in a world that was otherwise eroding it. In short, Europe offered comfort: protection from decline; reaffirmation of their social model; the foundation of peace.

 “This sense of comfort is now falling away. In its place, Europe is increasingly seen as a menace; a destroyer of privileges and a source of new threats.”

 The Economist then goes on to highlight two recent issues that are rankling the French: the European Commission’s directive to liberalize services and discussions of potential membership for Turkey in the European Union.

The thrust of the matter is that France has been a longtime champion of Europe, and thus of European political and economic union, because Europe has always served France to its own ends. It has always been the cock of the walk, so to speak, and it always expected to be such.

But now, there is a sense of losing control, and France is seeing a slow build of resentment all the way down to the grass-roots level. There is a real chance that it will show its displeasure by voting “no” to a referendum on the European constitution, scheduled for May 29 this year. If France or any other EU member votes no in coming months, it could open the door to a full-blown crisis of confidence.

This trend is potentially disastrous for the euro because it can only get worse. France is not just objecting to a loss of image and status (though that is very much a part of its resentment). It is actively opposed to economic liberalization, as well. (Remember that in Europe, “liberal” has a very different connotation than in the United States; economic liberalization is shorthand for moving toward free markets and lessening the heavy hand of government.)

The French are also actively opposed to a breakdown in pan-European political aspirations. The French vision for Europe is to see a continental political machine acting as a new power in a “multipolar world” (Chirac’s terminology) — with France pulling the levers, of course — rather than a laissez-faire conglomeration of countries that is, horrors, more interested in making money than preserving culture and influence. Once again, from the same Economist article:

“It is this notion of the ‘wrong sort of Europe’ that mobilizes the no campaigners [those who would vote no to the referendum]. Laurent Fabius, the Socialist Party’s No. 2, supported Maastricht, and still calls himself ‘fundamentally pro-European.’ But now he fears that ‘Europe will become just a free-trade zone.'”

And therein lies the rub. If Europe were to become “just a free-trade zone” as Fabius fears, that would be the optimal scenario. It would be the best thing that could happen for Europe — and thus for the euro — in the long run.

Problems Facing the Euro: The Worst Outcome for France

But it would also be the worst outcome for France.

In a mere “free-trade zone,” where free markets had the upper hand, France’s social policies would be subordinated. The 35-hour work week, mandatory four weeks of vacation, over-generous pensions, domination of unions and state-backed “champions” of French industry… all would eventually fall by the wayside.

French political dominance would be ground away to nothing. Imagine how distasteful it would be if Chirac and France were forced to view the likes of Italy and Portugal as equals in the backroom… and to be rendered impotent in the face of vulgar economic liberalization, with no consideration for the “French way.” A true Gaullist would sooner drink Bartles & Jaymes or use American cheese in his souffle! Don’t mention those spoiled-brat Eastern European upstarts, either… Turkey is simply off limits in polite conversation.

This essay is a bit tongue in cheek, but the underlying problems are deadly serious. Germany is not nearly as entrenched as France, but it exhibits similar problems. While Germany’s leaders seem to have more political will for economic reform, it is not clear they have the, ahem, testicular fortitude to stand up to their citizenry on issues of key importance.

With unemployment pushing 13%, something clearly has to be done… but in the face of snarling opposition to change, the spirit may be willing, but the flesh is weak. The Wall Street Journal points out a small bright spot for Germany, in that Chancellor Schroder has toned down his alarmist rhetoric regarding the “flat tax revolution” taking hold among the Eastern European upstarts. Being an immediate neighbor to the upstarts, Germany may be positively swayed, if only a little, by their economic vigor. But this is small comfort in comparison to the looming challenges.

These problems will not go away. One way or another, they must come to a head. As France and Germany lead the EU down a path of rationalization for reckless spending, as France realizes with greater horror that it is no longer cock of the walk and as the new upstarts show greater evidence of smashing the status quo rather than accepting it, odds of an internal clash leading to a European Union crisis — and a potential demise of the great social experiment that is the euro — increase by the day.

In closing, a comforting thought. When all fiat currencies leave an equally bad taste in the mouth, we certainly know where to go.

Justice Litle,
o-editor of Outstanding Investments
April 6, 2005