13 March 2015

The Fall of the EURO

The acceleration of the €’s fall to $ 1,06 as I write these lines, against $ 1,40 last May last May amounting to some 24%, gives pause for thought.

Several months ago, scores of politicians, economists and commentators were vociferating against the “strong” € considered to be responsible for the sluggish economy in particular of exports. Today those voices are silent as the fall in oil prices, the rebound in the US economy and quasi zero inflation add new factors that should support EU growth.

Nevertheless, citizen’s disillusionment over the EU is reaching new heights as demonstrated by the electoral breakthroughs – confirmed or announced – of extremist Europhobic parties. Their success is further comforted by the weakness of governments who consistently blame the EU for their own shortcomings.

While President Juncker is advocating building an integrated European defence capability in order to address the geopolitical threats ((Ukraine – Middle East – Africa) and his Commission follows through on existing initiatives aimed at deepening EU/EMU integration (TTIP-Banking Union) and starts work on new groundbreaking policies (Capital Markets Union – Energy Union), never have the disagreements between Member States appeared so great, undermining the expected solidarity between them.


The fears surrounding “Brexit” or “Grexit” illustrate these disagreements. Each has the capacity of jeopardising the progress made since 1952. The implosion of the EU/EMU would have catastrophic consequences, a fact that the majority of Greeks have well understood but leaves a most British indifferent. That is why “politically correct” appeals calling for all Member States to abide by the rules are being expressed: the Eurogroup to Greece, the Council/Commission concerning the European Semester and the ECB for structural reforms to accompany its monetary policies.

In this highly unstable environment, the behaviour of financial markets leave most observers perplex. The € had retreated – in relation to the $ - ever since the possibility followed by the announcement and finally the implementation of QE was mooted last summer. This movement was reinforced by American monetary policies which in turn suspended QE, announced a future tightening and is now waiting for the decision. The implementation of these diametrically opposed policies has lead to record low levels of interest rates as well as high stock market indices. This trend could continue insofar as movements associated with the low (negative) € interest rates (which are close to their floor) are relayed by an increase in $ rates, leading to further depreciation of the €; this appears however far from justified based on any form of economic or financial fundamental analysis, unless…..?
 


Indeed if, in parallel to its official pronouncements calling for structural reforms and further budgetary discipline, the ECB had doubts that its exhortations will be heeded, would it not be prudent for the Bank to consider a “Plan B”? The media have echoed the existence of contingency plans prepared by some Member States (and some non Members) of EMU in case of an implosion of the single currency; would it not be normal that the ECB had its own?
 


What follows is pure speculation; it is not based on any factual information. Neither does it constitute a recommendation but simply attempts to provide an explanation for the current problematic situation.
 


If there was to be a reinstatement of national currencies, would it not be far easier to manage it if the € was worth $0,83, its low historical value reached in 2001. Should it be the case, then the legal concept of the “continuity of contracts”, that underpinned the introduction of the single currency could largely be upheld. Instead of an series of “devaluations” relative to the € which would lead unavoidably to the default of Greece (and other Member States), the “new drachma” could maintain a parity close to $ 0,83 while the other “new” national currencies could revalue in varying proportions. Their debts, which would remain denominated in €, would be devalued accordingly allowing each country to decide on its own between a “strong” currency which would reduce its outstanding debts to a larger extent and a “weaker” one that would reinforce its competitivity. Several countries could agree to recreate a “currency snake” limiting fluctuations between them.



By avoiding the default of its Members, the ECB would protect its own balance sheet. It would be necessary to reinstate as soon as possible a free foreign exchange market which would allow the new European national currencies to adjust between themselves and also versus third party currencies. The European “single market” should also be preserved leaving to the market to adjust rather than having recourse to protectionist measures.
 


This scenario, if credible, could explain the recent performance of stock markets because the value of individual shares tend to adjust to their intrinsic characteristics and should therefore be privileged in case of an “orderly” dismemberment of the €.As far as bond investors are concerned, they would already have borne the brunt of their losses progressively as a result of the fall in the value of the €.
 


This process would need to be validated, with tools that are not available to me, in the event that my preferred scenario – completing EMU on a “federal” blueprint – would be out of reach. A careful preparation could possibly preserve the essential aspects of the “European dream” before re-launching its march forward on a healthier basis.


Paul N. Goldschmidt
 is Director, European Commission (ret.); Member of the Steering Committee of the Thomas More Institute.

© Paul Goldschmidt