Why the Euro is bad for Europe

Money is debt. Yes, I know that sounds weird, but the tenner in your wallet may be an asset to you, but it’s a liability to the Central Bank of whatever country you happen to live in. Now it used to be in some countries you could swap your banknotes for a fixed amount of gold. There are reasons, that I’ll tell you about in a minute, why you can’t do that any more. So what makes our money……..money? The simple answer is that it’s money because the government says it is. The whole game is played with mirrors. Remember a few years back the banknotes used to say “Promise to pay the bearer on demand…….” If you take in your tenner they’ll give you another one in exchange. Eventually someone realised it was a bit silly so they don’t say that anymore. Money has value because of 1) its general acceptability and 2) its relative scarcity compared to the demand for it.

Now about the gold standard. It used to worry people that paper currency had value just because somebody said so. What was to stop governments printing and spending money at will, creating runaway inflation? The gold standard required governments to keep a reasonable fraction of their currency liabilities as gold. The central banks could create currency liabilities (ie print money) up to a certain multiple of its gold reserves. Gold coins used to circulate as part of the money stock.

But the gold standard had two huge unintended consequences. Firstly, it removed exchange rate risk across national boundaries (of the countries using the gold standard), facilitating massive lending based on the confidence that the debts would always be repaid because they were backed with gold. Secondly, any variations in the quantity of gold held by the central banks had an exponential effect on the money supply. This was ok when confidence was high and people were happy to hold bank deposits and paper currency. But during the Great Depression people became frightened. and tried to switch their assets into safer forms. Foreign holders of US dollars were particularly anxious to swap them out for gold, especially after Britain suspended the convertability of the pound into gold in 1931. As the gold reserves declined, the monetary system came under strong contractionary pressures, exactly what it didn’t need at that time. The gold standard was abandoned soon thereafter. In the words of British economist DH Robertson: The value of a yellow metal, originally chosen as money because it tickled the fancy of savages, is clearly a chancy and irrelevant thing on which to base the value of our money and the stability of our industrial system.

What I’m taking a long time to get to here is that we find ourselves in an eerily similar situation today. We have a strong creditor nation lending across national boundaries with no exchange rate risk, with the expectation that the loans will be repaid because, even if there was a crisis, the euro would be sacred in the minds of European politicians. The “credibility” of the system has to be maintained at all costs. So as our debts mount, we are lent even more money so we can pay back the earlier loans. At the same time, we are being told to cut back on spending at the very time when we should be doing the opposite.

Let’s be clear on something. These bailouts are not bailouts of the Irish people, or the Greek people. They are bailouts of the French and German banks who lent recklessly to us during the boom. Now you, the people, are being asked to shoulder the burden of the risk that should belong to the banks. At the same time you are being told you have to do this to maintain the credibility of the system, which all the while becomes more and more incredible.

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7 thoughts on “Why the Euro is bad for Europe

  1. First, I don’t understand why the removal of “ exchange rate risk across national boundaries (of the countries using the gold standard)”, is a problem. I usually see that word “risk” as a bad thing in economics… as in there are no guarantees that this venture is going to be profitable… hence risk. You seem to explain this by the statement “facilitating massive lending based on the confidence that the debts would always be repaid because they were backed with gold. I understand this to mean that it instilled confidence because the debtor nation could not simply print currency and repay with worthless paper. Would that be a correct understanding?

    Second, you seem to suggest that an unintended consequence of the gold standard was that it “removed exchange rate risks across national boundaries”. Then you say later in paragraph 4: ” We have a strong creditor nation lending across national boundaries with no exchange rate risk,”. But this time it can’t be blamed on gold. So there had to be another reason that this could be done that has nothing whatever to do with gold… right?

    I try to keep in mind a couple of things here. One is that I realize that this article is not about gold, per se, but rather to explain something that you see as just as bad as a gold standard: the Euro.

    My explanation is that it is not the gold standard, or the Euro, that is the cause of the problem as much as it is the breakdown of morality, which if I remember correctly, you see as a different field of study. Well perhaps. Meteorology is a different field of study than farming too, but the farmer still depends on water.

    When money is lent there are two parties making moral agreements. One promises to repay, the other trusts to be repaid. If the promisor is serious, he will not borrow more than he can repay. If the lender is serious, he will not lend what he does not trust can be repaid. I am suspicious in our modern age that politicians don’t really care much if creditors ever get repaid, they are way more interested in the short term which goads them to borrow borrow borrow, so they can keep their political seats. It’s always easier to run campaigns as Santa Claus don’t you think? This is a blight on the politician, yes, but I think it speaks more to those who keep voting them in. My thoughts are that we here in the US have pretty much cornered the market on the borrow, print, tax and spend to get re-elected chicanery.

    Whatever happens to you guys in Ireland, I feel certain that it is only a prelude to what is for sure coming here in the U.S.

    All this said, I am not an all out gold standard person. I truly was interested on your take. I realize gold is dug out of the ground and as such it’s supply is not constant, and beyond being pretty is not really worth that much. But it is scarce, and as such protects the people against government imprudence and political expediency.

    • You’ve raised some very good points here, so I’d like to address them one by one:

      First, I don’t understand why the removal of “ exchange rate risk across national boundaries (of the countries using the gold standard)”, is a problem.

      It becomes a problem when the capital inflow to the debtor nation causes a domestic distortion based on unrealistic expectations of future growth, like the housing bubble in Ireland.

      I understand this to mean that it instilled confidence because the debtor nation could not simply print currency and repay with worthless paper.

      The lending was driven by supposedly efficient German and Dutch banks, acting as the financial intermediary between the rest of the world and the Eurozone periphery. Skewed managerial incentives, the intensification of competition and , most importantly, the expectation of being too big to fail led to these institutions becoming dangerously over-leveraged. They knew that their governments would bail them out, as the alternative was the collapse of the sacrosanct euro.

      My explanation is that it is not the gold standard, or the Euro, that is the cause of the problem as much as it is the breakdown of morality, which if I remember correctly, you see as a different field of study.

      What I said was that we can’t look to an entirely free market to solve a problem like homelessness. That’s a bit different than saying morality plays no part. I actually wrote a little diatribe last year bemoaning pretty much the exact same thing that you do.

      If the promisor is serious, he will not borrow more than he can repay.

      It’s all about expectation. I don’t believe that anyone who bought a house during the boom years in Ireland ever thought that they would not be able to repay the debt. We were awash with money, unemployment was almost zero, everyone felt wealthy, and nobody listened to the “doomsayers” who were warning us that it was all an illusion.

      If the lender is serious, he will not lend what he does not trust can be repaid.

      The lenders had every trust that it would be repaid, and they have been proven right. The Irish public now own all the failed banks and we are having to cut spending on vital public services to repay even the unsecured bondholders in these banks. Why, you may ask? Because the “credibility” of the euro must be maintained at all costs.

      Whatever happens to you guys in Ireland, I feel certain that it is only a prelude to what is for sure coming here in the U.S.

      What do you see as the parallels? You have your own currency, so you have a vital tool that we don’t – monetary policy. Ireland ran a budget surplus (as did Spain) right up to 2008, so the standard right wing mantra about the financial crisis being caused by free-spending governments does not hold up. You could be heading for a stock price bubble, but any losses resulting from a stock market crash are unlikely to be nationalised, unless the stockholders are themselves all large, highly leveraged institutions, which I don’t think is the case.

      • Just to keep it simple, I’ll take your first point:

        It becomes a problem when the capital inflow to the debtor nation causes a domestic distortion based on unrealistic expectations of future growth, like the housing bubble in Ireland.

        Normally capital inflow is an economic positive. I think I differ with you on “unrealistic expectation”. Oh, not that there wasn’t such expectations, but I think that those expectations were more of a symptom than a cause. My question is, what caused the unrealistic expectations?

        In the US it was caused by easy money. Anyone who could fog a mirror could get a loan to buy his very own mcmansion, or maybe two. This of course created faux demand… until the assets began to decline. But then this raises another question. What caused this easy money? That’s easy. There was no risk because the loans were backed by the government. It was a wonderful example of a moral hazard.

        It’s interesting that this was a global bubble however. It raises a few questions that perhaps you can help me answer. Where did the Irish Banks get the money they loaned out to create the bubble? Was the money that drove the bubble created from debt, as you point out in your first sentence? Or did it come from investors of other countries?

      • The Irish banks got the money from foreign investors, directly it was from other European banks, indirectly from whoever, in turn, had invested in those banks. As I mentioned elsewhere, government borrowing did not play a part in Ireland’s crisis. Here we had a banking crisis that became a public debt crisis, because the bank guarantees went much further than they should have (to just protect depositors). In Greece and Portugal, a public debt crisis became a banking crisis. Same result, very different cause.

  2. BTW, I thought of you today. There was an editorial in our Wall Street Journal titled: “Don’t Blame Ireland for America’s Tax Blunders”, by John Bruton and Kevin Murphy.

    It seems that one of our esteemed senators, in an investigative committee hearing, described Ireland as a “tax haven”. It went on to explain why the problem wasn’t Ireland but the U.S.’s tax code.

    • I’m very much in favour of low corporation tax, but it’s a little worrying that such a focus is being put on Ireland. Especially because last year we signed up to an EU treaty which can censure us for anything that causes a “structural deficit” (a deficit caused by policies rather than external shocks) – France, Germany, UK et al have never liked our low tax rate, and I wouldn’t be surprised to see them in the near future telling us we have to raise it, if we don’t manage to reach deficit targets through expenditure cuts, which have been quite savage already.

      • In pondering the EU and this post, am I wrong in thinking that the EU was meant to replicate the U.S.? If that is true, I find it worrisome for Europe. The Governor of Texas is running ads in California in an attempt to get California businesses to relocate to Texas. California would love nothing better than for the centralized government (Washington) to remove this sort of competition between states. I suspect, should we stay on our present course, this will happen. The states have already been reduced to mere counties. Like the EU, this was not the original intention.

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