We're All Becoming Germans Now, Except The ECB

Includes: ERO, EU, EZU, FXE, IEV
by: Shareholders Unite

Some previous episodes of European efforts in monetary integration and containing currency fluctuations provide curious insights into the nature of the present crisis and the wide-ranging effects of its proposed solutions.

Exchange Rate Mechanism

In the late 1980s and early 1990s, Europe had its Exchange Rate Mechanism (ERM), the precursor to today's European Monetary Union (EMU). There were rather heated discussions (in Britain) whether Britain should join. Thatcher was against it but her Finance Minister (or Chancellor of the Exchequer, as they're called over there) in those days, Nigel Lawson, and a few others were in favor.

In the end Britain joined, but a couple of years later they were unceremoniously evicted through the hands of George Soros (and company) who betted, correctly, that the British could not raise interest rates in the middle of a recession to keep the pound tied to the German mark and that they would have to let the link with the D-mark go.

Germany was experiencing a boom as a result of the German reunification and, completely on cue, the Bundesbank raised interest rates to contain the risk of overheating and inflation. Basically, the German reunification was an 'asymmetric' shock; it affected only Germany but not the rest of the fixed exchange rate system.

Insight 1: It is very difficult to maintain fixed exchange rates between countries experiencing different economic circumstances.

After Britain was kicked out of the ERM on Black Wednesday, the Chancellor of the Exchequer (Norman Lamont, Lawson's successor) was famously singing under the shower. Although the whole situation was politically very humiliating, economically it was exactly the opposite. Britain could reduce interest rate fast and the currency devalued significantly once the ties to the D-mark had been severed, and the economy quickly came out of recession.

Insight 2: Adjustment mechanisms are highly important in dealing with asymmetrical shocks.

The basic thing that is wrong with the eurozone today is that it has insufficient adjustment mechanisms. Britain in 1992 could devalue its currency and lower interest rates, but with one currency, this is no longer possible today for the likes of Greece, Spain, Italy, and Portugal. Some, but only some, noted the deep underlying consequences.

Nicholas Ridley, Minister for Trade and Industry under Thatcher, gave an interview to the Spectator in which he called plans for a single currency (the plans would lead to the Maastricht Treaty and EMU) as a German racket designed to take over the whole of Europe and said that giving up sovereignty to Europe was as bad as giving it up to Adolf Hitler. The interview was illustrated with a cartoon depicting Ridley adding a Hitler moustache to a poster of the German Chancellor Helmut Kohl.

This cost him his job, of course, and he was much ridiculed at the time (including by us). We wrote at the time (1990) that he got it exactly backwards. The European Monetary Union (EMU) wasn't a German plan for European domination or some form of Fourth Reich by economic means; rather, it was much more an Italian and French plan to escape German monetary domination.

Asymmetrical adjustment and deflationary bias

The point was, under the ERM, Germany, as the anchor country, did have a monetary freedom that other countries simply didn't have. In Amsterdam, we quipped that the Dutch central bank enjoyed about 45 minutes of monetary independence as that was about the time frame it usually followed German changes in interest rates. If it failed to follow German lead (this happened once), the spread between German and Dutch bonds widened and the guilder would move down in the currency band.

Germany set its policy with regard to German economic conditions and the other member countries were supposed to follow or jeopardize the link between their currencies and the D-mark, whether the German monetary policy conditions suited them or not. When the currencies of (trade) deficit countries came under attack, they were supposed to defend them with currency market intervention, higher interest rates, credibility boosting measures (like reducing demand) or, as a measure of last resort, realigning the value of the currency against the D-mark.

That is, the ERM was highly asymmetrical, with the burden of adjustment falling exclusively on deficit countries without any reflationary (demand boosting) compensation from the surplus countries. This gave the whole system a rather deflationary bias. Efforts to make this system more symmetrical by obliging both the central bank of the strong (invariably Germany) and the weak currency to intervene did not work in practice as Germany invariably sterilized the effects of these currency market interventions.

Insight 3: By fixing their currencies to the D-mark, the member countries of the ERM obliged themselves to become more German as the burden of adjustment fell upon them.

This state of monetary leadership was acceptable for a small country like the Netherlands (for whom Germany is by far the most significant trade partner), but much less so for bigger countries like Italy and France. Under the EMU, at least they would have equal seats at the table of the European Central Bank (ECB) with the Germans, and policy setting would be joint, rather than the single prerogative of the Germans.

European Monetary Union (EMU)

And so EMU happened. But has German dominance or asymmetric adjustment gone away? Perhaps for the first decade, but in today's eurozone crisis, these fixtures of the old ERM have come back with a (rather terrible) vengeance.

In the first decade of EMU, the periphery (as well as others, like Iceland, the UK and the US) could suddenly embark on a wall of cheap credit, with money flows coming from the center attracted by the sudden disappearance of currency risks. This led Michael Lewis to argue that:

What they wanted to do with money in the dark varied. Americans wanted to own homes far larger than they could afford, and to allow the strong to exploit the weak. Icelanders wanted to stop fishing and become investment bankers, and to allow their alpha males to reveal a theretofore suppressed megalomania. The Germans wanted to be even more German; the Irish wanted to stop being Irish. All these different societies were touched by the same event, but each responded to it in its own peculiar way.

Well, that liberation from the Bundesbank lasted for almost a decade, exactly the decade in which the periphery, fueled by cheap credit and capital inflows, allowed its competitiveness to erode by some 30% or so (depending on the country).

But this has all gone terribly wrong and, once again, the burden of adjustment falls solely on the periphery. So it could be said that Ridley had something of a point after all (even though the way he delivered it was particularly crude).

Indeed, this has been said, in the same Spectator and by the son (Dominic) of the then Chancellor of the Exchequer, Nigel Lawson. Here is some more stuff what Ridley said in that remarkable interview in 1990 (from the recent Spectator article):

I’m not sure I wouldn’t rather have the shelters and the chance to fight back than simply being taken over by... economics. He’ll soon be coming here and telling us that this is what we should do on the banking front and this is what our taxes should be. I mean, he’ll soon be trying to take over everything.

Now, if you replace Britain by Greece (or Italy, or Spain), it turns out Ridley did have something of a point. Indeed, when we read the (still vague) German plans for a 'fiscal union,' there can be little doubt that the powers (either from the intergovernmental Council, as the French want, or from the Commission, as the Germans seem to want) from those proverbial 'unelected bureaucrats' will be considerable.

The Germans basically want the others to become more German, and to what extent that is possible remains to be seen. It also remains to be seen how tolerant populations will remain in the face of this large scale 'social engineering.' Then again, what is the alternative? In a way, it's deeply ironic, as the onset of the EMU was highly liberating for the peripheral eurozone countries.

Insight 4: Once again, all the burden of adjustment falls on the periphery and they will have to become more German. But this time around, there isn't the safety valve of escape in the form of devaluation, nor some ploy by Italy and France to limit the power of the Bundesbank.

However, this might be in exchange for the ECB becoming less like the Bundesbank. The jury is still out on that one, so...

Insight 5: The price for saving the euro is for the periphery to become more German, but for the ECB to become less German.

Has it all been worth it?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.