The Euro Crisis Is Over

Includes: FXE
by: Herve van Caloen

It was in the late 1970s that President Giscard d'Estaing and Chancellor Helmut Schmidt launched the European monetary system. Already, most pundits knew it would never work.

How could a fixed exchange rate (with some flexibility at first) between Germany and France ever work? The inflation differential between the two countries was just too big and structural. If not cultural.

Without a periodic devaluation of the franc, French companies would quickly lose their competitiveness. France would have to make unlikely fundamental reforms to bring its long-term inflation rate in line with Germany for this new currency system to work. That, the overwhelming majority of experts believed would never happen.

I clearly remember a German manager of a leading company licking his chops. The fixed exchange rate was a wonderful opportunity to run over the economic Maginot Line.

Fast forward. From the "currency snake" to the "ECU," Europe gradually built a common currency, the euro. Pundits again told us the latter would never work. Even before it got off the ground, financial experts in the City condemned it to inevitable failure.

A decade later, these experts thought they were finally being vindicated. Club Med countries were coping with growing deficits and the Northern European countries were balking at more wealth transfer programs. Whereas the euro had brought cheap money to Italy and Spain in the early days, now markets were pushing these rates to stratospheric levels. Something was about to break.

It didn't. Instead of whining, member states decided to follow the logic of a common currency. If a country cannot devalue its way out of misery, structural changes are the only solution. If debasing one's currency is not an option, something else has to give. In an open economy, cost has to adjust.

In particular, labor cost has to come down and that includes more labor flexibility. Don't tell anybody: the euro is all about supply-side economics. This cannot be mentioned in socialist Europe. But make no mistake about it: Europe has put in place a mechanism that gives politicians the needed cover to implement obvious structural reforms. The socialist Gerhard Schroder understood this ten years ago. Today, his more conservative successor is telling the rest of Europe to follow his example.

The euro has now been tested as never before in its short history. Over the last three or four years, politicians have been pushed by the financial markets. They responded the way one expects them to. They moved only when confronted with potential disaster. They took tepid decision after tepid decision. But, gradually, the Europeans have moved to solve the euro crisis.

Here is how it works in Euroland. The southern Europeans have been dragged, yelling and screaming, to more fiscally responsible policies. The northern European countries led by Germany, have been dragged, yelling and screaming, to more monetary flexibility. And now, after many tentative half measures, we have a credible framework to deal with the euro crisis.

It is quite simple. The European Central Bank, under the strong leadership of Mario Draghi, has announced an arbitrage policy between the different bond markets of the member states. The ECB will buy bonds in Spain to push interest rates down when the spread with German bonds gets too wide. By doing so, it makes the Spanish bond market more attractive and will encourage the private sector to participate. In return, Draghi conceded to the very skeptical Germans a sterilization program. The way I understand this is that the ECB will keep its balance sheet at today's (high) level. Whenever it buys more sovereign debt with one hand, it will sell other assets with the other hand. For example, buying Spanish bills while selling German bills.

There is another concession made to Germany. Countries will have to ask the ECB to intervene in their bond markets. The ECB, in return, will be able to ask for more structural changes as a condition for help.

Indeed, this is again about supply-side economics. So far, the markets are buying it. Spain and Italy have not had to ask for help. The mere possibility of such a policy has pushed down their cost of financing.

All this means that euroland is accepting a tough recession. That's the good news! The reforms are hurting. But so did the German reforms ten years ago. Schroder even lost his reelection because of them. However, he built the foundation of Germany's industrial revival and today the country is better off for it.

Finally, as often stated by pundits, the euro may very well be a fabrication of the elites. However, what one has to understand is that the euro is popular. The Dutch elections have once again demonstrated it. The pro-euro parties won an overwhelming electoral victory last week. This in spite of the fact that they too, like their neighbors to the east, are major financial contributors to the many European bailout programs.

But what about the high unemployment rate? Will the Southern European countries tolerate it much longer?

It all depends on the definition of unemployment.

Let's face it. Most people do not want to be unemployed. But with all the European social networks in place, this is not what Americans go through when they lose their jobs. Just imagine yourself on a piazza sipping an espresso after collecting your benefits and waiting for your year-end bonus. You do not make much money, but life is not too stressful and you still have your medical expenditures all paid for by the government. Once in a while, you can even make some extra money doing an "unofficial" job.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.