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The Euro, Germany and Currency Shocks

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Few economic challenges are as potentially destabilising as threats to currencies – or exchange rates. German history, including the rise of Hitler, was a shattering response to the hyperinflation that destroyed savings in the 1920s.  Assets had been destroyed by a currency that in Nov 1923 traded at 67 billion to the US dollar. Inflation that meant money was carried in wheelbarrows; and one needed more and more barrows.
Ever since that time, German unions, businesses and households have been inflation averse to a very marked degree – which made the 1999 Euro decision understandable in non-inflationary times, but unwise given widely divergent economic conditions across Euro nations and an uneven level of fiscal discipline across many European countries.

But let’s go back to the decision to float, not fix, the German currency.  In March 1973, resulting from the US inflation due to the Vietnam War, the German Deutsche mark (DM) really had to be floated in order to respect community inflation fears.  But at that time the Bretton Woods agreement manifest in the IMF policies mandated fixed exchange rates against the US $ and (until 1971) gold.
The inflation resulted from President Johnson refusing to fund the Vietnam war though taxes – so that US inflation was spreading across the fixed exchange rate or unified currency world. By floating the DM and then other currencies, the transmission of the inflation around the world was at least partially mitigated in those countries who floated early. (Australia waited too long.)

What is really weird, given German resistance to fixed rates back in the 1970s, and the artificial unified East and West DM in 1990, is the decision to form the Euro in 1999. While the so-called “European Project” made sense as a free trade area, aimed at economic integration of goods and services in Europe, to go further and force a common currency was bizarre, as was German support. Almost all my academic, IMF, Fed and British colleagues agreed the conditions for monetary union were not present.

Despite the UK and economist scepticism, there were those so enamoured by the lower transactions cost argument, and who liked the champagne (Bob Mundell), that it happened and seemed to go well, assisted no doubt by the long economic boom of the early “noughties”.
Until the Made-in-USA mortgage and derivatives fuelled the Global Financial Crisis was unleashed in September 2008, causing bank failures and massive US, UK and Irish conversion of private bank debt into public debt – on a scale never expected in any reasonable nightmare.

So, in 1999, it was agreed to go the next step in the Maastricht agreement: to share a common currency across Euro countries that aimed to be further integrated, despite very divergent fiscal labour market and regulatory policies. (But some smarter players stayed out, notably the UK.)
As one who worked for the IMF group in Washington D.C. in 1970-72 assisting the German Bundesbank to float the DM, I was always incredulous in the late 1990s that a common currency – the Euro – would be seriously considered. Yet it was agreed across a number of key European countries – nations that in no way comprise what my hero and Nobel laureate Robert Mundell describes as an “optimum currency area”.

From that day on, rather than be able to adjust the domestic currency to non-conforming inflationary or unemployment pressures, or respond to uncommon shocks, the effect of the Euro was that countries as diverse as France, Italy, Germany and Greece would have to share in some averaging of currency adjustment as macro economic conditions varied across countries.
True there were “agreements” on debt ceiling rations and ranges, but the failure of Germany and France to play by these rules made them an immediate joke – as seen more recently in the case of Greece, Portugal and Italy., to name a few.
While the effect of this may have helped the German economy in an almost protectionist way, through an artificially low Euro for them, in the last decade, the overall unemployment levels and economic growth outcomes in the Euro areas have been mediocre at best,  in comparison with Australia and the UK.

The good news within Australia or the US is that while we too have “single currency areas” we also have a largely integrated economy with largely common policy demands. But imagine if there was a Tasmanian Devil as the currency of Tasmania; or a NSW peso! And worse, independent central banks printing Devils or Pesos to suit the political demands of the States is a very frightening thought! Thank God, Keynes or Hayek, we have no such potential.
The reason we don’t want separate currencies around Australia is simply that we are one labour market, we can freely move, and thus the inflationary unemployment or conditions are similar; making the case for a single central bank – the Reserve Bank of Australia – and a single $A.  

We generally endure similar shocks, and we adjust in part by travel, fly-in-fly-out workers in mining towns, and internal migration to the boom states.
And the market changes the $A daily as currency supply and demands change, and as our inflation gets out of line with external inflation. (If we are basically price-stable and the world inflates, then our $A appreciates, as it has over recent times.)

The Patchwork Exception?

Now it is true, the China led resources boom across Australia is having uneven effects. Were there to be a WA “Goldbuck”; might it facilitate smoother adjustment as it appreciated relative to the $A at times like the present. Thereby easing pressures on the other States and say manufacturing or agriculture?
The answer is that given the disruption a separate currency would cause in other ways, nobody seriously favours WA going it alone on currency, despite their stance at federation, although as populations grow, the case is not outrageous.
Which all gives us a clue as to why the (Financially Disunited) States of Europe thought a common currency might deliver stability and growth. They want full integration and the simplicity of a common currency – but they failed to realise how it would restrict their monetary autonomy.
Until now. As they all share the post GFC shocks from the US, and the governments have to bail out banks with excessive lending. Converting excess private debt into excess public debt, in some cases tripping up because of incapacity to service the newly excessive debt.

But the real answer to the US generated GFC2 was simply sound regulation and enforcement of rules in the US. Plus they need major restrictions on contributions from the mortgage industry to Congressman and Senators (I gather they reached $700 million in 2007!).  
Congress has simply exhibited the worst features of democracy and donations when it comes to the vexed issue of financial regulation.
What the USA needed and still needs is Australian style regulation and enforcement, no less!

The main problem with the Euro is that the currency area itself  is far from ideal – the Euro extends to countries with differing labour markets, despite technical freedom to move across boundaries.  Risk criteria differ, as do housing, finance, and social policies. And worse, the $600 trillion of derivatives “made in the USA” are creating toxic Scud missiles capable of bringing down any banking system or local authority foolish enough to be sucked into Credit Default Swaps and other deliberately obscure and regulatory avoidance instruments. Oh for pre-Euro autonomy.

However a floating currency offers no panacea. Ask the Poms. The pound has still suffered from the same excessive private and mortgage debts, securitisation and derivatives. And from the private debts that became public debts with the bailouts of the banks (Northern Rock, RBS)
Furthermore, language, culture, social policies and education systems all differ in Europe such that to share a Euro across Germany, France, Greece, Netherlands and Italy for example is to pretend there is real financial harmony despite missing the pre-requisites.
 

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