Lessons from the Euro

by: Adele Wick 17. May, 2010 0 Comments

Last Monday, the Euro soared against the dollar after a near-trillion-dollar bailout of the currency that unites the European Union (EU) was announced. This Monday, it dropped to a four-year low. What are the lessons here, and are we going to listen to them? The first lesson is that the real value of a currency depends mostly on two things. The first is quantity and the the second is the strength of the economies behind it. Propping it up with expensive bailouts is not a long-term solution. These days, it doesn’t even look like a short-term fix.

Absent profound technological change in the way transactions are facilitated and great vacillation in interest rates , the demand for money grows one on one with growth in the economy. When the money supply increases too fast, equilibrium is achieved in two ways: inflation reduces its “real” value to what we want to hold or its home country gets rid of the excess by sending it abroad, importing more than it exports.

Paper money has virtually no intrinsic value. We value it for what we can exchange it for. In other words, the strength of the Euro depends on the strength of the economy it represents. In this case, it’s the combined strength of the sixteen countries that comprise the EU. Greece’s fiscal and financial crisis both brings to global scrutiny the faltering fiscal health of several other countries in the union and makes their situations even more dire as their governments contribute funds to Greece’s bailout rather than bringing their own balance sheets into less financial disarray.

Money facilitates exchange. This is a huge benefit. Without it, we’d be back to barter, where we can buy something only if we have something else the seller wants. The question is this: how big should a single-currency area be?

The decision to forgo one’s own national currency and instead unite with other countries in using a common currency are not without costs. First, each nation in the zone loses the power of independent monetary policy. Second, it loses the ability to adjust some relative prices across national boundaries by devaluating its currency.

For many countries, the first loss is really a gain. It imposes discipline. Excessive expansion of the money supply causes inflation, not enduring growth in the economy and reduction in unemployment. For small developing countries, this discipline also increases credibility.

The second loss involves cost adjustments. A change in the exchange rates of trading partners adjusts relative costs. One reason Greece is in trouble is that its labor costs are too high relative to worker productivity. If Greece were operating with the drachma instead of the euro, the drachma would decline and make Greece more competitive — or less uncompetitive — with its trading neighbors. Absent this relatively automatic adjustment, Greece needs to take political actions to reduce its costs. And one of the main sources of skepticism over the value of the Greece bailout is lack of confidence in Greece’s political will and ability to abide by austerity measures that are part of the rescue package.

What now?

Here are the lessons. First, stability in the common-currency area of the EU requires fiscal rules and their enforcement. The Maastricht Treaty was supposed to insure fiscal sobriety, but clearly it lacks teeth. Second, the euro is in trouble because the EU is in trouble; it cannot be rescued without treating the underlying causes. Third, budgets need to be respected on several levels — individuals, cities, states, governments and countries can all go bankrupt. Fourth, these consequences are hard to keep isolated. They spread across the globe, quickly.

Is America listening? Do we realize that these lessons apply equally to us, a common-currency area of states rather than nations? Some Americans are pleased by the decline of the Euro relative to the dollar. French wine and cheese are cheaper, as are trips to Rome. It now seems highly unlikely that “petro-euros” will replace “petro-dollars” as the measurement unit for oil prices and the currency in which many transactions are made even when no partners to the trade live in the United States. These are nice results, but they may be offset by declining exports to the UE and their effect on a home recovery that’s far from robust. EU difficulties appear to be spreading across the globe, quickly.

Watch out, America. Our problems are not unlike Europe’s. We, too, are on a course of unsustainable growth in debt and deficits. Some of our states are in worse shape than others.

Surveys show that 55-70% of American dollars are held outside the United States. They got there in good measure because of trade deficits — nifty exchanges of paper for real goods and services in exchange for slips of paper. They stayed there because they were considered a decent — steady, safe — store of value. The America dollar may look better than the euro at present, but competition from other currencies backed by the economies of countries with more sober fiscal and monetary policies and cheaper goods for exchange is on the rise. No country can afford to live beyond its means for long, much less forever. Currencies may just be the canaries in the coal mines, the first strong sign of trouble ahead.