Global Macro Investing, Part V
(Note: this post is sympathetic to the political views expressed by the author of what I consider to be the best book on the Euro, Philipp Bagus’ The Tragedy of the Euro, available for free on the given link).
The Euro is a currency unlike any other. While most currencies evolved in the free market, the Euro was created by politicians as a replacement to national currencies. The tale of the Euro starts with the tale of the formation of the European Union (EU).
Treaty of Rome, 1957
Europe was always rife with internal strife. The founding fathers of the EU wanted to restore peace and prosperity to the region, and advocated laissez-faire or free markets as the means towards that end. The Treaty of Rome in 1957 was the main achievement towards that end. The Treaty delivered four basic liberties: free circulation of goods, free offering of services, free movement of financial capital, and free migration. The Treaty restored rights that had been essential for Europe during the classical liberal (free-market oriented) period in the nineteenth century, but had been abandoned in the age of nationalism and socialism. The Treaty was a turning away from the age of socialism that had led to conflicts between European nations, culminating in two world wars.
Over time, the socialist agenda took over. A coalition of nationalist, socialist and conservative interests dreamt of a European central state run by efficient technocrats, which would one day become so powerful that the sovereign states within the EU would become subservient to them. A monetary union under a single fiat currency issued by the EU was a step in that direction.
The official line of argument for the defenders of a single fiat currency was that the Euro would lower transactions costs—facilitating trade, tourism and growth in Europe. More implicitly, however, the single currency offers a means to consolidate power during crises. Crises could be used as an excuse to call for the centralization of fiscal policies, which may then be used to harmonize taxation and get rid of tax competition. The monetary union would inevitably lead to a fiscal union, a one Europe state.
The Maastricht Treaty, 1991
The Treaty set down the details of the introduction of the Euro. The European Monetary Institute, the forerunner of the ECB, was founded, and participants in the monetary union were elected. Five criteria for selection were negotiated and established.
Price inflation rates had to be under a limit set by the average of the three aspirants, within the lowest inflation rates + 1.5 percent
Public deficits had to be not higher than three percent of GDP
Total public debts had to be not over sixty percent of GDP
Long term interest rates had to be under a limit established by the average of the three governments paying the lowest interest rates + two percent
Exchange rates had to stay within the limits set by the European Monetary System. The fulfillment of these criteria was facilitated by the political will demonstrated in favour of the Euro. The support from the stronger countries in a common monetary system implied that interest rates converged. As expectations for an entry in the Eurozone increased, highly indebted governments had to pay lower interest rates. Also, inflation rates decreased in highly inflationary countries as people expected a lower inflation of the Euro than they did of the preceding national currencies.
The Tragedy of the Commons
The tragedy of the commons is an example of how socialism destroys the environment. An un-owned pastureland is used by shepherds to graze their flock. For each shepherd, adding to his flock increases his profits whereas the costs of depletion of the pasture are shared with all the other shepherds. Hence, it makes economic sense for all the shepherds to increase their flock regardless of the damage they cause to the pastureland – the costs are socialised and the gains are their own.
The Euro is the pastureland. A government running a high fiscal deficit and accumulating debt destroys the value of the currency, but the costs of that destruction are shared across the Eurozone, whereas the immediate benefits of government spending are enjoyed by those in power. The rules established in the Maastricht Treaty to prevent this occurrence have long since been flouted openly by all the countries.
The sovereign debt crisis of 2011 is only the first indication of worse to come as the pastureland gets degraded. Greece is only a symptom of the deeper problems that exist with the Euro. Either the socialist vision of fiscal integration is realised (equivalent to the shepherds forming a syndicate) or the Eurozone countries do what’s best for them in the short-term and ultimately end up destroying the currency. The outcome is binary. A third option, which has not been provided for in the original treaty, is a country exiting the European Union and giving up use of the Euro.
Meanwhile, the Euro is viewed as an offset currency to the dollar. The European Central Bank (ECB) has stated that it will do whatever it takes to create inflation in the Eurozone. Inflation destroys the value of the currency (see Understanding Inflation). It takes a headstrong and particularly foolish man to be long the Euro at this point.
This part concludes the discussion on currencies. In the next part, we will look at financial instruments that deal with currencies. One need not be a forex trader or a player in the futures and options market to take advantage of movements in currency values. We shall explore opportunities available for the average investor to participate in this market.