Home Business & Finance Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them
The Euro’s Golden Lessons
Underscoring the antagonism between gold and democracy is the euro. That continental currency, now embracing 19 nations of the EU, can be seen as a non-metallic image of the gold standard. Instead of each of those nation’s legacy currencies being made convertible into the yellow metal at a set rate, they have been equated at a predetermined level against a euro note. In turn, this piece of paper, as well as its electronic representations in bank checking and savings accounts, is under the ultimate authority of an agency placed well outside the political reach of the particular nations joined to the euro architecture. Just like governments cannot create or destroy gold at will, so too the members of that currency framework cannot legally print or shred new euros on their own. With its headquarters in Frankfurt, the body that oversees the euro, the ECB, geographically symbolizes its roots in the Bundesbank. The hard money principles of the German central bank, forged by the country’s tragic experience with hyperinflation, are the closest thing that a major central bank has ever come to mimicking the discipline imposed by gold.
Indeed, the classical gold standard seems to have been an inspiration of sorts for European monetary union. Evidencing this is two of the early political figures in the multi-decade process that culminated in the euro. One of them is Valery Giscard d’Estaing, who advanced from serving as De Gaulle’s finance minister in the 1960s to the presidency of France between 1974 and 1981. The other figure is Helmut Schmidt, the Chancellor of West Germany from 1974 to 1982. Giscard justified the pursuit of a common European currency framework as a return to the better monetary world that prevailed before 1914: “During the second half of the nineteenth century, up to the 1914 war, France enjoyed continuously successful economic growth and a steady buildup of its engineering industry, with a currency that was totally stable ... the French as a nation cannot cope with an inflationary economy and a weak economy. They thrive on stable money”. Schmidt, in turn, explicitly compared the idea of a European currency system to the pre-World War I gold regime: “We had a currency union up to 1914 in Western Europe—the gold standard. From a historical point of view, I would draw a direct parallel”. The monetary structure that ended up being constructed only approximated the gold standard of old. Nonetheless, it was close enough to give rise to an ominous clash with the democratic realities of the more vulnerable Eurozone states.
As numerous observers pointed out amid the euro crisis, the continental currency unit historically reflects not so much a multilateral economic strategy as it does a larger political project. The euro’s ultimate origins extend to the immediate aftermath of World War II. Surveying the enormous damage wrought by the six-year conflict, Winston Churchill called for an effort, “to re-create the European family, or as much of it as we can, and to provide it with a structure under which it can dwell in peace, safety and freedom. We must build a kind of United States of Europe”. Four years after this appeal, Robert Schuman, the French foreign minister, issued a declaration whose guiding principles had been devised by Jean Monnet, a French civil servant. In what came to be called the Schuman declaration, the French government requested West Germany take part in an initiative that would place their respective coal and steel industries within a common market overseen by a higher governmental body. Inasmuch as these materials were the basis of weapons and armaments, Monnet’s idea was that having the two great powers in continental Europe working together under the same political umbrella would make a recurrence of war less likely. Thus was the European Coal and Steel Community established. It brought those two economic sectors under a unified aegis not just in France and West Germany but also in Italy, Belgium, Netherlands, and Luxembourg.
In 1958, this framework was expanded to the rest of the European economy. While the goal of advancing economic growth now came into more prominence, the new arrangement was justified on similar grounds to its coal and steel predecessor. To wit, commercial interactions would foster interdependencies and mutual sympathies among nations contributing to the preservation of peace. Signed in 1957 on Rome’s Capitoline Hill, in a symbolic reminder of the historical precedent that existed for the unification of Europe, the treaty of Rome brought the European Economic Community into being. It began as a customs union in which the six signatories shared a common tariff wall and pledged the creation of a borderless economic space among their countries. The free movement of goods, capital, and labor was not fully secured until the 1986 signing of the Single European Act. By then, the EU (as the multilateral organization eventually came to be called), had added to the original six-nation membership.
Then came the fall of the Berlin Wall in 1989. There is reason to believe that European monetary union only came about precisely because of that world-historical event. To be sure, the euro did not emerge all of a sudden out of the debris of the Berlin Wall. The idea of a single currency was first broached in the last days of Bretton Woods in the 1970 Werner report. The breakdown of that international financial architecture, along with the monetary disturbances and oil price shocks associated with it, forestalled any hope of implementing Werner’s plan during the 1970s. That decade, however, saw an attempt to fix exchange rates known as the snake. Under this regime, currencies were allowed a maximum of 2.25 % deviation between them. The snake proved too politically onerous for Italy, France, and the UK to abide by its strictures. It effectively became a deutsche mark zone encompassing West Germany and its various monetary satellite countries. Not much later in 1979, another effort was launched to fix Europe’s currencies, known as the European Rate Mechanism (ERM). This proved somewhat more resilient, producing enough confidence for the 1989 Delors report. Repeating Werner’s earlier proposal for monetary union, the report was received positively by Europe’s political elite and was subsequently codified in the 1992 Maastricht treaty. This document certified that the effort to unify Europe had shifted from a reliance upon economic means of association to the political mode. Instead of simply enabling voluntary commercial exchanges in tying the continent’s population together, Europe moved its unity project to the more coercive agency of a transnational state apparatus.
During the 1990s, many were the voices that declared the euro project stillborn. However, helped along by a strong recovery in European economic fortunes during the mid-to-late 1990s, political forces pushing for a continental currency managed to defy the reigning pessimism. Even at the outset, there was a divide between Europe’s northern and southern tiers. Countries like Germany, the Netherlands, and Finland in the north had both stronger economies and a better record of controlling its public finances than the southern nations of Greece, Spain, Italy, and Portugal. All of the latter countries had developed a habit of depreciating their currencies, thanks to the money printing to which they resorted in order to fund their deficits and debt. Encouraging such devaluations as well was the need to make their exports competitive against the goods being produced more cheaply on a per-unit basis by the more productive workforce in the north. Why, then, would politicians in the southern tier give up the ability to depreciate the local currency? Why abandon a tool that allowed them to conveniently manage the conflict between taxpayers and tax consumers in their respective jurisdictions? And why would northern politicians tie their nation’s fate to their southern neighbors? Why risk having to bail out those countries once their addiction to deficits and debt reasserted itself?
Perhaps the longing to secure a lasting peace in Europe was enough to overcome these chasms in national economic interests. Statements made by Helmut Kohl, the German chancellor who signed off on his country’s agreement to join the euro, suggest the desire for peace was decisive: “The bitter experiences of war and dictatorship in this century teach us that the unification project is the best insurance against a relapse of national egoism, chauvinism, and violent conflict”. Even so, the reunification of Germany that was taking place around the time the euro was being conceived sparked fears of a resurgent colossus in the heart of continental Europe. A reunified Germany would approximate the size that the country previously encompassed when it caused World War II, if not also World War I. As a condition of recognizing the country’s expanded borders, the leading Western powers exacted various commitments, including one allegedly at the behest of French President Francois Mitterand. He purportedly required Germany to give up its hallowed deutsche mark and accept a single European currency.
The evidence for such a deal is not clear-cut, if only because Mitterand seems never to have uttered the quid pro quo explicitly. He never exactly said to Kohl, “I won’t support reunification unless you back the euro”. Der Spiegel, a German news magazine, unearthed secret government documents hinting pretty strongly at such a deal. In his blow- by-blow account of the euro’s birth, David Marsh notes that Mitterrand became incensed after Kohl had failed to consult him on a detailed plan for reunification which the latter had communicated to German legislators. In a meeting a couple of days later with Germany’s foreign minister,
Mitterrand indicated that Germany had to discuss the terms of monetary union or otherwise face an alliance of France, Britain, and Soviet Union. “We will return to the world of 1913”, Mitterrand said. Without saying it in so many words, the French President insisted upon a degree of conditionality between his willingness to go along with German reunification and the latter’s participation in a common currency.  Pulling Mitterrand in this direction was a long-standing axiom of French foreign policy, bred by three bloody conflicts with Germany (the third during World War II involving an occupation of France) since its original unification in 1870. That maxim stated that Germany was a threat that had to be vigilantly contained. Thus, given the evolving movement toward European unification, Germany had to be fully ensconced within that project.
Also influencing Mitterrand’s thinking, in a mindset shared by the French political class, was a deep antipathy toward the deutschemark. In one speech, he actually likened the West German currency to an atomic bomb: “The Germans are a great people deprived of certain attributes of sovereignty, with reduced diplomatic status. Germany compensates for this weakness with its economic power. The Deutsche mark is to some extent its nuclear force”.6 0 On numerous occasions, the strength of the Bundesbank-run currency had compelled France to watch helplessly as its franc sank. This laid bare to the world and to their public the failings of French politicians in managing the country’s fiscal and monetary affairs. Though, economically speaking, France straddles northern and southern Europe, just as it does geographically, when it comes to its FX policies, it has proved itself to be southern. Doing away with the deutsche mark would end this embarrassment for the French. This must also have motivated the full-fledged members of Europe’s southern tier. Its politicians also had to regularly suffer the indignity of their currencies getting lambasted in the markets by the deutsche mark.
Beyond this, both the southern and northern sides were inclined to subscribe to the euro by less subversive impulses. In the south, governments sought to avoid the prospect of their nations’ companies having access to the more advanced economies of the north being restricted were they to have stayed out of the euro. Not participating, too, might have compromised the southern nations’ influence within the EU as a whole, where the one vote per country principle allows those countries to push above their economic weight. Among more market-oriented politicians, there was the hope that the rigors imposed by a monetary policy orchestrated through an outside agency would break domestic political logjams in the south. These were preventing the deregulation of labor and product markets as well the reining in of persistent government budget deficits. Assisting the euro’s cause in the north was the support gained from exporters, who were attracted by the prospect of being able to outcompete firms in the south without having to worry any longer about these countries devaluing their currency to eliminate their productivity edge. Europe’s financial sector also had an interest in seeing the Euro come into existence. That way, banks could operate with fewer encumbrances on a continental marketplace and thereby realize economies of scale. The critical thing to understand is that purely economic objectives, unrelated to the interests of politically influential domestic groups, do little to explain why the euro entered the financial markets in 1999.
At that time, skeptics usually expressed their reservations about the long-term viability of the new currency by appealing to the notion of an optimum currency area. This is the thesis, originally articulated by Nobel Prize-winning economist Robert Mundell (the first person indicated in the aforementioned Mundell-Fleming hypothesis), that a given territory can share a currency to the extent that its business cycles occur in uni- son. That is, if one part of the currency zone, given its predominant industries, tends to go into recession while another part is economically stable or expanding, then it is not optimal to have a single FX rate for the whole area. The reason is that the part suffering a recession needs to have monetary policy relaxed. That implies a depreciation of the currency. Yet such a decline will not necessarily be forthcoming because the monetary authorities have to factor in conditions elsewhere where economic conditions are better. The resulting monetary policy winds up representing some kind of mean between the necessities of the two regions, leaving neither properly accommodated. To allay this, people have to be able to move freely into higher wage areas. At the same time, wages have to be free to drop in recession zones so as to enable firms there to reduce prices and compete more effectively. Fiscal policy must also come into play. Wherever commercial activity is slow, governments must stimulate their economies by running budget deficits. Meanwhile, governments in prospering regions must cool their economies by running budget surpluses. Critics argued that the Eurozone had none of these features of an optimum currency area. Not only are economic cycles not synchronized, but cultural and linguistic differences between countries restrain people’s willingness to move into more economically promising regions. Europe’s labor markets are notoriously inflexible. National governments, too, were originally restricted in their capacity to employ fiscal policy by the rule that annual deficits could not exceed 3 % of GDP. Nor could any one government offer fiscal assistance to another. Bailouts were prohibited by the Maastricht treaty, a provision necessary to win German support.
What plunged the euro into an existential crisis was not exactly what the proponents of the optimum currency area thesis had in mind. Instead of divergences in the business cycle, the Eurozone was initially hit by a financial crisis emanating from the USA which affected all countries. If anything, the northern tier was more adversely impacted because its banks had invested more heavily in American sub-prime mortgage securities. The 3% deficit rule was entirely set aside (it had been violated before) as countries saw expenditures increase automatically on their social safety nets even as many of them engaged in Keynesian style fiscal pump priming in a bid to stave off recessionary conditions. A huge bailout fund was arranged, once again breaching a Maastricht requirement, with Portugal, Greece, and Ireland obtaining funds, though that did little to ease pressure on the euro in the financial markets.
What really threw the Euro into crisis was that it came into collision with the constraints present in democracies to anything even mirroring the strictures of the gold standard. More so than in the north, the southern European democracies entered the financial crisis having seen organized labor exploit their regime’s susceptibility to majoritarianism and special interest group lobbying. In 2008-2009, according to the OECD, three of the four Eurozone countries offering the highest level of employment protection were Portugal, Greece, and Spain. That makes it difficult for wages to decline in southern European countries during economic downturns. And when a country does not have its own currency to devalue, no other adjustment mechanism exists to reduce labor costs on a real inflation-adjusted basis and make its exports cheaper on global markets. With the euro, the southern European countries were effectively in the same predicament that they would have been in had they operated on a gold standard. Another effect of labor market inflexibility is that it inhibits investment. After all, firms will be wary of hiring workers when they cannot easily let them go should the company’s economic fortunes unexpectedly change. With less capital to work with as a result, laborers in southern European nations are less productive. In turn, those countries’ economies grow less, which makes bond traders and investors more nervous about their ability to pay off their rising public debt.
This debt had long been trending upwards. In the southern European nations, the taxpayer versus tax consumer dynamic had propelled the debt creating propensities of democracy to the fullest. In both Greece and Portugal, though more so in the first, parties sought to win voters by promising social programs, pensions, and public-sector jobs. True enough, the governments of northern European countries spend heavily on tax consumption activities as well. But they oversee high-trust societies where individuals are more willing to pay taxes to the state. Southern European nations tend to have low- trust societies where the state is viewed with suspicion. Hence, tax avoidance is more common. Underground economies in southern Europe are three times the size of those in the USA and Germany.
Since 2013, the impression has grown that the euro crisis has made a turn for the better, or at least has been put into remission. Even the rekindling of tensions with the 2015 takeover of the Greek government by the Syriza party did little to shake the sanguine mood in financial markets toward the Eurozone. The sense was that Greece was now cordoned off from the rest of Europe. Yields on Spanish, Italian, and Portuguese debt, which had been trending down since 2011-2012, continued to hold steady during the Greek drama, rising only slightly. But let us not be fooled into thinking that all this occurred due to the various bailout funds that were arranged, a process that ended up in the establishment of the European Stability Mechanism in 2013. With an initial lending capacity of €500 billion, this facility offers Eurozone countries undergoing financial stress a permanent source of assistance. It cannot be doubted that this represents a step in the direction of fiscal union, as does the European Fiscal Compact, implemented in 2014, which is designed to make countries more immediately accountable for running excess budget deficits. Fiscal union is often put forward as a solution to the euro’s problems along the lines to what the USA effectively has in place to buttress the dollar. Were the euro zone to adopt a fiscal union, the tax revenues and expenditures of all member nations would be pooled. This would make it easier for resources to be redistributed from regions that are relatively prospering to those less economically vibrant. As the European Stability Mechanism, however, is restricted to emergencies, it is far from the regular and ongoing allocation framework that would constitute an authentic fiscal union.
Nor have the Euro’s problems been alleviated because the most vulnerable countries in the currency union have successfully tackled their respective fiscal messes. Other than perhaps Ireland, where the debt to GDP has declined slightly from its crisis period high, austerity has not stopped debt levels from escalating among the most pressured euro nations. All these nations ran head into a lethal defect of austerity policies. Granted, the reductions involved in government spending do ultimately benefit the economy by freeing up resources tied to the state that can be more effectively deployed in the free market. But the tax increases that also form part of the standard austerity package invariably crimps the private sector—the very part of the economy that must integrate capital and workers dislocated out of the public sector, the very part that must motor the growth necessary to generate higher tax revenues for the state. Instead, austerity slows down economies, giving rise to less tax revenue than expected. In response to this, governments are then compelled to undertake a sequence of additional austerity measures that compound the economic troubles. Worse yet, such measures fire up social tensions, undermining the political cohesion required for economic restructuring to succeed. Seeing this very dynamic transpire in southern European nations, it is no wonder that by 2013, even the IMF, a longtime prescriber of the austerity drug to nations suffering from fiscal and monetary ills, expressed misgivings about austerity.
In accounting earlier for why the Western democracies, led by the USA, abandoned the gold anchor in the early 1970s, I argued that it was written into the DNA of popularly elected regimes. To reiterate, democracies are institutionally disposed to heighten the perennial class conflict between taxpayers and tax consumers, favoring the latter over the former. To manage this conflict, elected politicians have very strong incentives to remove any constraints on the discretionary management of the money supply. In other words, democratic governments are congenitally liable to spending above their means and thus are driven to obtain complete sovereignty over money so that it can be printed as necessary to pay the bills.
Confirming this is the relatively short history of the euro. Barely a decade into its existence, the high political costs of resolving the fiscal disorders that reached a crescendo among the currency’s economically weaker members not surprisingly gave way to the relative allure of a monetary solution. In so doing, the features of the euro that likened it to a precious metal system were effectively ditched. More and more, the ECB began to resemble a typical post-gold standard central bank in coming to the aid of specific nations in distress by providing liquidity.
Mario Draghi is the man primarily responsible for this momentous shift. At the same time, he is the chief reason why the euro’s prospects are looking a tad brighter six years into that currency’s crisis. Assuming the ECB’s Presidency in 2011, Draghi took little time in introducing the Long Term Refinancing Operation, a program offering low interest rate loans to European banks. These institutions were then able to use the funds borrowed to buy their country’s bonds and collect the higher yields for a tidy profit on the interest rate spread. The ECB thereby encouraged the purchase of troubled southern European bonds without actually having to buy them on their own, conveniently skirting the Maastricht treaty provision forbidding the ECB from directly financing states. In February 2012, the ECB extended this program by advancing €529.5 billion to 800 banks, slightly more than the initial €489.2 billion provision to 523 banks. Figuring that this would not suffice, however, Draghi proceeded to more boldly challenge the Maastricht treaty’s constraints. To be sure, Trichet had previously tested these constraints by rationalizing bond purchases on the argument that they were only banned in the primary market (i.e. debt securities bought directly from governments), but not in the secondary market (i.e. debt securities bought from other investors). This is a distinction without much of a difference in that a government could sell its debt to commercial banks who in turn were free to immediately resell it to the ECB. Draghi’s testing of the Maastricht treaty’s limits turned out more radical thanks to his now famous speech of July 26, 2012. Before an investment conference in London, he said: “the ECB is ready to do whatever it takes to preserve the euro”.
Negative market sentiment quickly reversed on this statement. Draghi subsequently backed this declaration with the Outright Monetary Transaction Program, under which the ECB commits itself to purchasing an unlimited amount of a nation’s bonds so long as it seeks assistance from the European Stability Mechanism and abides by the latter’s fiscal strictures.
Though no country made such a request throughout the remainder of 2012, the mere announcement of the program altered market expectations so as to lower bond spreads. But as the Europe’s economy continued to flounder, and as a calming of financial markets took pressure off the continent’s politicians to push for further reforms, Draghi was impelled to up the monetary ante. In January 2015, he announced a massive scheme of QE, similar to what the US Fed had previously done, involving monthly bond purchases of €60 million until September 2016, for a total of €1.1 trillion. As 2015 came to an end, this campaign was extended by six months to March 2017 for a revised total of €1.46 trillion.
Arrayed against Draghi throughout his revolution of sorts was the President of the Bundesbank. In holding this office, Jens Weidman is also a member of the ECB’s governing council. But as he merely represented one vote, he could do little to stop Draghi in trying to maintain the original intent of making the ECB into a continental version of the Bundesbank. Of course, in order for this intent to have been reversed at all, Draghi had to be appointed in the first place, which required the approval of the Eurozone’s two leading powers, France and Germany. Given Draghi’s background at Italy’s central bank, it was widely surmised, and very much feared in conservative German quarters, that he would be less reluctant to press the monetary accelerator than Trichet had been. To Germany’s political leadership, as opposed to its central bankers, Draghi must have appeared an attractive candidate by promising to lighten the hard task they were facing of having to convince their electorate of the need to harness their tax payments for the purposes of bailing out southern Europe. With this, the taxpayer versus tax consumer battle essentially took on a crossborder, and indeed a cross-cultural, dimension. As for France, given its traditional monetary stance, it would have had few qualms about Draghi. The only sticking point to his appointment wound up being their demand that an Italian member of the ECB’s Executive board leave early to make room for a French replacement. When all was said and done, this entire affair demonstrated that, though sitting governments may have to bide their time, the power to appoint central bank officials is a powerful tool at their disposal to swing monetary policy in their preferred philosophic direction.
The euro had to be taken to the brink, but France succeeded in disarming Germany’s atomic bomb. France should credit the workings of democracy for this—both within the countries making up the Eurozone and within the governance structure of the Euro itself.
|< Prev||CONTENTS||Next >|