Abandonment of the Euro Becomes Conceivable

From FT.com:

The under-fire euro fell further on Wednesday, slumping to an eight-month low against the US dollar amid rumblings over the long-term future of the eurozone.

The fresh selling was prompted by a report claiming that Hans Eichel, the German finance minister, and Axel Weber, the president of the Bundesbank, were present at a meeting at which the possible break-up of European Monetary Union was discussed.

The German Bundestag is also said to have commissioned a report on the legal repercussions of a country wishing to leave the EMU.

Germany’s finance ministry labelled the talk “absurd”, while Mr Eichel and Mr Weber issued a statement saying the euro was a “unique success story”. But the damage had been done.

Of course there are pro forma denials, but it looks like the French and Dutch referendum results have allowed the German govt to raise the obvious questions about why the Bundesbank should continue to support Europe’s weaker economies. The bigger question is why Germany went along with the Euro scheme in the first place. But having done it, and finding the going perhaps harder than they anticipated, the German pols and finance bureaucrats may now be looking for a place to get off the train.

Although most currency analysts regard the break-up of the eurozone as an extremely faint prospect, they said the potentially disastrous repercussions of such an event mean it could not be totally ignored.

Tony Norfield, global head of forex strategy at ABN Amro, put the probability of a splintering of the eurozone at “5 per cent or less”.

“Our view is that EMU will not break up. That will be way down the line as the last resort because of the political capital eveyone has got invested in it,” he said.

Nevertheless Mr Norfield added that if a break-up was to occur, it would be a “disaster” for the euro.

When people start talking like this it means that the odds of the events they are trying to dismiss are now high enough to be undismissable. This doesn’t mean Euro abandonment is a certainty, only that the odds of it are increasing. Look for more such talk in Germany and elsewhere.

If the Euro falls apart it won’t happen suddenly, just as Euro introduction was planned over an extended period. Governments are usually slow and deliberate about such major policy changes. Nonetheless, EMU failure would be like a giant fish hook ripped from the guts of the European political class: painful, messy and very interesting to watch. And it just became more likely.

20 thoughts on “Abandonment of the Euro Becomes Conceivable”

  1. Sounds like panic in the face of the unknown. But here is what is known: EMU was puttering along without this constitution. My conclusion: it will probably continue to do so if this constitution never happens. Maybe it’s time to be buying Euros.

  2. … or time to short Euro as political pressure is building up? If there is flight to dollars, expect interest rates to go down further … perhaps another wave of mortgage refinancing in the US … more money in consumers’ pockets.

  3. I wonder if the story of Tower of Babel is related to previous attempts at EU-style empire building? Any thoughts on this tower coming down?

  4. My understanding is that Germany went along with the Euro and the EMU in return for EU support of German unification.

    The Bundesbank was highly skeptical, as they are now, but bowed to pressure from then Chancellor Kohl.

  5. The Germans were skeptical that the other European countries would be able to keep their part of the bargain. It turns out Germany can’t. Moreover, its obvious the German economy can’t tolerate a strong currency. I’ll say this, only a very strong economy can tolerate the damaging effects of a very strong currency.

  6. Is there any reasont to believe that the mark would be weaker than the Euro? I think it would be stronger given Germany’s trade surpluses. German’s seem to want to use the Euro as a scape goat for their problems, but I think they will be in for a rude awakening even if the mark is reinstated.

  7. I have been saying the Euro is doomed for a while. At some point, some country will be forced to bail out because their economy is choking to death. then there will be a run and the whole thing will be dead in a few weeks. If I were a national banking authority in one of those countries, I would be working on a contingency plan.

  8. Oh, man, we bailed out Mexico, will we have to bail Europe out again?

    Or only those countries who want our help?

  9. Sandy, nah. They have assets a plenty. Maybe Boeing can buy Airbus for 50 cents on the dollar.

  10. I’m something of an economic neophyte here, so help me out:

    Even if the Euro collapsed would Europe ever “dollarize” their economy?

    Is there a limit to how many countries could “dollarize” and does there come a point when so many economies use the dollar as their currency that America’s control over the dollar’s value becomes attenuated? Has something like that already happened with the “Eurodollar” I sometimes hear about?

    How do we control the dollar’s value in the first place? Why are American dollars so stable? Or are they?

  11. Curracy Questions,

    “does there come a point when so many economies use the dollar as their currency that America’s control over the dollar’s value becomes attenuated?”

    I’ll take a stab at it. With a fiat currency, the “value” (in this context) of the currency is largely controlled by the currency’s central bank (or equivalent institution) which controls the physical number of monetary tokens (bills) issued. Ideally, the bank tries to match the issuance of tokens to match the expansion or contraction of the economy. If it issues to many tokens, the currency inflates. If it issues to few, it deflates.

    It is the reputation of the central bank that makes a currency sound or not. If the central bank has a history of inflating or deflating the currency for short term political gain (like say Mexico), then nobody will want to hold the currency. If the central bank as a good reputation like the Federal Reserve or the pre-euro German Bundesbank, then the currency is more sound.

    The number of countries that “dollarize” won’t effect this basic principle save that it effectively creates a larger economy for the dollars to work in and possible require the central bank to issue more tokens than it otherwise might. The foreign nations won’t have the ability to inflate or deflate the currency because they won’t control the central bank.

    This is a separate issue from the value of currency relative to other nations currencies.

  12. “Even if the Euro collapsed would Europe ever ‘dollarize’ their economy?”

    Unlikely. A country that dollarizes looses a certain amount of control over its economy. This may be a good thing, if you are suffering from capital flight because your people do not trust your management of the currency, which has been an endemic problem with latin american economies.

    Most European countries did not have this problem pre-Euro and would undoubtedly go back to a local currency.

    “Is there a limit to how many countries could ‘dollarize'”

    Not as long as the Federal Reserve can accomidate the demand.

    A dollar is the unit of account of a liability of the Federal Reserve Banks. To make dollars the Federal Reserve purchases a US Treasury security. There are more than $4 Trillion worth of Treasuries outstanding, but the total amount of dollars (called Reserve Bank Credit in the balance sheet published every Friday in the Wall Street Journal) is about $800 Billion.

    “does there come a point when so many economies use the dollar as their currency that America’s control over the dollar’s value becomes attenuated?”

    No. The Fed can always control its own balance sheet, which is the ultimate source of dollars. the problem lies with the dollarized economy which may find the Fed excessively stringent or loose for its purposes. This is the problem that Europe is suffering. Germany needs a loose supply of currency and Spain needs a tight supply.

    “Has something like that already happened with the “Eurodollar” I sometimes hear about?”

    The Euro or the eurodollar? The Euro is the currency of the EU. Eurodollars are dollar denominted deposits held by banks in Europe. In the 1970s eurodollars were, for regulatory reasons, a problem for the Fed. The regulatory anomalies have been resolved.

    “How do we control the dollar’s value in the first place?”

    See above. The Federal Reserve Banks buy or sell Treaury securities. Purchases create dollars, sales destroy them. The Feds art consists in balancing suppy and demand of dollars, which in turn affects interest rates because the sale of Treasuries lowers their prices (sends rates up) and the purchase raises the prices (sends rates down).

    “Why are American dollars so stable?”

    Such stability as we enjoy comes from the stewardship of the Fed, which has been run for the past 26 years by two remarkable gentlemen, Paul Volcker, 1979 -198?, and Alan Greenspan (Yoda) since then.

    “Or are they?”

    The answer is that the value of the dollar is measured by what it will buy, i.e., the cost of living. for the last twenty five years the cost of living has gone up about 2% per year. Is that stable? Not as stable as some other countries, but some of those countries such as Japan have suffered chronic economic problems. About the best way to put it is that we have traded some stability for some economic growth, and we seem to be relatively happy with it.

  13. I think Shannon got it right. Fiat currencies are effectively backed by consensus expectations about the reliability of the issuing central banks.

    One of the advantages of the Euro for countries other than Germany and France is that it gets their govts off the hook politically for monetary mismanagement. For that reason there might be some political incentive for Euro govts to adopt the USD if the Euro fails, though I suspect it would be difficult to sell this idea to nationalistic electorates.

  14. Jonathan: The reason European Governments won’t adopt the dollar is that they do not have capital flight. They have unemployment and sluggish economies. They need looser curency policies. The Fed will not accomodate them. They need to control their own monetary policy.

  15. You guys are great! I love blogs. Thanks for answering my questions.

    It sounds like there is a relationship between the national debt and the amount of currency in circulation.

    I’ve always thought of the national debt as bad. Am I totally off-base in thinking we should pay off the debt? Is “paying off the debt” impossible / not applicable because all the currency would have to come out of circulation? Is “money” itself actually an instrument of government debt? (The words “Federal Reserve Note” printed on it makes it sound that way.)

    Where does money come from?

    Is all “newly-created money” in the form of loans to banks which in turn loan to everyone else? Wouldn’t that mean that the only way money gets into the economy is through defaulted loans?

    It’s the one thing I’ve never understood: say you have a population of 200 million, and you need X number of dollars in circulation to keep the economy stable.

    10 years later you have 300 million people, the economy is twice as big, and you really need X+N dollars in the economy to keep it running smoothly.

    Where does the “+N” come from? Where does it go? Who spends it first? How does it get into circulation?

    Some conservatives in the 70’s argued for the gold standard. Under the gold standard wouldn’t the size of the population eventually cause deflation, an ever-increasing value for the same pile of gold spread out over more and more people? Isn’t too few dollars just as bad as too many?

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