October 11, 2003

"The Disappointing Euro"

Departments: Economics and Modern Languages
Hours: 3
Audience: Frog haters.
Lecturer: Pierre-Antoine Delhommais

This article at Le Monde, the "New York Times" of France, by Pierre-Antoine Delhommais is one of a growing number of articles from the French Intelligensia decrying the failure of France. Although it is in French, and not very complimentary at that, it puts some facts behind some observations about recent French and German economic moves that are VERY enlightening. I will translate relevant portions as best I can, and all errors arising from translation are entirely mine. I will mark difficult passages with a "*", where I had problems with the translation.

Nearly five years after the launch of this unique currency, the disappointments of the Euro become more numerous every day. Too many promises made before January 1, 1999 haven't been kept, and too many of its benefits and advantages (presented as certain), have not become concrete.

Delhommais points out that one of the hopes of the Euro was to serve as a counterbalance to the United States, halt the slide of Europe, and cause an economic miracle, allowing Europe to also declare "an ideological and cultural victory".


The American "produit intérieur brut (PIB)" progressed at an annual rate of about 4%, while the Euro Zone was in recession. Even in the 90's, a situation so humiliating for Old Europe had rarely been observed.

Stare at that paragraph for a long moment: Delhommais takes the raw numbers for the United States, applies a formula used to measure Old Europe's economic progress, and comes up with a healthy growth rate, while the European countries themselves score a flat zero!

The use of Rumsfeld's term, "Old Europe" is telling: Delhommais is rubbing it in. Hard.

Mr. Delhommais continues:

If one adds to that the insolently healthy economy of the United Kingdom, who kept its pound sterling, and of Sweden, who kept the kroner, the final blow is in plain sight. The bitterness is so great that certain of those disappointed with the Euro are near to yielding to their nostalgia for the European Monetary System (Système monétaire européen (SME)).

Pining for the good old days, it seems. The SME was the monetary system before the Euro was created.

Here's Delhommais' explanation of the SME.

With the SME, the politically driven economies of Europe found themselves placed under the strict surveillance of financial markets. Each national budget was, in effect, submitted to the verdict of investors from around the world. If the financial affairs of a nation was to their taste, investors would bring in huge amounts of capital to that nation, strengthening its currency and causing a fall in interest rates, two positive elements of its economy. If, on the contrary, the budgetary direction displeased them, they would withdraw their funds, unleashing a currency crisis and enflaming rates. Under pain of asphixiating their economy, the government would be obliged to correct its course posthaste.

Obviously, this state of affairs wasn't exactly embraced by all:

At the time, many disliked this method of censure, denouncing this "intolerable pressure of Anglo-Saxon speculation", and the menace that it represented for democratically elected governments. One understands better, today, the calculations behind the shift in France, Germany, and Italy: that the death of financial market control would benefit them.*

With the euro, impunity is guaranteed. Bad economic policies receive no sanctions, public government deficits receive no punishment. Berlin, Paris, and Rome can, without fear, continue to deepen the budgetary feeding troughs because they won't be penalized when they borrow to cover their deficits. The interest rate paid by France on these loans is, despite a 4% budgetary deficit, the very same that would be charged to Spain, whose situation is better, thus constituting both an anomaly and an injustice at the same time. When it comes to the euro, investors no longer can make a difference when it comes to budgetary vice or virtue.

Because of this situation, they cannot play any more the role of safeguard that they held in the SME, a safeguard more solid and effective than any pact of European stability. Before, the penalty for the abuse of public finances was imposed almost immediately, extracted in the form of cash flight and an almost immediate flareup of interest rates. Today, within the pact, penalties are imposed only after a long, complex, and drawn-out process. Before, under the SME, the slightest hint of displeasure from American financier George Soros would cause fear and trembling in European capitals. Today, those same capitals ignore threats from Brussels. Then, the financial ministers sought, by all means possible, to get into the good graces of New York speculators. Today, they can publicly express their distain with regard to the Commission and its president, Romano Prodi.

Mr. Delhommais proceeds to cite several instances of where Germany, France, and Great Britian were forced by foreign investors to change monetary and government policies, up to devaluating their currencies in the face of a humiliatingly strong peseta, thanks to Spanish fiscal responsibility. He then cites examples of where the financial structure erected to support the euro prevented countries like Germany from using devaluation a a means to recover from economic recessions: Germany could devaluate the Mark, but had no power to devaluate the euro. Another mechanism, changing interest rates to spur or cool down the economy (the primary mechanism the United States Federal Reserve uses), was also taken away when the mark was dropped in favor of the euro, which mandates one interest rate to cover all the EU nations.

Translator's note: I chose to use the word "safeguard" for the French term "garde fou" that Mr. Delhommais used. "Garde fou" literally translates to "Fool-guard", I.e. the keeper who watches the inmates in an insane asylum.

Here is where my commentary on MR. Delhommais' article ends, and my thoughts on the matter begins. They can be summed up in one sentence:

The introduction of the euro as the common currency of the European Union created a commons.

The creation of a commons is significant, since it creates a necessary pre-condition for a phenomenon called the "tragedy of the commons". Originally, the commons was a public field in the middle of the community in which everyone's herd animals grazed. At some level of usage, the commons is sustainable, but only if everyone cooperates and limits the number of their herd animals grazing on the commons. However, suppose someone, wishing to maximize their benefit from the commons, adds extra animals to their herd. The commons starts to suffer, and all the animals suffer in some way that makes them less useful and valuable to their owners. However, the cheater, having extra beasts, comes out ahead. Eventually, everyone figures out that cheating is the way to win, and starts adding to their herds. The commons degrades, then fails completely, causing everyone's herds to die, and everyone FINALLY loses. Steven den Beste at USS Clueless has written about the tragedy of the commons, one of which discusses how the gradual, almost undetectable, degradation of the commons is one of the main factors in its progress. The lack of immediate, negative feedback regarding the consequences of cheating is one of the factors that drives the tragedy, and one solution is to introduce more immediate feedback.

The virtue of the SME that Mr. Delhommais pointed out was that fiscal irresponsiblity on the part of any European nations was almost immediately punished by flows of private investment funds out of the country. The unpleasant side effect on exchange rates that exchanging the currency in which the funds were held added to the pain. If the funds going out went into a more fiscally responsible rival, boosting their currency and economy, then that added insult to injury.

To illustrate this, consider the situation of publicly held corporations that issue stock. The value of the stock is partially based on the quality of corporate management, and it is often the case that stock values fluctuate based solely on whether a certain person arrives as a new CEO, or a skilled CEO leaves the company or retires. While the product put out by the company plays an important factor in its success, the role of management is rightly also considered an important factor.

Thus, investors play an important role in regulating corporations by buying or selling the stock of the company based on how well the corporation is governed. Competent management that watches pennies and carefully pursues new opportunities will influence investors positively, while Enron-esque profligates will see the value of their stock options plummet as investors move their money into safer and more profitably managed corporations.

However, suppose a consortium of corporations agree to merge their stocks and create a common pool of funds from which they can all borrow at the same interest rate, into which they put their profits for distribution as dividends, and of which the investing public can take a stake by purchasing only one stock. How would potential investors evaluate the safety and attractiveness of the stock?

The answer is that it would be incredibly complicated to analyze: Some of the companies would be competent, borrow responsibly (if at all), and turn a profit that would make the common stock more valuable. At the same time, the wastrels and losers would have access to the same fund. One would hope that the fund managers would have standards in place that would prevent member companies from wasting money or pursuing dead ends, but it would depend on how strong the managers were. If they were very, very strong, then the consortium transmorgrifies into a conglomerate. However, if each president of each member corporation retains total control of their corporation, and can influence who can be a fund manager, then there will be trouble: the wastrels and losers can go through money quicker than the competent and frugal can make it, and have an incentive to weaken the central authority so it can't stop the gravy trains.

When faced with such complications, the smart investor wouldn't touch the stock.

This is exactly the situation with the euro: The frugal have been lumped in with the wastrels, and investors are required to deal with them all, good and bad, on the same basis, or else not deal at all. The wastrels borrow money at the same rate as the prudent and frugal, starving the latter of necessary funds.

And like the investors in my example, the smart thing to do would be to avoid the Euro-based economies, since their fates are now tied to France's and Germany's.

Here's hoping the British follow the lead of the Swedes...
My thanks to Merde en France for the pointer to the article.

Posted by ptah at October 11, 2003 03:04 PM

This is quite interesting. I hadn't considered that effect of the euro-- though that's probably because I have basically no understanding of monetary policy considerations.

A little while back, I blogged about how great the President of Spain is, noting that he was very proud of his country's economy and fiscal discipline. Not that I understand how, but embracing capitalism probably had something to do with it.

Now all we need to do is bring about a similar change in welfare states such as France, Sweden, and New York.

Posted by: Mitch at October 13, 2003 02:08 AM
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