... on overlooked negative factors for the eurozone
This is an article I wrote back in September 2013 for FXStreet. In light of the recent Greece situation, it might still be of interest to some readers:
An overwhelming amount of research has already been published in regard to the future of the Eurozone, ranging from blind optimism to blind pessimism and everything in between. One of the most oft-mentioned factors from the pessimists is that member states have to borrow at different interest rates at the long end, while the short-term interest rate is decided by a common monetary framework. In this article, I would like to explore additional factors on the pessimistic side of the equation.
Firstly, whenever one of the weakest countries (for example, Greece) gets into trouble in a debt crisis, the Euro is bid down by market participants. At that point, both the strongest country (let’s say Germany) and the weakest country have an ‘averaged’ weaker currency. This should partly assist in solving some of the weaker country’s issues via the relationship of the weaker currency causing a reduction in imports and boosting exports, thereby causing a positive effect on the local economy, increased tax receipts and, lastly, an improved fiscal situation. However, this beneficial effect is actually smaller rather than larger for the weaker country due to the common and weaker ‘averaged’ currency causing the benefits ‘received’ by the stronger country not to be passed onto the weaker country (such as Greece) in any form. In other words, the combination of a common monetary framework and a separated fiscal framework causes the stronger country within the system to ‘benefit’ at the expense of the weaker country. The weaker country causes the exchange rate movement, but the stronger country benefits the most from it. Moreover if both still had their separate currencies, one could argue that the German Mark would be stronger than the ‘averaged’ weaker Euro and the Greek Drachma would be relatively weaker than the ‘averaged’ weaker Euro, allowing a magnified beneficial effect via the transmission channel as outlined above.
The second point I would like to mention relates to the extreme cultural diversity across the Eurozone. The architects of the Eurosystem used the argument that the United States of America was once composed of independent, fragmented states that combined to form the whole. But when a person from Texas visits Europe, it is more likely for him to say that he is an American than it is for a person from Germany or France visiting America saying that he is European. It was assumed that when an economic divergence occurs within a system – as in the case of Germany’s economy being stronger than Greece’s – that people from the weaker economy would move to the stronger to find work. If that argument holds, we should see even individual unemployment rates across all of the member countries, which we don’t! Furthermore, different cultures also have different norms regarding the work–leisure ratio. The Italians even have an expression: il dolce far niente, which means “the sweetness of doing nothing.” Then there is also the fact that each culture still has its own language, further hindering factor mobility.
The third factor revolves around the current strength of the Euro. The Euro is showing strength that is well beyond what is justified by economic fundamentals. Government officials might be interpreting this strength as discounted expectations by market participants for a rosy future, but this interpretation may be wrong. Part of the strength seems to be derived via Switzerland, which has shown a significant positive divergence from the Eurozone in terms of economic activity. Even if currency intervention is to be ostensibly abandoned completely, market participants may still not fully adjust for fear of returning intervention. Part of the strength may also come from the United States’ pressure on China in respect of their currency policy. The USD/CNY has weakened substantially, yet the EUR/CNY has actually strengthened. This might imply that China has shifted some of its foreign exchange reserves into Euros, perhaps indirectly via Swiss Francs.
The strength of the Euro is counterproductive given the level of current economic activity and inflation. It will eventually cause falling exports and rising imports, exacerbating the unemployment situation, cause further downward pressure on inflation via falling import prices, and make the ECB’s monetary policy less effective. It may be argued that countries with excess savings might be doing Europe a favour by investing in their long-term government bonds, but one important factor should not be left out of account. What is there to prevent a country with access savings not initially to “help” out the Eurozone by purchasing their long-term government bonds just to eventually buy up companies cheaply whose profit margins have suffered while the rising euro (due to capital inflows from the purchase of those bonds) has caused increased competition from imports. The long-term benefits gained, such as the technical know-how and intellectual capital, may far outweigh some temporary losses on government bond holdings and exchange rate movements. For example, how does one explain Zhejiang Geely’s purchase of a money-losing Volvo?
Obviously, there are many benefits from the establishment of a common currency, but considering the diverse reactions and responses to events of different governing bodies within the Eurozone, one often still gets the feeling that there is not that 100% commitment to make it work. Perhaps not everyone in Europe is quite ready yet to call themselves European!