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Analysis/Comment Last Updated: Aug 23, 2010 - 8:24:15 PM

The Euro is a success; Free lunch yet to be invented
By Michael Hennigan, Founder and editor of Finfacts
May 7, 2010 - 7:15:16 AM

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Green: EU countries using the euro: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain

Mauve: EU countries not using the euro

The Euro is a success despite the problems that have arisen with the system of independent fiscal policy for member states. In or out of the euro system, the free lunch has yet to be invented in global economics.

While the EMU (European Monetary Union) has been a success, it is clear that the criteria for entry have been too low. Countries with weak governance systems; economies with deep structural flaws and a weak central surveillance system, coincident with an international credit boom, have seen increased living standards alongside unsustainable debt. Now, in the absence of the devaluation tool, it can seem like the Eagles' famous 1977 hit: "Hotel California" - - "You can check out any time you like/But you can never leave!"

From Nobel laureates, hedge fund managers or commentators, at times of crises, there are always plenty people vying for media attention with herd-like warnings of pestilence or another of the Four Horsemen of the Apocalypse. But have no doubt,  absent the euro, Europe would have been dominated by currency crises in recent years and there is no easy panacea in having an unstable currency, high interest rates and inflation.

Devaluation can provide a short-term fix for commodity producers but finding new markets for finished goods involves a lot more than price.

One very positive aspect of the Great Recession has been the limited resort to protectionism compared with the 1930s when depression spread like a virus because when every country takes actions to protect their own interests, the whole system is imperiled.

Greece and Portugal account for less than 5% of the Eurozone’s GDP. Even when Ireland and Spain are added in, the so-called peripheral countries or PIGS account for less than one-fifth of the region's GDP. 

Since the launch of the euro in January 1999, 15.7 million net new jobs were created by 2008, three times more than during the same number of years before the euro and around 2 million more than in the US during the same period.

Finfacts article: US jobs market underperformed the Eurozone and other economies in the decade before the Great Recession

The sum of intra-euro area exports and imports increased from about 31% of GDP in 1998 to around 40% in 2007 - - approximately 9 percentage points. During the same period, extra-euro area trade growth even exceeded that in intra-euro area trade, rising 13 percentage points from 31% to 44% of GDP in 2007. China is expected to become Germany's biggest export customer by 2016.

The ECB has had a major role in supporting/preventing failures in the banking systems in Ireland and other embattled economies since Aug 2007.

There was also a big rise in private cross-border private capital flows.

Jean-Claude Trichet, President of the ECB, said in a speech in Munich on April 29, 2010 that Economic and Monetary Union - - in short: EMU - - is a union based on two foundations: economic and monetary. These are two foundations that reinforce one another: "Responsibility for the 'M' is centralised and assigned to the Eurosystem with the ECB at its core, aiming to ensure price stability in the euro area over the medium term. We have defined price stability as an average annual inflation rate below but close to 2% over the medium term.

How have we performed against this objective since the introduction of the euro? Based on current staff projections for this year, by the end of 2010, the average inflation rate in the euro area since the introduction of the euro is estimated to be around 1.95%. Beyond the ups and downs of the economic cycle since 1999, despite the swings in the international prices of raw materials, monetary policy has managed to keep its inflation record faithful to its strategic aim. I am satisfied that we have fulfilled our mandate.

Speaking in Germany, I would like to recall that the average annual inflation rate in this country in the 1990s was 2.2%, and in the 1980s it was 2.9%."

In Europe, there are challenges but as Newsweek magazine says contrary to the widespread cliché of American dynamism versus European economic stagnation, over the past decade Europe's top companies have beaten America's (not to mention Japan's) by an often substantial margin. Despite the rise of China and the rest, Europe has held roughly steady, at about 17 per cent, its share of world exports since 2000, while America's has fallen by more than a third, from 17 to 11 per cent  - - a crude but significant indicator of global competitiveness. Since the early 1990s, Europe has steadily expanded its share of the world's 100 biggest multinationals compiled annually by the UN Conference on Trade and Development, from 57 in 1991 to 61 last year, while the US number has dropped from 26 to 19.

Contrary to common belief, the French save more than the Germans and Japanese, once big savers, are now among the lowest in advanced countries.

Inconvenient truths for the euro haters but relevant to highlight!

There are problems of regional disparities in the US, UK and Germany, where huge sums have been spent to lift living standards in the former Communist East Germany.

The German statistics office, Destatis, reported on Thursday that an average 17% of the population in the European Union were at risk of poverty in 2007. This percentage corresponds to some 85 million persons. In Germany, the at-risk-of-poverty rate amounted to 15% (about 12.5 million persons) and was below EU average. These results and more were obtained in the annual EU-SILC 2008 survey.
At 17%, the share of the population at risk of poverty in the twelve new member states was the same as in the EU on average, while it was slightly below EU average in the Euro area (16%). Although these average values do not differ much, a direct comparison of EU member states reveals a large gap. Latvia recorded the largest number of persons at risk of poverty: more than every fourth (26%) was at risk of poverty in 2007, followed by Romania (23%), Bulgaria (21%), Lithuania (20%), Greece (20%) and Spain (20%). In contrast, only 9% of the population were at risk of poverty in the Czech Republic, in 2007, which was the lowest rate in the entire EU. Slovakia (11%) and the Netherlands (11%) also had comparatively low at-risk-of-poverty levels. Ireland was just behind Germany at (16%).

Economic development takes time.

Kenneth Rogoff, Harvard University professor and author of This Time is Different’ wrote in the Financial Times this week:"A recurring theme of my academic research with Carmen Reinhart is that “graduation” from emerging market status is a long, painful process that can take 75 years or more to complete. Twenty years without, say, a sovereign debt crisis is significant, but hardly enough definitively to declare a country a “graduate”. Greece resolved its last sovereign default only in the mid-1960s and Portugal had an International Monetary Fund programme as recently as 1984. (Spain’s modern history is much better, despite holding the record – more than 12 – for most independent sovereign default episodes.)"

The common feature of the embattled economies, including Ireland is they have been very badly misgoverned and they are in need of fundamental reform.

"In a study done last year, the OECD described government-run Greek hospitals as deeply corrupt. It concluded that we could save 30% of the costs, which is enormous....In Germany, a stent for heart operations costs about €500. In Greece it costs €2,000 to €2,500. The fault lies with corruption," Greek Prime Minister George Papandreou said in an interview with Der Spiegel magazine last February.

Despite their economic limitations, unless these countries aspire to be governed like for example Denmark, they will continue to flounder.

Employment in foreign-owned companies in Ireland has fallen to 1998 levels while the end of the housing boom has resulted in high unemployment that will remain elevated for years.

At the height of the property bubble, Irish politician, Mary Harney, disdainfully spoke of being closer to Boston than Berlin and today, some people have the neck to claim German success is the cause of the woes in Ireland, Greece and so on!!!

As for bondholders like Harold Wilson’s infamous “gnomes of Zurich” can get a bad press but spare a thought for the battered Irish private sector worker who is lucky enough to be part of a distressed pension scheme.

Brian Griffin, who leads Mercer’s investment consulting business in Ireland has commented:““A typical Irish pension fund would have up to half of its bond portfolio invested in government bonds issued by Spain, Portugal, Ireland, Greece and Italy. While previously this would not have caused investors undue concern, recent events have identified the additional volatility and credit risks associated with these bonds markets.”

Debt write-offs, inflation and a confetti currency as an alternative to the euro, are not victimless.

Finally, media commentator and Harvard University professor, Niall Ferguson, writes in an article, The End of the Euro: How the crisis in Greece could lead to the demise of Europe's most ambitious project, in the current issue of Newsweek:"Europe now faces a much bigger decision than whether to bail out Greece. The real choice is between becoming a fully fledged United States of Europe, or remaining little more than a modern-day Holy Roman Empire, a gimcrack hodgepodge of 'variable geometry' that will sooner or later fall apart."

EMU is likely to last much longer than the loss-making Newsweek, which was put on the auction block this week and Prof. Ferguson will undoubtedly move on to other beguiling hopeless cases.

Edmund Phelps, professor from Columbia University and Nobel Prize winner for Economics in 2001, considers the outlook for the European economy in the face of a potential sovereign debt crisis:

A number of other summary points that were published earlier this week;

1. The global economy is growing, in particular in Asia and the US; European manufacturing and service sectors are expanding.

2. The European Central Bank has taken aggressive action when required since the onset of the credit crunch in August 2007.

3. Absent the euro, the past two years would have been dominated by news of currency crises in Europe.

4. Convergence is not an easy process as Germans might tell you; after spending huge amounts in the former East Germany, total economic output (which compares per capita GDP) in 2007 in the East was about 70% of that in West Germany.

5. On devaluation as a panacea: Last January, George Provopoulos, governor of the Bank of Greece, wrote in the F T: During the 1980s, Greece had another twin-deficit problem (large and unsustainable fiscal and external imbalances) and its own national currency, the drachma. It waved the magic wand twice, with large devaluations of the drachma in 1983 and in 1985, but in the absence of long-lasting structural adjustment and sustained fiscal contraction. The devaluations were followed by higher wage growth and inflation, with no sustained improvement in competitiveness. Speculative attacks against the drachma were avoided only because of strict controls on capital flows, an option that is no longer feasible or desirable. The twin-deficit problem remained. So much for the magic wand of currency devaluation.”

6. There is no ready solution to strategies that can require a decade or more to have an impact; look at our own foolish expectations from the so-called ’smart economy’; developing new export markets is generally very difficult.

7. It is easier to identify a problem than propose a credible solution. Germany was prudently governed and undergoing reform when it was partytime for Ireland and other misgoverned countries. These countries squandered billions of euros in German financed EU funding.

In 2003, Prof. Hans-Werner Sinn of the Ifo institute, had a book published: Ist Deutschland noch zu retten? (Can Germany Be Saved?) - - Its blurb read: “Taxes keep rising, the pension and health insurance systems are ailing. More and more companies are going bankrupt or are leaving the country. Unemployment has reached alarming levels. Germany is outperformed by its neighbours. It’s growth rates are in the cellar, and it can’t keep up with Austria, the Netherlands, Britain or France. Germany has become the sick man of Europe. “

The admirable thing about Greek PM George Papandreou is that he readily acknowledges where the principal responsibility for Greece’s woes lay.

Bundesbank president, Prof. Axel Weber, has acknowledged that German enterprises will naturally have to focus more on the domestic market than before the crisis and he said in March that Germany’s export success was based on companies embarking on a “painful, but eventually successful, restructuring process, including innovation, outsourcing, wage moderation as well as a balance sheet cleanup.” He said it should "be noted these were market-based adjustments, neither initiated nor managed by policy makers.”
Either way, peripheral countries have to get their economies in better shape; the biggest challenges are from beyond Europe.

8. The credit boom enabled many countries to live beyond their means; that scene has changed and the growth of the leading emerging economies will put further downward pressure on advanced country living standards, as conventionally measured.

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