Sunday, June 6, 2010

Euro: back in time

When in 1987, Britain became a member of the European Exchange Rate Mechanism (ERM), investors believed that sterling, then linked to the Deutsche Mark, was as good as the mark. 

Citing Mark Tier in the book "The winning investment habits of Warren Buffet and George Soros":

"As British interest rates were higher, money poured into sterling. In a reflexive, self-full-filling prophecy, this increase in demand for sterling helped keep it stable against the mark...and set the scene for its subsequent fall.
Then the Berlin Wall was torn down, the Soviet Union collapsed, Germany was reunified, and the system, said Soros, 'was thrown into a state of dynamic disequilibrum.'"

I think that history tends to repeat, so let's see what happened thereafter.

The chancellor Helmut Kohl, and the Bundesbank, started a discussion over the rate at which East Germany's currency (the Ostmark), should be exchanged for Deutsche Marks. Kohl wanted a higher rate, looking for his party's popularity in the coming election. But, on the other hand, the Bundesbank stated that a high rate of exchange was very negative for the anemic european economy. A higher rate would become very difficult to persuade private investors to make businesses there, it would cause a massive increase in government deficit, high unemployment and inflation. Finally, the Ostmarks were exchanged at .... 1:1 rate for the first 4.000, and 2:1 rate the rest. 

According to Soros ("Soros on Soros: staying ahead of the curve", 1995), that set the scene for the collapse of the ERM:

"There was a latent flaw in the ERM as well, but it became blatant only as a consequence of reunification. The flaw was that the Bundesbank played a dual role in the system: It was both the anchor of the ERM and the constitutional protector of the stability of the German currency. During the near-equilibrum period, the Bundesbank could fill both roles without problems, but with the reunification of Gemany, which caused the exchange of the East German currency for the Deutschemark at a very high, excessive rate, created a conflict between the two roles of the Bundesbank: its constitutional role and its role as an anchor of the ERM....
The tremendous injection of capital from West Germany into East Germany set up strong inflationary pressures within the German economy."

At that time, by constitution, the Bundesbank should push up interest rates in order to control inflation pressures. But this was inappropriate for Europe and in particular Britain, since they were in recession. In Soros words: "That throw the ERM, which had been operating near-equilibrium, into dynamic disequilibrium". To avoid this kind of conflict of interest in the Bundesbank, Kohl proposed to Mitterrand (French president) a reform in the european institutions. This (adding other things) was the initial impulse to create the Euro and the European Central Bank.

So, in conclusion, the Bundesbank was advocating a different monetary policy than the one that chancellor Kohl needed and Germany was adopting a monetary policy (tight) inappropriate for the rest of Europe. This tension would not last too much. Sterling collapsed on Black Wednesday, September 16, 1992. And other weak European currencies depreciate too. 

Nowadays, we have some similarities with that scenario. First, Germany, given it's productivity and fiscal situation, would need a different monetary policy than the rest of Europe, since it has the best qualities to beat the recession . Notice that both Germany and France are between the most efficient countries (Source:, statistics at 2007):

With this undervalued euro and productivity, (good combination for growth) a tight monetary policy would be appropriate in case the first shoots of inflation appears in Germany. But this is no the case in the rest of the countries. Second, there is a tension between the monetary policy of the BCE and the fiscal and economic situation in countries like Greece, Italy, Spain, Hungary and Portugal (among other countries). The BCE advocates for tight policies (I mean tight in relationship with the ideal suitable policies for recession) in this countries, something difficult to manage in countries with negative growth. If they were not members of the euro, they would depreciate their currencies and there would not be such tension. But this tension could not last for ever. Something should happen.

Here the comparisons between these economies, estimates at 2009 (data source: CIA world factbook):

GDP (purchase power parity, in millions)



Current account balance as % of GDP:

Real GDP growth:

Notice that Germany is a country which would need a different monetary policy than the rest, if it had not had a negative real GDP growth. Then, with a depreciated euro, if the Germany machine starts rolling, the tension between the different economies will growth and the weakest countries would find very difficult to stimulate their economies, adding pressure to their membership of the common European currency.

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