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A Brief History for the Euro

2002-03-12

The euro, introduced two months ago, is unlikely to survive because it is founded upon political strategies rather than economic principles. Whether the European Union itself survives is an open question.

A European union was conceived in the aftermath of World War II by Jean Monnet and Robert Schuman as a mechanism to:

  • reconcile France and Germany (Napoleonic Wars, Franco-Prussian War, WWI, WWII)
  • legitimize, stabilize and support West Germany’s post-war democratic government
  • reconstruct the West German economy
  • integrate West Germany into the West European political economy:
    • to prevent a future European war
    • to promote West European economic growth
    • to counterbalance the Soviet Union

The political will for European integration was strengthened during the Suez Crisis of 1956 when it became clear that:

  • the United States had become a global superpower
  • the British and French Empires were disintegrating
  • Germany would likely remain divided
  • only a united Western Europe could ‘compete’ with the United States and the Soviet Union

European integration proceeded as follows:

  • 1951 the European Coal and Steel Community (ECSC)
  • 1957 the European Economic Community (EEC)
  • 1957 the Atomic Energy Commission (Euratom)
  • 1967 the European Community (EC) superseded the ECSC, EEC and AEC
  • 1971 adoption of the Werner Report on monetary integration
  • 1973 end of the post-war economic growth cycle
    • oil price shock
    • stagflation (weak economic growth + high inflation)
    • historic decline in productivity growth
    • collapse of the Bretton Woods Agreement of fixed international exchange rates
  • 1975 Britain joined the EC
  • 1976 collapse of Sterling, IMF bailout
  • 1979 the European Monetary System (EMS) established fixed European exchange rates (with a 4.5% trading range)
  • 1985 Schengen Agreement to eliminate border controls
  • 1986 the Single European Act removed controls on the flow of goods, labor and capital (came into effect in 1992)

At this point, the European Community made a structural choice. The Impossible Trinity states that any group of countries seeking economic union must choose two of the following three options:

  • independent monetary policy (ability to set national interest rates)
  • fixed exchange rates between member countries
  • free flow of capital (no controls over money flowing into or out of a country)

The European Community chose fixed exchange rates and free flow of capital, but it meant that member countries would have to give up control over their interest rates and accept a single, one-size-fits-all, European monetary policy. The EMS would have to evolve into a rigid monetary union. The safety valve of floating exchange rates would be removed. Yet in order to succeed, a monetary union between countries requires the following:

  • a common language and culture
  • a common legal and institutional framework
  • high capital and labor mobility
  • a strong, central fiscal authority (a fiscal union)

A whole requires fluidity between its member parts. Economic agents and their resources must flow quickly and smoothly between opportunities and geographic locations. There can be no legal, cultural, linguistic or institutional barriers. Compartmentalization, the friend of ships, is the enemy of monetary unions. Moreover, there must be a strong, central fiscal authority (central government) to cross-subsidize cold zones (low investment, low growth) with money from hot zones (high investment, high growth).

Unaware of the impending Information Revolution, the European Community sought to revitalize the post-war economic paradigm. Yet the post-war political paradigm was coming to an end:

  • 1989 collapse of the Soviet Union, disintegration of the Warsaw Pact
  • 1990 German reunification, former East Germany becomes part of NATO
  • elimination of the need for alliance between Western Europe and the United States

This unexpected political shock produced an unexpected economic shock. German reunification generated inflation (in former West Germany) as eastern Germans (and other eastern Europeans) frantically purchased goods and services with inflated currency (a subsidized exchange rate of 2:1 instead of a realistic 6:1 Ostmarks to Deutschmarks) from western German businesses. By 1992, the western German economy was hot while the rest of Europe was cold (in recession). The German central bank (Bundesbank) raised interest rates to cool the German economy. The other European countries raised interest rates to maintain the fixed exchange rates set by the EMS. Yet high interest rates in the rest of Europe were stifling economic recovery.

In the midst of this economic imbalance, the member countries of the EC signed the Treaty of European Union (Maastricht Treaty), which established the European Union (political) and European Monetary Union (economic). There would be one European central bank (ECB) issuing one European currency (euro) and setting one European interest rate. The Maastricht Treaty was rejected in a Danish referendum, barely survived a French referendum and was frog-marched through the British Parliament (without a referendum). The economic imbalance was untenable. The EMS collapsed.

At this point one would have expected the European Community to abandon monetary union. The Information Revolution was gathering speed, generating a new, global, economic paradigm, which married inexpensive, decentralized IT systems to new and sophisticated financial instruments. Never before could floating exchange rates be managed so effectively and efficiently by businesses and individuals. The Industrial Era of Customs Unions was ending just as the Maastricht Treaty was coming into effect.

Why, then, did the European Community (now the European Union) persist with its goal of monetary union? Because with the collapse of the Soviet Union, the reunification of Germany and the absorption of former East European (Communist) countries into the former West European (Capitalist) economic system, the West European project became a pan-European project. With the Soviet Union out of the way, there were renewed ambitions to construct a ‘United States of Europe’ to rival the United States of America. Thus, while economic arguments for monetary union were getting weaker, political arguments for monetary union were getting stronger.

Today, 10 years since structural problems undermined the EMS, those same structural problems remain. The Information Revolution is accelerating. The Internet became a global phenomenon in 1995, eBay and Google were founded in 1998. In the 10 years since the signing of the Maastricht Treaty, there have been almost seven complete iterations of the 18-month IT product lifecycle (based on Moore’s Law). As a result, the cost of a unit of 1992 IT-functionality (computer+telecommunications capability) has fallen 99 percent. To put it another way, the 1992 price of a unit of IT functionality now buys 100 units. By 2012 it will buy 10,000 units. This does not include the service industries that will sit atop all that IT functionality.

How long, then, can a socially compartmentalized monetary union survive in a decentralized, global Information Economy? Even if the European Union were to create a fiscal union managed by a strong central government, the only thing to flow across borders will be money. Human capital will remain rooted in the geography of linguistic, cultural and institutional communities. If we rerun the EMS experiment, this time with a fiscal union, would Germany consent to huge subsidies for the rest of Europe?

What, then, is on the horizon? Let us look at some trajectories.

  • 1995 the World Trade Organization supersedes the GATT
  • 1996 United Arab Emirates and Qatar join the WTO
  • 1997 Hong Kong reverts to China
  • 1999 Macau reverts to China
  • 2000 Oman joins the WTO
  • 2001 China joins the WTO
  • 2002 Taiwan joins the WTO
  • China and Vietnam begin their Industrial Revolutions
  • India begins its Industrial/Information Revolution
  • 2 billion people (1/3 of the global population) come online
  • Dubai begins construction of a global financial/IT/media hub

In terms of size and significance, the political and economic changes afoot exceed the collapse of the Soviet Union by scales of magnitude. What happens when this economic tsunami rolls across a brittle European Monetary Union?

The Asia Effect:

  • low-cost Asian labor suppressing wages in low-skill industries in developed economies
  • low-cost eastern European labor suppressing wages in low-skill industries in western Europe
  • a decline in the price of traditional goods and services in developed economies through cheap imports from Asia and eastern Europe

The Technology Effect:

  • dramatic increases in productivity from new IT systems
  • a wide range of new IT-based goods and services
  • a decline in the cost of production of traditional goods and services
  • a decline in the price of traditional goods and services
  • rapid obsolescence of traditional manufacturing systems in developed economies

The Economic Result:

  • high unemployment in countries that are slow to adopt the new economic paradigm
  • high inflation in the emerging Asian and eastern European economies
  • low inflation in developed economies
  • low interest rates in developed economies

It would appear that the developed world is facing 20 years of of low inflation and low interest rates. At the same time, China will be importing large quantities of raw materials and machine tools and exporting large volumes of traditional manufactured goods. Producers and consumers in countries that supply China with raw materials and machine tools will benefit. Consumers will benefit in countries that purchase traditional manufactured goods; producers will be undermined.

Across the developed world, sustained low interest rates will generate an investment boom, a consumption binge or both. Those countries that use low interest rates for consumption will sacrifice a once-in-a-generation opportunity to increase TFP growth (through technological innovation, new plant and equipment, more efficient organizational systems, R&D, high-tech entrepreneurship), foregoing the returns necessary to service the debt.

What happens, then, if German producers, consumers and investors seize the opportunity afforded by China’s Industrial Revolution while Spanish consumers binge on cheap imports and cheap loans? In 20 years, Germany could reap the rewards of high TFP growth while Spain goes bankrupt. The only way out for Spain in such a situation is a massive devaluation of its currency, dramatic falls in low-skill wages or a combination of both. Membership in the euro will prevent the first; riots in the street will prevent the second. Will a frugal Germany be willing to bail out a profligate Spain? Unlikely.