More Reasons Why the Euro Won't Work

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In my previous

column on

EMU

I wrote on the political forces that have driven about a dozen European countries to participate in this grand single currency experiment that will be launched on New Year's Day 1999. Now I am going to relate some of the reasons why I think this whole thing is a very big mistake.

To begin, I find it somewhat confusing that the EMU project will create a single central bank for the 11 or more participating countries without creating a corresponding central treasury. This leads me to say up front that there would be nothing economically wrong with the various states of Europe merging in total as one "United States of Europe" -- a complete political union with one single government, one single treasury and one central bank. In that context, one currency makes perfect sense. But a monetary union without the backdrop of a full political union is a different matter. That will make for trouble.

First and foremost, I think the project may be doomed by the weakness of the stability pact. This is the agreement that was designed to prevent member governments from cheating on their budget deficit and overall indebtedness targets. In theory, the rest of the states have the right to impose onerous fines on fiscally errant members.

Now consider this scenario. Country X is unhappy that it is not sharing in the prosperity of the other members of the union. It gets no joy from the ECB. The bank refuses to lower euro interest rates because the northern bloc insists on holding the line on inflation. Political pressure from within Country X begins to mount. Its government decides to let the stability pact be damned. Full speed ahead with fiscal stimulus. Spend, spend, spend. Lower taxes. I think it is entirely open to question whether the union members would have the political willpower to hit Country X with big fines. For one thing, there probably would be sympathy from some other members, say Countries Y and Z, who also are smarting under the ECB monetary policy. On a bigger scale, the imposition of fines within the terms of the stability pact would probably be tantamount to a constitutional crisis for EMU.

This illuminates a common thread in this EMU project. Before the single currency, each government faced the judgment of the foreign exchange market. Now they can hide behind the currency union. What is going on here is a wholesale substitution of loose, fuzzy political mechanisms for the normal brutal but efficient and immediate judgement of economic markets. To my way of thinking, this is the wrong economic model. I trust the markets, with all their imperfections, far more than I go along with how politicians run economic policy.

Another concern that I have relates to the role of the ECB. Something that I have not seen given much attention anywhere is whether the ECB has the responsibility for stabilizing interest-rate spreads between the sovereign debt of the union members. Maybe no one is talking about this now, but just wait and see how the political pressures form.

As I understand the plan, all sovereign debt of member nations will be denominated in euros. That does not mean all the bonds will trade in the marketplace at the same yield. Weaker nations will trade at a premium yield to stronger ones. I see a subtle but potentially disruptive problem if the ECB gets into the spread stabilization business. The question comes to life with particular importance when you consider whether the ECB, in lieu of lowering overall euro interest rates, renders help to a particular member, or group of members, in the form of crushing any premium yield that has come to be attached to their debt.

Let's return to the case of Country X that decides to go on a full-fledged budget busting stimulus binge. Country X will have to issue bonds to pay the bill. That tells me that their spread to the German euro bonds will balloon upwards. Now what if anything is the ECB supposed to do about this? Maybe they will lean towards selling Bunts (Germany) and buying BTPs within the ECB portfolio. This would be a sterilized operation in the sense that it would have no impact on the money supply -- but taken to an extreme, it would degrade the balance sheet of the ECB and weaken the currency. It is a compromise, so to speak -- countries like Germany get to keep high interest rates. Others like Italy, Spain and France get help with their yield premium.

This analysis points to an important thing to monitor going forward -- look for sudden or even creeping changes in the composition of the ECB's bond portfolio. At the limit, they could end up with the currency of united Europe being backed by a central bank that is long up to its tonsils with the debt of the weakest nations in the union.

But you don't need to make such an extreme case to realize that the ECB will be an immensely political central bank. We already see it in this childish wrangling over who will be the head of the bank and for how long. The Germans want a Dutchman and the French want their own man, Mr. Trichet.

A political currency is a weak currency. In fact, if you are planning to make a career of trading the euro, I advise you to first bone up on political science.

David DeRosa heads a trading research firm and is an adjunct professor at the Yale School of Management. His column on international finance and trading appears Mondays, Wednesdays and Fridays. He welcomes your feedback at

derosa@derosa-research.com.