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The euro’s path to junk status

Published in Business Spectator (Melbourne), 22 January 2015

Ending the Swiss franc’s peg to the euro surprised market participants, analysts and commentators alike, including this writer.

Unlike the introduction of the euro peg in 2011, which was flagged beforehand, the end of the measure was prepared in secret.

However, the timing of the Swiss National Bank’s decision could not have been more appropriate. From all indications, it looks increasingly certain that the euro is morphing into a junk currency.

Last week, the advocate general for the European Court of Justice presented his interim ruling on the European Central Bank’s Outright Monetary Transactions program, effectively allowing the bank the purchase of sovereign bonds. (Whether the German constitutional court will follow this opinion is a different matter.)

Today, the ECB is widely expected to announce the beginning of its quantitative easing program. The only question mark concerns the size of the money-printing exercise, which might reach a trillion euros. And on Sunday, the anti-austerity Syriza party is likely to win Greece’s snap elections, which could trigger a new eurozone crisis.

So congratulations to the Swiss for pulling the plug on its de facto eurozone membership of the past three years. They got out just in time, as things are going to get worse — much worse.

Admittedly, the immediate future does not look too rosy for the Swiss. No doubt its export-oriented economy will be hit hard by the appreciation of the franc against the euro. But such short-term pain is worth suffering if the alternative is being part of a crumbling currency bloc.

Only half a year ago, the euro traded at close to $US1.40. It has since fallen to around $ US1.15 and leading analysts predict it to be at parity or below over the coming years. This is a function of US monetary policy slowly returning to more normal circumstances at the same time that Europe is preparing for a glut of freshly created euros.

Beyond that, it is a sign that Europe’s common currency has lost its credibility.

It was never meant to be this way.

When the euro was introduced, it was presented as a solid, respectable and hard currency. It was a currency that was meant to rival or even replace the US dollar as the world’s leading currency. It was hoped that it might eventually become the currency of choice for commodity trading. And to the European public, it was sold as a safe store of value. If only.

Any fiat money (i.e. a currency not backed by a physical commodity) is entirely dependent on trust. It is difficult enough to create and maintain such trust for currencies of established nation states which can often look back to centuries-long histories. It is far more difficult to establish trust for an entirely new currency that is jointly managed by more than a dozen diverse countries.

The European Union therefore tried hard to provide a legal framework from which trust could grow. In particular, European Treaty Law mandated that:

European governments were required to adhere to strict fiscal rules regarding permitted debt loads and budget deficits.
The ECB was meant to be politically independent and solely focused on maintaining price stability.
Neither the European Union nor any of its member states should be liable for the debts of any other member state.
The ECB was not allowed to finance governments in any form.
In principle, these rules would have been a sufficient for a successful currency. There is only one problem: no-one ever played by them when it mattered.

Rule #1 was ignored before even the euro got introduced. The Maastricht Treaty’s provisions to limit debt-to-GDP ratios to 60 per cent and annual deficits to 3 per cent of GDP did not have a lasting effect. Despite significantly high debt loads, countries such as Belgium, Italy and Greece were admitted to the eurozone club. And despite higher annual deficits in 2003, Germany and France escaped punishment.

Rule #2 was also disregarded before the euro even saw the light of day. Wim Duisenberg, the ECB’s first president, was not allowed to serve his full eight-year term (which was supposed to increase his independence) but had to promise to resign half-way through his term to make room for Jean-Claude Trichet. It was an early sign that the ECB was closer to politics than it was meant to be, and that price stability was not the only thing it concerned itself with.

Rule #3 only looked good on paper until the moment it was tested in practice. From the start of the Greek debt crisis in late 2009 until the first Greek bailout in May 2010, it only took about half a year. Once Greece was bailed out, the path was cleared for further assistance measures for Spain, Ireland, Portugal and Cyprus. To make matters worse, the introduction of the European Stability Mechanism even provided an entirely new toolkit to systematically conduct such treaty violations. We may well see the reappearance of the ESM if Greece gets into trouble after Sunday’s elections.

Out of the original set of rules, only rule #4 thus remained intact (more or less). Of course, the ECB had already assisted government financing in different ways. For example, it had provided additional finance to commercial banks through its Longer-Term Refinancing Operations. This allowed commercial banks to purchase sovereign bonds, which helped to suppress their yields. ECB President Mario Draghi had also helped Europe’s finance ministers with his pledge to do “whatever it takes” to save the euro.

With the ECB’s quantitative easing program, government financing is moving to a new level. Instead of providing only roundabout support to struggling European governments, the ECB itself will become the provider of finance. It may be doing so under the pretence of fighting deflation. However, it is also providing fresh money to European sovereigns, thereby reducing their refinancing costs.

With all core rules governing the workings of the eurozone now suspended, who would still have trust in the euro as a currency? The Swiss obviously did not and rushed to end their unfortunate currency peg, even if it cost them dearly in the short term. International currency traders do not seem to have much trust left either, if the euro’s plunge against the US dollar is any indication.

Over time, European politicians and central bankers have removed all the rules that could have made the euro a success story had they been adhered to. Ironically, none of the deviations from the original rules of monetary union had the desired effect of strengthening the euro as a currency, solving the Eurozone’s economic imbalances or promoting economic growth in Europe.

On the contrary, with every rule it has abandoned, the euro has become more and more of a junk currency. It has lost any credibility it ever had and it is far from being seen as a potential global lead currency.

Europe’s central bank has manoeuvred itself into a hole and the introduction of quantitative easing shows that it won’t stop digging. At least the Swiss National Bank got out before being dragged down any further.

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