May 08, 2006

The instabilities in the Euro

Scanning the papers yesterday and I saw this peice in The Business. There is a massive house price bubble infalting in Spain, with the Euro base rate at 2.5% and Spanish inflation at 3.9% it makes sense to take out as much debt as you can get your hands on, since the ECB is effectively giving you free money to do it with.

So people are, and since mortgages are the easiest way of getting a really large pile of debt there is a huge housing boom fueled by having the wrong interest rate. The house price bubble itself stokes up more inflationary preasure, which makes debt even more attractive. If spanish interest rates where set for spain then this could be offset by a rate rise. But they are not, so an inflationary spiral has started with no tools to control it.
The consequence of faster-rising costs in Spain is that it is steadily losing competitiveness against other euro-zone members such as Germany and France. Angus McCrone, author of the report and an economist at the Centre, said: “Since they are all locked into the same fixed exchange-rate regime, Spain has no chance to address a loss of competitiveness in the traditional way, by allowing its currency to fall. The recent Spanish economic performance is unsustainable.”
But the bubble can probably continue until either Spanish inflation reduces, or the Euro interest rates increase, neither of which are likely in the short term, and the longer the bubble lasts the more painful when it bursts.

There is another way of regaining competitiveness that may kick in eventually, relative deflation. However, as Italy is discovering, this is a very painful process that could last a long time. Not that Italy can realistically leave the Euro due to it's Euro denominated debts.

From a report last year HSBC thinks that there are three ways out of the Euro's problems:
First, significant economic and institutional reform is delivered which dramatically improves the functioning of the single currency. One problem here could be agreeing on the nature of the reform that is required. Second, European governments may attempt to protect domestic industries from foreign competition, although we suspect this would prove highly counter-productive. Finally, the economic situation may become so intolerable that the political commitment to the single currency is tested to the limit.
Since last year we have seen that the first option is seen as the last resort, especially in France, as it would mean disturbing the European Social model which is for some reason highly valued. So the second is the most probable.

Protectionism is also one of the EU's current policies and the one that eats the most cash, as CAP is principally about protecting European (and of them principally French) farmers from external competition. It is fraud ridden (no surprise there, this is the EU afterall), increases costs for consumers, and their taxes, hurts the third world, and yet still does not particually help European farmers. Even if they are somewhere other than England and actually get to see any of the money. This is already beginning as can be seen by the destruction of the Services Directive and reluctance of most of the major EU countries to not allow workers in from the 10 new EU countries. Protectionism is the most likely path. But since it does not tackle the underling problems they will not go away, and will create problems of it's own further increasing the internal preasures for breakup or reform. From there again it is not reform that will be the option of choice, especially with the current state of popular opinion towards the EU.

I expect the Euro to disintergrate within a decade, and probably sooner rather than later.


Blogger tomdg said...

The problem of a single interest rate being inappropriate for a large area isn't a new one; we've had it in the UK for years. "Every time they raise interest rates to slow house prices in London, thousands of people in the North East are made unemployed". I wonder why the pound hasn't fragmented?

Are interest rates inherently bound to a currency? Would it be possible, by taxation or fiat, to implement different local interest rates within a currency zone? That might be a help to the UK as much as to the eurozone.

Another interesting example is the US$ currency zone, which arguably includes the whole of the americas. What keeps that together?

I don't know the answer, of course, but it seems there must be some counter-pressure which tends to keep currency zones larger. It may be that it's a political pressure rather than an economic one?

9:16 am  
Blogger chris said...

It is political preasure that keeps most currencies together. That is why the north and south manage to maintain the same currency despite it not always being in their best interests. That is also why the Euro will not survive.

It was designed as yet another step on the road to a single nation state, and the Euro can only survive if the EU reaches it's goal of being a single nation state. But the momentum towards forming a nation called Europe is ebbing away, as they are increasingly having to ask the people in referenda as to whether they want to continue. And when asked in a referendum the people tend to say 'no'.

10:27 am  
Blogger chris said...

South America is not the same as the Eurozone. Many have exchange rate pegs to the US Dollar, but can and do revalue when needed. Each country sets it's own interest rates and taxes, so can set both monitary and fiscal policy as is best for it.

Euro countries have only fiscal policy to try and control their economies.

10:33 am  

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