Of Currencies, Crises and Completions

In all the best fairy stories, the birth of the beautiful baby princess is accompanied by three fairy godmothers. The godmothers and their various gifts form the framework for the subsequent story, as the princess grows up and lives out her destiny.  So too, the birth of the Euro was accompanied by three gifts – but in this case they were rather different.  They were a Problem, a Secret and a rather Tall Tale.

The Problem is simply put.  The ambition of the founding fathers of the Euro was to create rather more than just a common currency.  Rather, they had in mind an Economic and Monetary Union – this is in fact what E.M.U. stands for, despite the common belief that it stands only for European Monetary Union.  And the difference is important, because a true Economic Union is an altogether larger and more ambitious construct than a common or shared currency:  it requires greater harmonisation of all aspects of the member states’ economies, and in particular much closer co‑ordination between their respective finance ministries.

And this was where the Problem arose, because the founding fathers of the Euro soon discovered that there was not enough political appetite in the national capitals of the EU for the required degree of closer financial (and especially fiscal) co-ordination and co-operation for a true economic union to be created.  National governments were not ready in the late 1990s to share more than a very small amount of their fiscal resources, let alone allow the establishment of a common finance ministry at Union level.  So it was agreed that member states would remain fiscally sovereign, and that the EU’s budget would remain a minute fraction proportion of the total EU GDP.  And that E.M.U. would be launched as a structure with a Union-wide monetary policy but National (member state) fiscal policies.

At the time of the launch of the Euro, this was widely understood and discussed.  But one small element of the incomplete nature of E.M.U. was deliberately hushed up.  This was that while a structure with a common monetary policy and separate fiscal policies will work in most circumstances perfectly well, there is one particular situation where it can have adverse consequences.  And that is where a situation migrates from being one that requires a monetary policy response, to one that requires a fiscal policy response.  And one important situation where monetary policy and fiscal policy meet like this is a financial crisis.

Let us review briefly the generally accepted analysis of types of financial crisis.  Firstly, we know that the financial system is inherently prone to periodic crises, due to its nature as a transformer of maturities (the fact that banks typically borrow short, lend long) and as a transformer of credit (the fact that banks use their balance sheets to give their depositors a better credit protection than that of the bank’s loan clients).  Because of these two transformations, there have always been financial crises, and even the most optimistic of regulators will admit that there always will be – the aim of eliminating all risk of financial crisis remains wholly Utopian.

Secondly, the standard text‑book analysis divides these crises into three types:

Firstly, there are small-scale crises, which the financial system can handle itself at no great cost. For these, both for reasons of market efficiency and of moral hazard, the authorities are best advised to do nothing and not intervene. Example: institution-specific failures.

Next, we have medium-scale crises, which the financial system may be able to handle, but only at great or extended cost. Here the authorities may be able to speed the resolution of the crisis and reduce the overall cost to society at large by judicious assistance.  This is usually done in the form of lending money against good assets, and as this is at heart a monetary operation it is usually done by central banks.  Example: general liquidity problems.

Lastly, we have large-scale crises, which the financial system cannot handle on its own at all. Here the authorities have to act, and need to do so not by financing the banking system’s assets via loans but by buying assets outright. This is nationalisation, which is a fiscal operation and so the responsibility of finance ministries.  Example: general solvency problems.

The most common point at which a medium-scale crisis migrates to being a large-scale or systemic crisis is where solvency problems in one institution threaten to cause further solvency problems in other institutions.  High-profile bank failures are therefore a dangerous time for any financial system and for the authorities responsible for it, as taxpayer’s money moves from being used in a way that is secured against good assets to a way that is unsecured and therefore potentially at risk.

And this is where the Euro’s founding fathers found that their construction had an Achilles heel.  With fiscal policy at the national or member state level, it was agreed and accepted that responsibility for handling bank failures would also have to remain at national level.  But this poses two questions:  how, in the absence of an ability to create money unilaterally, would a member state finance a large-scale bank rescue, and who would arrange and pay for the rescue of a bank that had significant operations in more than one member state.

The founding fathers had no answers to these questions immediately, and were left hoping that if no-one shone a light on their Achilles heel, perhaps they would be able to find a solution later, before the questions arose.  This was the Euro’s Secret, and the founding fathers were at pains to ensure it stayed well in the background, out of sight and, they hoped, out of mind.

And so, to further their aim of keeping the spotlight as far away from their Secret as they could, the founding fathers created a rather Tall Tale. This was the claim that the creation of the Euro was a unique experiment, and that there was no precedent for such a bold monetary union. Well, “up to a point, Lord Copper”, as the saying has it. For while it is possibly fair to say that no monetary union of this scale had been attempted before, there are a surprisingly large number of examples of previous monetary unions in history, and there are even quite a few examples of monetary unions between states which wished to retain fiscal sovereignty.

Moreover, research shows that the history of these monetary unions is very informative. It transpires that there are in essence just three main kinds of monetary union:

The first type of union is a monetary union in which a small country borrows the currency, and so also the credibility, of a larger country. Examples are legion, and include Luxembourg using the Belgian Franc, the Irish Free State/Republic of Ireland using the Pound Sterling from its independence until 1979, Panama using the US Dollar and so on.

This type of monetary union has historically always been successful, at least as long as the small country wants it to be – the larger country usually does not mind either way and quite often does not even notice the union. One does not imagine the Federal Reserve makes any allowance for the economic situation in the several countries that use the US Dollar when deciding on the Fed Funds rate.

The second type of union is a monetary union as part of a political union. Again, examples are legion, with in Europe alone the union of the English and Scottish currencies in 1707, the currency unions which formed part of the creation of Germany and Italy in the 19th century, the Soviet Rouble and so on.

And again, this type of monetary union has historically always been successful, at least as long as the political union holds. Moreover, a monetary union as part of a political union can overcome even major economic differences between the constituent regions, as in the Italian unification between the rich and industrial north and the very much poorer and agricultural Mezzogiorno, or more recently as in the second German union in 1990 when the Federal Republic absorbed the old German Democratic Republic.

Interestingly, such a monetary union does not often survive the break-up of the political union by very long, as the collapse of the Soviet Union showed, or the creation of the Czech Republic and Slovakia out of former Czechoslovakia, where the planned common currency between the two states lasted for just six weeks after the “velvet divorce”.

The third type of union is a monetary union between states which wished to retain fiscal sovereignty. Again, there are several examples, such as the Latin Monetary Union[1], the Scandinavian Monetary Union[2], the East African Monetary Union[3] and so on.

But history relates that such currency unions do not survive; in fact there is no example of one that has proved permanent[4]. Sooner or later the national interests of the member states of the monetary union dominate adherence to the common interest, and the monetary union is allowed to break up and wither away.

This was the awkwardness that the founding fathers of the Euro hoped to hide with their Tall Tale. The Euro, as the currency of a monetary union between states which wished to retain fiscal sovereignty, was not such an unprecedented experiment after all. In fact, there were several well known precedents, some of them quite close parallels, and the experience of those precedents was not altogether very encouraging.

Now one should not imagine that the founding fathers did not know this, or that they did not have a plan to overcome their Achilles heel. The inability to secure political agreement to a full monetary and fiscal union for the EU from the outset did not dampen enthusiasm for this as the ultimate goal; and if this goal were to be achieved, then the Euro would move much closer to the second type of monetary union and would correspondingly be much more secure. But in the meantime, the founding fathers moved to discourage too much historical analysis and comparisons, and the Tall Tale served its purpose very well.

Until the present financial crisis erupted. Suddenly the nightmare of major bank failures in the Eurozone became a real possibility, and the incompleteness of Europe’s Economic and Monetary Union began to be much more widely realised and its consequences more widely appreciated. Individual countries in the Eurozone started acting independently, taking major steps such as guaranteeing their banks unilaterally[5]. Then a major bank with operations in more than one country – Fortis Bank – ran into trouble and needed assistance. In the case of Fortis, the Belgian and Dutch authorities, with impressive communautaire spirit and with assistance from Luxembourg, were able through discussion and agreement to put together a joint package of finance and support in time; but the co operation between the respective governments, successful as it was, was the co‑operation of people up against a ticking clock and with very few other options open to them, and it was clear to all that a better way had to be found to combat such situations in future.

And here another feature of the way E.M.U. has been constructed comes into play. As the financial crisis facing the Eurozone member states escalates, so the necessary solution moves from being one of monetary policy operations – which have been conducted very effectively for the whole Eurozone by the ECB – to fiscal policy operations. In other words, just as all commentators are agreeing that countries need to act together to tackle the financial challenges they jointly face, so the EU’s response moves from being at Eurozone level to Member State level.

Now as the Chinese know well, a crisis is also a time of great opportunity. The Chinese character for “Crisis” is made up of two elements, Danger and Opportunity. The danger facing the EU if member states cannot work together is clear. The power of national interests has undone currency unions in the past, and no-one can claim with credibility that the Euro is wholly immune from such a fate.

But the opportunity is also clear. Just as happens in the old fairy stories, the three gifts at the Euro’s birth are now all revealed. The Tall Tale is exposed, the Secret is out, and the Problem is to be faced. It is now clear to all that Europe’s monetary union is a half-finished project. The current arrangement was always going to be either the fore-runner of full economic union (including an EU federal finance ministry) or a dead-end which would in time collapse, and it was always likely that a financial crisis would be the spur for the EU’s politicians to decide which they want. That crisis has arrived, and it will be interesting to see what the politicians choose. If Europe’s leaders are bold enough, and if they can use this crisis to forge a deeper common approach to the challenges they face, then their monetary union may finally become the Economic Union the founding fathers dreamed of, and the future of the Euro will be much more secure.

But if not, then the Euro itself may be the most notable casualty of the current financial storm.

 

[1]             The Latin Monetary Union was founded in 1865 and was only finally disbanded in 1927. It was a currency union based on a common metal standard, and initially had 4 members: Switzerland, France, Belgium and Italy. At various stages of its existence it had other adherents, reaching a maximum of 14 countries towards the end of the 19th century. The union was not a true single currency, but rather was a regime in which countries minted their own coins to a common specification, with the aim that they would thus be acceptable in other member states.

[2]              The Scandinavian Monetary Union was created in 1873 with Sweden and Denmark as founding members, and with Norway joining two years later. It lasted until 1914, when wartime exigencies forced the countries to suspend convertibility, and again was a regime of mutual acceptance of each state’s coins in the other states. All three countries continued with their own currencies throughout the period of the Union and after, one result of which is the common name of Krone/Krona for their currencies today.

[3]              The East African Shilling was the common currency used by the separately governed British possessions of Kenya, Uganda and Tanganyika from 1921. The three territories, while all under British administration, were separate fiscal entities. On the independence of the three countries (on various dates between 1961 and 1963), the currency union continued in place for a further 3 years, and the EA Shilling was only demonetised in 1969.

[4]              Examples which might seem to be counter to this, such as the East Caribbean Dollar and the West African Franc, are in fact examples of type one monetary unions – the common currencies are all pegged to a major currency, and in effect therefore the small countries are borrowing the currency and credibility of another country’s currency.

[5]              The question of how exactly a member state of the Eurozone finances a major bank support operation has still not been fully determined. Finance ministries can only use the resources they can raise on the capital markets, for example through bond issuance, and national central banks are barred under the rules of E.M.U. from financing them by money creation should this prove insufficient.

A version of this essay was first published by State Street Global Advisors as part of their Insight programme