Germany and the Euro

This post is a response to a comment by Tim (here):
"I just heard that Germany is considering leaving the euro. ...What do you think?"

I have not heard such a rumor - at least not at any credible level. I would be surprised if such sentiment was gaining significant strength in Germany. Here is the latest data I could find and my understanding of what is happening.

Per Eurobarometer 70, December 2008, 56% of German population tend to trust in the ECB - a fall of 4 percentage points on Spring 2008. EU27 average was significantly lower at 48% (a fall of 2 percentage points on Spring 2008). This still places Germany as 13th ranked country in the EU27 in terms of overall trust in the ECB. Ireland is 14th with 52% (down 6 percentage points on Spring 2008). In general, decline in trust for ECB tends to be rising with the worsening in economic conditions: Portugal leads the fall with -10%, Spain follows with -8%, Ireland comes next.

Also significantly, the decline in those trusting ECB has translated into an even higher rise in those who tend not to trust the ECB (as opposed to those who declined to answer): in Germany, 8 percentage increase in those who do not trust the ECB, in Spain +13%, in Ireland +10%, and so on. This shows that people are actually becoming more decisive in their negative position vis-a-vis ECB policies. But, again, it does not show Germans swinging decisively against the Euro membership. In my view, the rising negative perception of the ECB is driven by the policy lags with which the ECB greeted the economic crisis between July 2007 and July 2008.

As far as I understand, there was no direct question on the Euro in the preliminary EB70 results available at this time.

Eurobarometer 69, Spring 2008, does show results for trust in Euro itself. Even before the crisis pushed Germany into a recession, only 17% of Germans tended to claim that their approval of the Euro is one of the top two reasons for supporting the ECB. Same as in Ireland, but below the EU27 average of 19%. Table below gives results for "QA25a Which of the following are the main reasons for trusting the European Central Bank?":
"QA26a Which of the following are the main reasons for not trusting the European Central Bank?" Table below shows response to the above question:When it came to mistrusting the ECB, 18% of Germans named being against the Euro as one of the top two reasons for their position vis-à-vis the ECB.

These numbers do not show a significant doze of skepticism about the Euro amongst the Germans, but they do show that the two tails of the attitudes to Euro distribution are both ‘fat’ and virtually identical in size. In other words, anti-Euro enthusiasts are roughly as prevalent as Euro supporters in Germany. In Ireland, those mistrusting the ECB due to their dislike for the Euro are less numerous than those who support ECB because of the Euro.

Overall, 60% Europeans (EU27), 69% of Germans, and 87% of Irish approved of the Euro in Spring 2008. Going further back in time, Eurobarometer 68 (Autumn 2007) shows 68% of Germans supporting the Euro, 87% of the Irish doing the same. EU27 average was 61%. Eurobarometer 67 (Spring 2007) showed 71% of Germans supporting the Euro, as opposed to the EU27 average of 63% (Ireland – 88%).

So on the net, the trend in the EU27 is for a very slight decline in support for Euro from 63% in the Spring 2007 to 60% in Spring 2008. For Germans these figures were 71% to 69% and for Irish – 88% to 87%. This is hardly a sign of a decisive shift in opinion against the Euro.

It will be interesting to see, once full Eurobarometer 70 results are in, if there has been further erosion in support for the Euro. Most likely, given the current economic conditions, there would be a rising sense of pessimism. But I still doubt Germany will reach a swing point.

Needless to say, the implications of a German exit from the Euro would be disastrous for the global financial system and for Ireland in particular.

First there will be an effect of unwinding the Euro positions worldwide and a monumental mess of absorbing ex-Euro positions (assets and liabilities) into national currencies.

Second, there will be a logistical nightmare of reintroducing new exchange rates, as the original (EMU-entry point) exchange rates are no longer reflective of the actual economic conditions.

Third, there is a problem of divesting the ECB roles back to the national Central Banks and re-establishing these Central Banks' reputational capital.

Fourth, for countries like Ireland, indeed for the APIIGS, the end of the Euro would spell a massive and instantaneous devaluation. Imagine the trade flows and investment positions disruptions that would arise if the reintroduced 'punt' were to be devalued by ca 50% instantaneously.

Fifth, the Euro has become a part of the reserve currencies basket around the world. It is hard to see how the central monetary authorities around the world can unwind their Euro holdings in an orderly fashion in the current environment.

Sixth, the resulting crisis at the EU level - triggered by a removal of the fundamental pillar of EU expansionism and internal markets supports - will be of a magnitude equivalent to the current economic and financial crises combined. Amongst obvious economic implications, there will be a significant political cost of the tearing up of the entire fabric of the EU elite built on the singularly integrationsit agenda.

Fortunately, once again, I am not seeing any significant signs of the public opinion in Germany shifting decisively against the country membership in the Euro.

10 years of the Euro: Part III. Two notes

In two footnotes to these two posts on the Euro (Post I and Post II),

(1) A recent article by Maurice J.G. Bun and Franc J.G.M. Klaassen, titled "The Euro Effect on Trade is not as Large as Commonly Thought", published in the Oxford Bulletin of Economics and Statistics, Vol. 69, Issue 4, pp. 473-496, August 2007 provides an even more damming estimate of the poor Euro performance as trade-facilitation currency union:
"Existing studies on the impact of the euro on goods trade report increments between 5% and 40%. These estimates are based on standard panel gravity models for the level of trade. We show that the residuals from these models exhibit upwards trends over time for the euro countries, and that this leads to an upward bias in the estimated euro effect. To correct for that, we extend the standard model by including a time trend that may have different effects across country-pairs. This shrinks the estimated euro impact to 3%."
... and this is from two Dutch academics, not some 'Euro-skeptic' Americans or Brits... Ouch...

(2) The same issue of the Oxford Bulletin of Economics contained another article - previously published by the Austrian Central Bank - by Harald Badinger from the Europainstitut/ Department of Economics of Wirtschaftsuniversität Wien, titled "Has the EU’s Single Market Programme fostered competition? Testing for a decrease in markup ratios in EU industries". This research showed that using panel data covering 10 EU Member States over the period 1981 to 1999, for manufacturing, construction, and services, as well as for 18 detailed industries, the EU’s Single Market Programme has led to:

• an increase in competition in the aggregate manufacturing, and – less robustly – for construction;
  
• a decrease in competition in most service industries since the early 1990s.

This, also, is a discouraging sign for the Euro, especially as services account for more than half of the entire economic activity (and trade) within the Eurozone...
Once again, Ouch!..

10 years of the Euro: Part II. Mid-term Euro trend

See a disclosure here

It is this (see Part I) political motivation for the Euro that now threatens to undermine the main reasons for arguing that the Euro is a success story. European elites see the strengthening of the Euro against the US dollar as a sign that the new currency is gaining the market share as a global reserve currency.

But the problem for the Euro is that gaining a market share in a largely symbolic market for reserve currency at the expense of losing a market share in the real trade markets is a Phyrric victory.

NBER paper by Michael Bordo and Harold James (NBER Working Paper 13815, February 2008) makes similar point in devoting quite a bit of space to the discussion of the Euro as an international currency. They identify the precise mechanics for politically motivated international demand for the Euro as an alternative to the US dollar.

Because of the demand for Euro as an international reserve vehicle is politically motivated, argue Bordo and James,
“It is – projecting into the future – quite conceivable that there will be moments at which massive political pressure, built up by underlying anti-globalization concerns and focused on the technical necessities of dealing with major international crises, leads to a serious onslaught against the ECB and against the euro.”

From politics to economic fundamentals
Furthermore, the strengthening of the Euro throughout 2008 has been largely driven not by the underlying strengths of the Eurozone economies, but by the interest rates differentials between the ECB, BofE and the US Fed.

Chart 1 shows the link between the FX market and the policy gap – the gap between the cost of central banks funding as determined by the difference between the actual (realised) monthly Federal Funds Rates and the minimum benchmark ECB Deposit Facility rate from August 2000 through December 2008 (the entire historical data available to us).
As this figure highlights, the current Euro crisis is a lagged aftermath of the policy crisis that saw the medium-run directionality of the Federal Reserve policy becoming the exact opposite of the ECB’s policy stance around November 2005. By July 2007, as the credit crisis first manifested itself, the ECB’s suicidal denial of the problem became even more clear as the Eurozone rates have actually risen in the face of collapsing credit markets, just as the Fed aggressively pursued rates cuts.

Of course, many other variables help driving the exchange rates especially in the long run (more on this in the next post). However, the link between the Euro value and the interest rates mismatch between the ECB and the Fed is a historical regularity, as shown in Figures 2 and 3 below.
Figure 2 above plots the relationship between the monetary policy gap and the Euro/USD exchange rate. This relationship is causal, strong (with 63% of variation in the FX exchange rate captured by variation in the policy gap) and robust over time. It is also economically significant, with every +25bps change in the gap between the US Fed rates and the ECB rates inducing a ca Euro 0.021 strengthening in the dollar. This assumes parity at USD1.43 per 1 Euro for the period selected.

Figure 3 shows a similar relationship between the synthetic Euro/Dollar rate (linked to the traded index designed to replicate the returns on holding Euro). In fact, both the synthetic index and the actual exchange rates reaction to the monetary policy gap are virtually identical at -8.2 points for the former and -8.5 for the latter.
So where do we go next?
Figure 4 shows the actual movements in the monthly EUR/USD exchange rate and its 6-months and 12-months moving averages.

The relationship between the three lines indicates that in Q3 2008 we have entered a new trend of strengthening dollar that, so far, has taken us back to the levels closer to the resistance levels of the early 2007. The fact that we have, since, returned back to the levels consistent with Q3 2007 is a worrying point, as it suggests that November-December correction in the extremely high valuations of the Euro is not likely to persist in time.

However, there is little certainty as to the near-term direction in the EUR/USD rate. Several forces are currently pulling the FX markets demand for both currencies in different directions:
(1) The monetary policy gap is set to close in the next few months as the ECB loosens the key rates more dramatically than the already bootstrapped Fed;
(2) The liquidity policy gap (not plotted in this post) is also set to narrow as the ECB will be playing catch up with the Fed on injecting liquidity into the markets. Note: ECB’s liquidity creation is likely to support sovereign bond markets across Europe’s weaker economies (Ireland, Greece, Italy, Spain, etc), while the US liquidity creation is going primarily into banking and financial sectors;
(3) Financial markets demand for Euro is likely to weaken relative to the US dollar around Q2 2009 as US stock markets and bond markets will strengthen relative to the Eurozone;
(4) Both the US and the Eurozone’s imports will stagnate as the US consumers continue to de-leverage and the Eurozone consumers suffer significant personal disposable income shocks. However, while the US consumers de-leveraging has been pretty much fully priced in the current valuations, the slowdown in the Eurozone’s consumer demand is yet to be reflected in the FX valuations;
(5) US exports will remain relatively more robust than those in the Eurozone;
(6) A relative strengthening of the US economy vis-à-vis that of the Eurozone countries starting with Q2 2009 is likely to further improve demand for dollars;
(7) Relatively more dynamic prices contraction in the real estate coupled with the falling cost of mortgages financing in the US as compared to the Eurozone will continue to push the dollar down against the Euro;
(8) Stronger fiscal stimuli in the US than in the Eurozone will tend to favour relative increases in demand for dollar.
(1)-(3), (5)-(6) and (8) will all tend to support relative devaluation of the Euro. (4) and (7) will imply stronger decline in foreign exchange demand in the Eurozone than in the US – a force that will tend to support further devaluation of the dollar.

On the net, the preponderance of fundamentals suggests strengthening of the dollar relative to Euro in the next 3-6 months into $1.30/€1-$1.35/€1 range, but the key to this process will be increased volatility of the 3-months and 6-month MA trends (as opposed to the volatility in the daily series). The signs of this process taking hold should be traceable by the 3-way crossovers in the actual monthly series (led by weekly series) and the 6- and 12-months MA lines, as shown in the historical plot in Figure 4 above.

10 years of the Euro: Part I. Economic Dividend

Following one of the reader's suggestions, I decided to post some of my thoughts on the Euro and the direction of the EUR/USD and EUR/BPS exchange rates. This is the first blog post dealing with these issues.

A prior disclosure (see below)...


On December 29, 2008 Harvard’s Jeffrey Frankel – one of the world’s leading international macroeconomics experts wrote:
“By roughly the five-year mark after the launch of the euro in 1999, enough data had accumulated to allow an analysis of the early effects of the euro on European trade patterns. Studies include Micco, Ordoñez and Stein (2003), Bun and Klaassen (2002), Flam and Nordström (2006), Berger and Nitsch (2005), De Nardis and Vicarelli (2003, 2008), and Chintrakarn (2008)… Overall, the central tendency of these estimates seems to be a trade effect in the first few years on the order of 10-15%. None came anywhere near the tripling estimates of Rose (2000), or the doubling estimates (in a time series context) of Glick and Rose (2002).”


Reasons for relatively poor performance
In his 2008 paper, Frankel looks at the possible reasons for this poor (relative to the original expectations) performance of the common currency:
(1): It takes time for the effects on trade to reach full potential;
(2): Monetary unions have smaller effects on large countries than small countries, and
(3): The original estimates were spuriously high because bilateral currency links have historically been the result of bilateral trade links rather than the cause (the so-called endogeneity problem).

What Frankel found was that correcting for the first argument does not change the rate of underperformance of the Euro relative to the original expectations. In other words, “at the moment there is little evidence to support the lags explanation”. With respect to the second argument, Frankel established that “There is no tendency, overall, for currency unions to have larger effects on the trade of small countries than large.” Finally, testing the third explanation also shows that it fails “to explain the gap between the recent euro estimates and the historical estimates”.

What all of this suggests is that the original justification for the existence of the Euro – the idea that it will boos significantly economic competitiveness of the exports-driven Euro block of countries – is yet to be confirmed. Neither on its 5th birthday, nor on its 10th anniversary did the Euro show a significant (economically) prowess to drive economic development of the Eurozone.

Even more egregious is the fact that the estimated effectiveness of the Euro to generate exports growth did not appear to move up between January 1, 2004 and the end of 2008.

A handful of strengths
This is not to say that the Euro has been a failure. Frankel – long-time champion of the common currency – states in another article that: “Looking back, the euro has in many ways been more successful than predicted by the sceptics — many of them American economists.” The list of such successes that he provides relates only to the metrics which reflect the positive reception of the Euro and the ECB amongst the world economies.

More trouble ahead
However, as Frankel puts it:
“…some of the sceptics' warnings have come to pass: shocks have hit members asymmetrically; cushions such as US-type labour mobility have remained thin; and the Stability and Growth Pact has proven unenforceable. Furthermore, the popularity of the project with the elites does not extend to the public, many of whom are convinced that when the euro came to their country, higher prices came with it.”

The latter point is now being reinforced by the former across all European economies. In fact, popular decline of the Euro has been so steep in 2007-2008 that the Eurobarometer gauge of public opinion has shown declining willingness of the electorates in Germany, France, Italy and pretty much the rest of the Eurozone, to remain a part of the ECB-run common currency area in contrast to the upward support trend recorded in 2002-2006.

What is more problematic for the, still, relatively young currency is that the cost of the ‘one monetary policy – different economies’ strategy for the Euro might be a long-term suppression of growth across the entire Eurozone. If monetary policy were to become a tool for delivering European convergence, it might lead to the convergence benchmark being set at an anaemic growth trend of Germany, France and Italy. In other words, rather than pushing the slow growth larger Eurozone economies up, the Euro might be pushing faster growth ‘fringe’ economies (Ireland, Austria, Sweden and Finland, alongside the Accession 10 states that care to join common currency or peg to it) down.

Nobel Prize winning economist, Robert Fogel in a 2007 paper suggested that a rate of real GDP growth for the period 2000-2040 of 1.2 percent for the industrialized EU-15 will be only slightly higher than the 1.1 percent for Japan, but a “much lower than the 3.8 percent for the United states or 7.1 percent for India or 8.4 percent for China.”

A recent NBER paper by Michael Bordo and Harold James (NBER Working Paper 13815, February 2008) makes very similar point by stating that:
“In particular, there is the possibility for the EMU that low rates of growth will produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy. Such demands might arise in some parts or regions or countries of the euro area, but not in others and would lead to a politically highly difficult discussion of monetary governance.”

A litany of challenges
Bordo and James look into asymmetric regional shocks impact, labour mobility effects, wage and price flexibility conditions, and risk sharing mechanisms implicit under the Euro as discussed in the existent literature and find that in all of these issues, the Eurozone monetary policy institutions are inferior to the arrangements in the US.

“The most obvious threat to the single currency is usually held to arise out of the imperfect control and coordination of national fiscal policies,” say Bordo and James, going on to conclude, contrary to the pundits of greater federalism at the EU level that:
“A formalized system of fiscal federalism would however not necessarily deal with the problems of fiscal indiscipline on the part of member states. Indeed, the expectation of institutionalized transfers or bailouts following fiscal problems might well be expected to increase the incentives for bad behavior. Stricter observance of the existing system and its rules, on the other hand, might lead to pressure to reform. Fiscal reforms would in the longer run be expected to raise the rate of growth.”

Of course, to date, the EU has failed to enforce the code of fiscal discipline among its members. In fact, 2004-2005 saw a set of reforms aimed at diluting the Stability & Growth Pact criteria for fiscal performance.

Financial stability of the system is another area of challenge for the Euro, where the lack of coherent regulatory structure is the mirror image of the overly centralized monetary policy. Again, Bordo and Lames sum this up by saying that:
“The difficulty of an effective Europe-wide response to financial sector problems thus reflects a more general problem with respect to the making of monetary policy: there may be a different political economy of money in regions of the Euro-zone and EU member countries, leading to contradictory pressures on policy.”

All of this implies greater volatility around the trend for smaller and more open economies, so occasionally countries like Ireland will be going through more pronounced boom-and-bust cycles, but in the end, average (or potential) long-run growth will remain below that in the US, Canada, and the rest of the developed world.


Disclosure: I would like to explicitly state that I do not share in some analysts' view that Ireland would fare better outside the Eurozone, nor do I believe that the Euro has been a sort of a disaster. I see the Euro as a challenging and generally positive element of the European integration project. This view motivates my analysis of the weaknesses in the common monetary and currency policy to date. It is my desire to see a gradual strengthening of the European democracy and markets that inform my analysis. Sadly, I feel that this disclaimer is a necessity in the current climate of attacks on the freedom of thought and expression that characterise our (European) political and economic policy debates.