Tuesday, March 15, 2011

On the Value of Currency, and the Policies of the European Central Bank

On the Trading of Currencies as Commodities

The value of international currency is defined as the faith or speculation that the value of currency will increase. When the Western European countries maintained their own currency, usually indexing them to either a solid material, such as gold or silver, or to other currencies, their central banking policy was focused on domestic growth, as well as protecting against inflation and deflation. The consolidation of the various European currencies has resulted in the fate of one nation, such as France, becoming associated with that of a much poorer nation, such as Bulgaria.
            The recent economic crisis, beginning in 2007 and continuing through 2010, has been at least partially attributed to the values of currency. Jörg Bibow, in the article Europe’s Quest for Economic Stability, discusses key decision points of the European Central Bank (ECB). Bibow, writing in 2006, explains both strengths and weaknesses of the Eurozone banking model. The primary objective of the ECB, according to its founding charter, is to maintain price stability across the Eurozone.[1] Price stability, Bibow states, is “essentially a piece of Bundesbank nostalgia,” referring to the former German bank charged with maintaining price parity, and coordinating the now defunct erratic European Monetary System, from which the ECB’s framework is largely derived.[2]
As a matter of general policy, the ECB does not attempt any other ends aside from their primary mandate, only fostering interest in economic development and employment when the ECB views that engaging these ends will not interfere with price stability.[3]

On the Harm Caused by A Centralized Currency

Bibow accurately predicts the contention between the ECB and national central banks (“NCB”).[4] Bibow discusses the issue of self-interested national banks acting in their own interests as an issue that the ECB and NCB’s have yet to reconcile. The provisions of the founding treaties and charters allowed the NCB’s to stay open to regulate domestic affairs, being allowed to act as lenders of last resort; however, the ECB’s role is to make policy decisions on a high level. The effect, however, is that the ECB and NCB’s do not act as a unified actor, with goals that can be in opposition. Kathryn Dominguez, in the article The European Central Bank, the Euro, and Global Financial Markets (2006), cites the loss of NCB’s ability to control inflationary or deflationary pressures. Because the euro is not attached to a single NCB, countries in the Eurozone lack the ability to revalue their currencies, allowing the market to correct for imbalances. Using Germany as an example, Dominguez writes, “nominal exchange rates are fixed within Europe, differences in inflation across countries can still affect real exchange rates. For example, Germany’s low domestic inflation has made the country’s exports relatively cheap, while higher rates of domestic inflation in Greece and Spain make their exports relatively expensive”.[5] Dominguez supports Biblow’s conclusion that the ECB’s increased scope of membership is detrimental because the ECB’s policies may diverge from those of the individual member countries.  Further, Dominguez cites a study by Meade and Sheets (2002, in Dominguez, 2006) in writing, “Meade and Sheets argue that monetary policy decisions of the European Central Bank from 1999 to 2001 are consistent with national central bank governors voting in line with their national interests”.[6]
Bibow’s point of contention on this issue is that the ECB is, essentially, an independent institution. The ECB only answers to a board if bankers, and the “ECB refuses to publish minutes and voting records”.[7] Bibow comments that, “there are no effective checks and no real accountability on performance”.[8]
            Bibow (2006), cites the ECB’s policy of “price stability above all else,” a mantra Bibow attributes to Otmar Issing, as being actively anti-growth.[9] Bibow attributes this unwavering commitment, despite new information, as being causal to the early decline of the value of the euro, effectively forcing inflationary pressures on the value of the Euro. Bibow writes,
As to the euro’s plunge, the ECB’s role was one of acting as a twofold propogation mechanism as the bank’s words and deeds provoked market opposition. [...] So when the ECB backed up its confusing words with all to clear actions, that is, aggressive interest rate hikes, the market simply took flight, preferring policy makers that were perceived as more growth friendly.[10]
            Bibow further discusses the effects of perceived anti-growth policies, and the effects they have on the Eurozone members. Specifically, Bibow mentions that the contingencies required in accession to the European Union “imposes austerity especially on those who are crippled already, whereas stronger members may even have room to cut taxes.”[11] The inequitable treatment of the poorer Eastern European nations, compared to the largely stable Western European nations, has, Bibow states, caused the very condition the euro was designed to avoid: a “beggar-thy-neighbor” situation that allows an unacceptable amount of risk into the banking system.[12] Dominguez contributes to this thought by noting that “five out of the eleven countries in the euro-zone (Greece joined the euro zone in 2002) were in violation of the public debt rule. A strict interpretation of the [Stability and Growth] pact is clearly not being imposed; in 2005, the three largest euro-zone economies – France, Germany, and Italy – were out of compliance with both the budget deficit and public debt rules”.[13] Bigger, Western European economies are being treated preferentially – allowed to break rules when it is convenient – further increasing the probability of inflation, which further hinders growth in Eastern Europe.
Living standards in Germany, for example, are undoubtedly better than Romania; however, inflation in Germany keeps exports relatively high. What the euro has done, by standardizing currencies across Europe, is allow comparisons to be made in the same unit. The ECB, when admitting new countries into the Eurozone, uses a fixed exchange at the time of accession, leaving the same amount of currency buying the same amount of goods. Despite the equality of currency, one euro in Germany has the same value as in Romania, the disparity in economic output between the two separates developed and developing nations into almost separate regions. In Romania, since the potential output of the economy, and relative inability to garner interests in Romanian exports, limits the money supply, the Romanian population is still chasing after a limited amount of purchasing power; in Romania, demand for money outpaces the supply, and ability of the Romanian economy to get euros from international sources is limited. Without a population full of euros, government income from both personal and business tax revenue is likewise limited. With a limited income, and mounting expenses, countries act in the same way as individuals: they borrow money, spending income they haven’t yet earned in order to pay for things they want or need at the time, on the promise that in the future, when payments are due, the money will be there. When the bills are due, and the money is not there, speculation forces a country’s bond yields up, increasing the costs associated with lending, and trigging a liquidity trap. Because the euro in the failing country is now saddled by debt, the value depreciates across the zone.       

When It Rains, It Pours…

The last issue that Bibow examines is the potential for the Euro and the Eurozone to invoke a liquidity trap: “cutting short term rates would only undermine confidence and drive up bond yields”.[14] Bibow’s words ring true, especially when considering the system level of analysis that induced the Greek, Irish, and Portuguese debt crises.
Ireland, according to an article disseminated by Reuters, and published on CNBC.com, Worst of Times, Best if Times: Tale of Two Irelands, is undergoing a financial crisis as well. The article discusses the state of the Irish economy, contrasting Northern Ireland, in union with the United Kingdom as stable and continuing on a path to prosperity with an ever increasing trade surplus, with the Republic of Ireland, hampered by recession and job losses equal to one tenth of its population. Northern Ireland, as a member of the UK, does not use the euro as its currency – preferring the British pound, and has been ever increasing its self-rule. The difference in monetary control may seem to be unimportant, until the realization that The UK has a vested interest in the strength of the pound internationally, while the ECB has a plurality of national interests, ready undermine foreign competitors.  The Republic of Ireland joined the European Union, uses the euro, and recently enjoyed economic prosperity, is now faced with “a sudden fall in [domestic] output [that] has blown apart what were once exemplary public finances”.[15] The article further discusses the job vacuum left in the wake of a housing bubble, increasing unemployment to 14% from four, and renewed emigration to countries with jobs. The article mentions that firms from the United States “have invested more in Ireland than in Brazil, China, India, and Russia combined”.[16] The significance is only realized when combined with the information that foreign firms are only taxed at a rate of 12.5%, a decision made to entice foreign investment.[17] EU members, however, are less than thrilled, and the article suggests outrage that EU members now must fund a bailout of the Irish economy, while accusing Ireland of competing unfairly with the lowest tax rates on foreign firms in Europe.[18] Traditionally, as has happened to every economy, currency would have been devalued, the market allowed to readjust, cheapening Irish goods, spurring global demand for Irish goods at a now lower price, which will infuse new capital into the economy, leading to recovery. Lacking effective controls over their currency of use, the euro, the Republic of Ireland must now pay a value that it cannot afford, with a currency it does not have, with trade partners who seek to maintain their national interests – for their goods.
According to an article by Antonia Van de Velde, published on CNBC.com, titled Think BIIGS: There’s One Euro Country Under the Radar, Belgium is also facing a currency crisis. Belgium is unique among the troubled euro states today for two reasons: the first, that Belgium currently lacks a national government; secondly, that Belgian “public debt is just under 100 percent of gross domestic product”.[19] Essentially, Belgium is indebted to the world the entire sum of one year’s economic production, having spent money that has not been earned yet. In a traditional “one nation-one bank” system, Belgian currency would fall in value to a level that is sustainable in the market, or short term interest rates might  be lowered to decrease the costs associated with moving capital from the central bank though the entire banking system. However, because Belgium is part of the euro zone, the harshest consequence is the increase in the spread of Belgian credit default swaps.[20] Further, despite a debt load that would be considered in most other circumstances as technical insolvency, “Standard and Poor’s wrote that it’s AA+ rating on the country’s long term debt – the second highest rating at the agency – could come under downward pressure if a continued political stalemate  were to diminish the authorities’ capacity to address the ‘outstanding challenges’”.[21] The only positive factor, according to Van de Velde, is that the perception in Belgium is that if there is no government, there can be no spending.[22] Despite Belgium’s inability to decide whether it is German or French or Dutch, for a country, about the size of Maryland, it may have acted and spent differently would the true cost of Belgian debt not spread amongst its European neighbors.[23]
While the risk of a country, especially a modern economy, defaulting on its debt has fallen since the turbulence of the 70’s and 80’s, the fact that these conditions are perceived as consequence free encourages countries to spend more money than they have, to buy things they cannot afford (and as Suze Orman would add, to impress people they don’t know). The moral hazard, of removing consequences from bad decisions, has the effect of enticing other countries to engage in similar reckless spending practices – knowing that they would be shielded from their actions.
Dominguez further believes that limiting a government’s ability to control its own currency can not only affect the individual country, but can bleed over and poison healthy economies within the same currency market.[24] Stripping monetary policy from a country, and handing over that power to an outside power, further disrupts a nation’s ability to pursue the goals demanded by their population. Dominguez writes that the euro and the ECB, “was sold to Europeans as the means by which they could achieve political and economic stability”.[25] The euro, a common currency for all of the Eurozone, necessarily is contingent upon the member states’ values; Dominguez questions the ability of the Eurozone to stay together should Germany or France go into recession.[26] Dominguez asks, “If Germany or France go into recession and badly need monetary stimulus, how will the European Central Bank balance their needs against the rest of the euro zone?”[27] Quantitative easing serves to decrease the value of a currency, but with twenty-two member states’ economies crucially dependent on a newly-lowered value euro, the rest of the euro zone is poorly equipped to absorb such capacity.


            While the goals of a pan-European currency are admirable, and greatly benefit countries during boon times, the methods that the European Central Bank have chosen to use is of greater harm. Lacking the ability to make independent decisions on monetary policy, relative inflation can occur even between Eurozone countries. Rather than achieving the stated goal of price stability, the euro serves only to increase the amount of countries affected by an economic downturn; the amount of risk is just more broadly distributed. While diversification of a portfolio is, unquestionably, an important aspect of investing, incorporating toxic assets, even while packaged with healthy assets, is not. Not only do Eastern Europeans suffer as a result of unequal inflation, the Eurozone is unnecessarily liable for the debts and deficits of their neighbors that engage in reckless behaviors: Germany, France, and Spain – otherwise first-world countries that have debts beyond the allowances of EU and ECB regulations.
            The model of Adam Smith, who clearly describes the relationship and origins of division of labor and the development of market economies, can be applied to states. If the state is the individual in a state of nature, as Smith postulates our origins, then comparative advantage and trade of each nation is the same as the barter economy of individuals before the development of currencies as proxies for labor. The labor of a country is the amount of wealth contained in the country, which itself is related to the capacity of the economy for growth. While unionization into the European Union has proven to be beneficial, with regards to the lowering of trade barriers and establishing mutual trade and peace, the consolidation of currencies cannot be so readily lauded. Decoupling the growth of each economy for the value the country provides invites unnecessary risk into the global financial system. No longer is a country defaulting limited to the debtor countries; the shockwave will be sent throughout the zone, with a collective devaluation of currency. In Smith’s model, the loss of an individual will remove just one operation from the pin-making business – should a significant number of euro countries crash, it may result in the loss of the entire factory.


Bibow, Jörg. 2006. "Europe's Quest for Monetary Stability." International Journal of Political Economy 35, no. 1: 24-43. Business Source Premier, EBSCOhost (accessed November 22, 2010).
Central Intelligence Agency. 17 Nov 2010. CIA – The World Fact Book: Belgium. Published on https://www.cia.gov/library/publications/the-world-factbook/geos/be.html.

Dominguez, Kathryn M. E. 2006. "The European Central Bank, the Euro, and Global Financial Markets." Journal of Economic Perspectives 20, no. 4: 67-88. Business Source Premier, EBSCOhost (accessed November 22, 2010).
Reuters News Agency. 26 Nov 2010. Worst of Times, Best of Times: Take of Two Irelands. Published on http://www.cnbc.com/id/40377778
Smith, Adam. The Wealth of Nations. Edited by Alan B Kreuger. Translated by Edwin Cannan. Vols. Based on Cannan, 5th Edition, 1904. New York, NY: Bantam Books Publishing: Random House, Inc., 2003 (1776).
Van de Velde, Antonia. 26 Nov 2010. Think BIIGS: There's One Euro Country Under the Radar. Published on http://www.cnbc.com/id/40379099

[1] Bibow, 1996, pp. 32-33
[2] Bibow, 1996, pp. 32, 24
[3] Bibow, 1996, p. 34
[4] Bibow, 1996, pp. 24-25
[5] Dominguez, 1996, p. 79
[6] Dominguez, 2006, p. 73
[7] Bibow, 1996, p. 30
[8] Bibow, 1996, p. 29
[9] Bibow, 2006, p. 37
[10] Bibow, 2006, p. 37
[11] Bibow, 2006, p. 38
[12] Bibow, 2006, p. 38
[13] Dominguez, 2006, p. 76
[14] Bibow, 2006, p. 39
[15] Reuters, CNBC, 2010
[16] Reuters, CNBC, 2010
[17] Reuters, CNBC, 2010
[18] Reuters, CNBC, 2010
[19] Van de Velde, 2010
[20] Van de Velde, 2010
[21] Van de Velde, 2010
[22] Van de Velde, 2010
[23] Information about Belgium’s size compared to the state of Maryland, CIA World Fact Book Online
[24] Dominguez, 2006, p. 81
[25] Dominguez, 2006, p. 86
[26] Dominguez, 2006, p. 86
[27] Dominguez, 2006, p. 86

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