Happy Birthday € – The euro is ten years old
The world's most ambitious currency union in modern times has
by Paul Kieffer
As I drove from Switzerland toward Bavaria on the afternoon of December 31, 1998, I listened to a European-wide radio broadcast of historic proportions. The finance ministers of eleven European Union countries were meeting to confirm the official conversion rates of their currencies to a new shared currency, the euro. The final day's exchange rate was announced for the eleven currencies against the "European Currency Unit", an artificial accounting value used internally for the various EU national currencies. The exchange rate for each of the eleven currencies on December 31, 1998 became the official exchange rate for the euro. Germans learned that 1.95583 German marks would equal one euro, beginning the very next day at the start of 1999.
For the next three years the euro existed as an accounting value and in non-physical form (electronic transfers, banking, etc.). The eleven national currencies of the eurozone countries had fixed rates relative to their value against the euro, effectively rendering them mere subdivisions of the euro. Prices were now quoted in both the respective national currencies and the euro.
The next step was the introduction of bank notes and coins for the new currency on January 1, 2002. Preparation for the transition took months of planning and a major logistical effort as coins and bank notes were distributed to banks throughout the new eurozone. Although a two month phase-out period for the old national currencies was planned, within just days nearly all cash purchases were already being transacted in euros.
The 1992 Maastricht Treaty on European Union provided the framework for introducing the euro. The criteria for participation were strict and reflected Europe's concern over the potential for inflation. To become a member of the eurozone, EU countries may not have an annual budget deficit higher than three per cent of their GDP, and national interest rates must be close to those in the eurozone. The Maastricht Treaty provides for all EU members to use the euro, but the United Kingdom and Denmark were granted exemptions from participating in the monetary union.
With Slovakia's addition to the eurozone at the start of 2009, the euro will be the official currency for 16 EU countries, five other countries via formal agreements and another six countries without any official arrangement. Over 320 million Europeans use the euro as their official currency. In addition, some 40 countries around the world link their own currencies to the value of the euro, adding 180 million people who indirectly use the euro as their currency. (By comparison, about 60 countries peg the value of their currencies to the U.S. dollar.)
A former "Eurosceptic"
Nothing like the euro has ever been attempted our modern age, and possibly ever in human history. With the economies within the original eurozone ranging from Germany's solid performance with low inflation to soft economies Italy and Portugal with their higher rate of inflation some wondered whether the grand currency experiment was going to work. Among the doubters was Federal Reserve chairman Alan Greenspan. In an interview on May 2, 1997, Greenspan told the "International Herald Tribune": "The euro will come, but will not be sustainable."
Those who opposed the introduction of the euro in Germany were quick to quote Greenspan as a key witness on the folly of the new currency. His prediction was plastered on anti-euro posters and used in newspaper ads at the end of the last millennium in a last-ditch effort to save the German mark.
The first two years of the euro's existence seemed to confirm Greenspan's opinion. Its value dropped from $1.18 immediately after its introduction in January 1999 to only about 82 U.S. cents in October 2000. Some observers had predicted that inflation rates in the eurozone would level out, with countries having a higher rate of inflation seeing a drop and countries with a lower rate seeing a rise. The official inflation rate for those countries in the eurozone with traditionally lower rates of inflation did not rise more than about one percent after the euro was launched. However, public perception tended to blame the euro for higher prices, especially for the cost of entertainment and dining out. Germans were quick to find a nickname for their new currency – the "teuro", a play on the word for expensive ("teuer") and the euro.
Eight years after the euro's low point against the dollar the story is quite different. Prior to last summer's downturn in the value of the euro, its value had nearly doubled. (Recently the value of the euro relative to the dollar is again on the rise.) At the beginning of 2007 the total value of the dollar notes in circulation was less than the value of euro notes.
While the dollar continues to be the world's top reserve currency with approximately 65 percent of worldwide currency reserves held in dollars, the euro is now the second most widely held currency portfolio. Its share of world currency reserves has increased from 18 percent in 1999 to 27 percent today.
This development prompted Alan Greenspan to remark in a September 2007 interview with the German magazine "Stern" that it is "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency." That's quite a statement from a man who only ten years earlier had predicted that the euro would not be sustainable! According to Greenspan, the European Central Bank has "developed into a global economic force to be taken seriously."
An interesting side effect of the euro's appreciation against the dollar has been the "cushioning effect" that euro users experienced this past year. Until the recent drop in the price of oil on world markets, Europeans did not feel the full effect of the rapid rise in oil prices. Since the price of oil on the world market is pegged to the dollar, price increases for countries in the euro zone were offset to some degree by the increase in the value of the euro.
That cushioning effect actually became a sore point with some OPEC members and other oil producing nations like Russia. Because of the dollar's decline in value, their increased revenues from the higher price for oil do not translate into increased purchasing power when petro dollars are exchanged for eurozone products. It came as no surprise when certain OPEC members requested discussion on whether to abandon the dollar – at least in part – as the currency for setting the price of oil. More than two years ago Russian President Vladimir Putin speculated publicly whether his country might price part of the oil it sells on world markets in euros rather than dollars.
The euro's future
In a time of turmoil on financial markets around the world and a deepening recession, it might seem a bit bold to attempt to predict the euro's future. Even without the current crisis this could be a challenge, especially in light of the variation in the euro's value during the first ten years of its existence. However, two key factors provide guideposts for future observation.
The first is the dollar's position as the world's dominant reserve currency. Since currency reserves held by foreign governments are actually like an interest-free loan to the issuing government – exchanged either for currency or goods – foreign currency reserves act as a subsidy to the country issuing the reserve currency. The dollar has enjoyed this position since it replaced the British pound as the world's main reserve currency.
The dollar's use as a means of exchange for goods and services contributes to its standing as the world's reserve currency. Since about half of the value of the goods exchanged in international trade is denominated in U.S. dollars, the American greenback benefits even when the U.S. is not directly involved in the exchange because foreign currencies have to be exchanged for dollars to complete the transaction. One highly visible example of this is the market for oil.
Any move away from the dollar as a benchmark for the price of oil would weaken the dollar's value on world currency markets – and strengthen the euro. The dollar's decline has countries like China concerned about preserving the value of their large foreign currency holdings in U.S. dollars. The Chinese are already diversifying their vast foreign currency reserves, currently estimated to be worth some 1.4 trillion U.S. dollars. However, they are being very careful not to just dump the dollar, which would hasten the decline and only further lessen the value of their remaining U.S. dollar reserves.
Another factor likely to affect the dollar's position as the world's reserve currency is America's growing national debt, which has doubled in only eight years to total 10.65 trillion dollars. If corporate and private debt is included, the United States is awash in nearly 50 trillion dollars of debt. (The amount is even larger if as yet unfunded benefits already earned in the U.S. Social Security System and other entitlements are factored in.) The U.S. government is now making interest payments of 19 billion dollars a month to its creditors – more than 200 billion dollars a year.
The current crisis will only see America's debt situation worsen. The national debt figure does not include the 700 billion dollar bailout fund approved by Congress in September 2008. In October and November U.S. Treasury Secretary Henry Paulson borrowed over 400 billion dollars, and Scott Minerd of Guggenheim Partners predicts that America's budget deficit for 2009 will run as high as 1.5 to 2 trillion dollars, equaling ten percent of America's current national debt.
Some wonder whether America's growing national debt will eventually make the country a credit risk. According to Pierre Nahm, an advisor for hedge funds, the U.S. won't go bankrupt because a country has the option of simply printing enough money to pay its debts. In so doing, inflation takes its toll on the debt, and debtors would be repaid in devalued dollars.
Creditors apparently think that America will not swallow her wallowing debt so easily. The rate of "credit default swaps" (CDS) for U.S. treasury securities increased fourfold after the 700 billion dollar bailout was passed in September. In other words, the risk premium for 10 million dollars of treasury securities increased from 10,000 to 40,000 dollars, reflecting less confidence in the U.S. government's ability to repay its debt.
For the time being, it seems that America's largest creditor nation – China – has no choice but to continue to invest its dollar earnings in the United States. As long as the price of oil on world markets is pegged to the dollar and the Chinese continue to hold their dollar-denominated assets and invest in U.S. treasury securities, the United States will be able to keep running up the red ink. However, if either if these two factors changes, the dollar is in for rough times and its attractiveness as a reserve currency will be lessened.
The other key factor affecting the euro's future is the cohesiveness of the eurozone itself. Several internal challenges hinder the euro's further development as a competitor to the U.S. dollar as the world's major reserve currency. National budget deficits of some eurozone members in excess of the 3 percent GDP limit, weak economies of its newest members and inertia on the path to coordinated economic and taxation policies are important reasons why the euro remains in second place among major world currencies.
When the euro was introduced ten years ago, analysts warned that the internal structure of the eurozone might precipitate the collapse of the new currency. Sixteen countries are now members of the EU's monetary union, but each country still determines its own economic policies and taxation rates. For example, income tax rates are not uniform within the eurozone, and VAT (value added tax) on goods and services sold varies from 15 to 21 percent. (The EU mandates a minimum 15 percent VAT for all EU members.)
Predictions of the euro's demise have been proven wrong to date, but the fact remains that the eurozone is not a homogenous economic unit. However, the worldwide financial crisis is forcing eurozone members to cooperate and coordinate their efforts more than ever before. In October eurozone countries and the European Central Bank (ECB) announced their intention to prevent the collapse of any major financial institution within the eurozone. In a joint statement, eurozone countries pledged to coordinate their efforts and provide liquidity for banks for periods of up to five years.
The ECB agreed to create an unsecured lending facility to buy commercial paper from banks, similar to an earlier move by the US Federal Reserve bank. The ECB action guarantees the availability of funding for banks in the eurozone.
The eurozone action came only one week after an EU summit meeting that failed to produce an EU bailout plan for the entire EU. British Prime Minister Gordon Brown attended the eurozone meeting but was not involved in its formal decisions because his country does not use the euro and will not receive direct support from the ECB.
Earlier this month eurozone finance ministers rejected a call by the European Commission to lower the standard EU VAT rate as an economic stimulus measure for Europe, which has been in recession officially since the third quarter of 2008.
The closer coordination among eurozone countries is a noteworthy development reflecting a "United we stand, divided we fall"-attitude. Eurozone member states voluntarily became part of what is now a mutually dependent financial community, making it more than just an alliance that one could leave at any time. Any country that exits the eurozone would be on its own, and the only country that could possibly afford to do that would be Germany. However, as a member of the eurozone Germany's multinational companies enjoy the benefit of simplified bookkeeping in one currency across national borders, making it highly unlikely that Germany with its trade dependent economy would unilaterally withdraw from the eurozone.
With a country's currency part of its national sovereignty, eurozone members have in effect transferred part of their own sovereignty to the ECB. Bible prophecy indicates that this pattern in Europe established by the introduction of the euro will continue and intensify, culminating in a final transfer of authority to a central power called the "beast" (Revelation 17:12-13).
• Paul Kieffer, December 23, 2008