Free markets never allow for exchange rates to be constant. It is impossible for the millions of agents in different economies to agree every day on exchanging goods and assets of the exact same value. Fixed exchange rates can only exist because of central intervention in the foreign exchange market.
Central authorities intervene in the FX markets to alleviate the problems of floating exchange rates. When an economy faces high volatility in returns of capital, capital flows will also tend to be volatile and so will exchange rates. This can cause serious damage to export businesses, which might see their prices increase fast with a currency appreciation or for importers who might face rapid cost increases. Similarly, for economies highly dependent on foreign trade for the procurement of resources, such as oil, fluctuating exchange rates increase the risks of inflation. There are various reasons for which some economies seek to fix the price of their currency against another currency or against a basket of other currencies. But the most common characteristic of all currency fixes is that over a long period of time they all fail, spectacularly so.
Here is how a currency peg actually works:
Let’s assume that economy X opts for an exchange rate of XXX/YYY at which economy Y is ready to import more than what it wants to invest in economy X. The arising imbalance is covered by the central bank of economy X buying currency YYY by selling XXX’s in the FX market. It then uses the YYY’s to buy assets in economy Y and generate some income.
We can easily find an example of this system in the real world. China for the last 15 years has pegged its currency to the US dollar as part of its strategy to increase growth and employment. The fixed exchange rate has provided US and Chinese investors with an economic environment where labor intensive production can be moved to cheap China while keeping consumption in wealthy America. As production is moved overseas, value added in the US is falling, pushing down government revenue and thereby forcing the government to cover its budget shortfall through borrowing. China is buying the US government debt to keep its exchange rate fixed to the dollar maintaining this exchange of assets-for-goods. Is this system sustainable?
Well, of course not. US is effectively borrowing to finance consumption while the corporate elite is lobbying against tax increases which supposedly stand as an obstacle in creating new businesses and jobs on US soil. The truth is in reality that there is absolutely no reason to invest in the US when investors can find better returns on capital in China, free of the exchange risk and without their capital flows into China having any appreciating impact on the yuan. China on the other hand keeps buying US debt to keep its factories and the populace busy, necessary for the ruling party to maintain political control of the country, however in doing so it will ultimately destroy all of its accumulated wealth because US cannot balance its budget and will eventually have to either default or print the money it needs and inflate its currency (by borrowing from its central bank) which is another form of defaulting and is happening already.
There is so much to be said about this seriously flawed business model which on the long run benefits neither the US nor China, but my primary intention in this post is to expose the instability of the eurozone model. In contrast to previous examples, eurozone is a single economy engulfing many countries. Money in the euro area flows in the way shown below:
Here the actions of individual, independent agents in the two countries do not necessarily lead to a balance between the current account and the capital account. At the same time there is no central authority which can reverse the net outflow of money by investing in country X the money country Y is making out of X. How can country X keep its money in this case? It looks like if this situation carries on it is going to run out of money!
In practice, this will not happen because country X has a way to keep itself afloat for some time. This is to pledge assets as collateral with the European Central Bank to raise liquidity. But this option has a limited capacity to stem the structural imbalance: assets that can be used as collateral are finite. You can understand this if you think of money as water: the connection with water supply for country X has been cut off. The ECB is a tank of water that can serve country X for some time, but not forever. In the long run, country X will only be able to sell at substantially reduced prices its assets and its labor in exchange for goods, impoverishing itself in the process.
Let’s take two euro countries for an example and put Greece in the place of country X, media’s favorite. Greece after joining the euro gradually lost its competitiveness due to a slowly appreciating euro. For the first years this did not cause any problem because the increasing outflow for the purchase of goods was matched by an inflow of capital. The inflow of capital was not only for the purchase of Greek government debt. Greece was an underdeveloped country which presented foreign capital with promising investment opportunities free of the currency risk and not subject to currency appreciation as the foreign capital would flow in the country (same as the US-China example). Thanks to the capital inflow, Greece managed to grow faster than most of its European peers attracting even more capital on the way. But the inflow of capital would not last for long. In fact it would be reversed on the eve of the 2008 financial crisis. Since then, the money flows from and to Greece has looked like this:
Greece has been facing a massive outflow of money through the as-usual imports and capital outflows from investors who dumped any Greek security (debt or equity) to get hold of highly liquid and creditworthy paper, predominantly Government debt of one of the surplus countries. As money is leaving the country, economic activity is declining, making it more difficult for the government to raise revenue (fewer blue and red arrows in Greece’s box above), increasing the country’s risk and accelerating capital outflow. Here Greece has lost its competitiveness not only in the goods market but also in the capital market since the risk-adjusted returns on capital invested in Greece are lower than those achievable elsewhere in the eurozone. Greece cannot even create or get hold of its own capital because even domestic savers move their savings abroad.
Enter Germany in the place of country Y. At the same time that Greece is struggling to keep money in the country, Germany finds itself with more money. Money flows in through the as-usual exports, but at the same time Germany attracts capital from investors seeking a safe-haven for their euro investments. Remember from part I that money always flows within the same economy, but in the case of the eurozone this does not mean the same country. Money flows out of Greece and into Germany, boosting economic activity and revenue for the German government (more blue and red arrows above). The German government is effectively feeding itself out of the money supply which Greece has been deprived of. This is unfair because the people of Greece should have the right to benefit from the money circulating within their local economy, like Albert in the example of part I, generating growth and supporting a functioning economy. How can Greece operate if Germany, like a vampire is sucking its blood (=money) every night?
This is a game in which, unfortunately, Greece and Germany are not the only players. This happens on a grand scale between the deficit countries and the surplus countries and rendering this crisis not centric to Greece but systemic for the euro. On the one side there is Greece, Portugal, Italy and Spain, the country with the biggest current account deficit in the eurozone. On the other side there is Germany, the country with the biggest surplus, along with the Netherlands, Finland and Austria. The rest of the eurozone countries also belong to one of the two groups, but they either have a small current account surplus/deficit or they are very small. France for example has a small current account deficit while Slovakia has a large current account deficit but is relatively too small an economy to destabilize the euro system.
Is this model sustainable? Once again, no it is not. Just like China and US, the euro model is about to collapse in the way it operates. And this is not just because of Greece or the other deficit countries. The deficit countries have been financing their imports with money invested from the surplus countries, money invested in both equity and debt, public and private. As long as they cannot attract investments anymore they will be forced to cut down on imports giving the surplus countries a double whammy: a loss in their foreign investments (happening already) and a loss in the export businesses they have established.
The debt fiasco as I called it in part I is thus about to blow up in the faces of the critics of Greece (and of the other “peripheral” or “pigs” countries). Critics do not get that the deficit and the surplus countries are just opposite sides of the same coin, the yin and the yang of the euro economy. The former exist because of the latter. And one cannot seize to exist without the other one seizing to exist as well. So to all those from the surplus countries who for the past two years have been so sarcastic or mean about Greece, I could only say one word: “Congratulations”. Congratulations because after a decade long economic competition against the countries that are both their clients and their debtors, they have finally won.
In this post I tried to explain in a simple way the origins of the eurozone crisis and in doing that I am pointing the finger back to those who were so eager to raise theirs in the beginning of the crisis. But exposing the collective ignorance fed by institutional idiocy is just the means and not the end. What I want to achieve with this series of posts is to short-circuit the nonsensical presentation of the crisis by the media, the politicians and other opinion makers who keep the ordinary people misinformed and put those in one country in confrontation to those in another. The sooner we, the people, bypass this paralytic line of thinking, the sooner a consensus is going to be formed among Europeans about what the way forward is.
For those returning to this blog in the coming days or weeks, here is a taste of what they can expect to read:
– That Greece was never really given a bailout; Germany was.
– That the discontent about the Greek bailout or the entrance of Greece in the eurozone is not only unfair, but also irrational.
– That the accounting tricks of Germany are way more dodgy than those of Greece and are starting to bite.
– That the eurozone is the best example so far of why Marx was right.
– And more…