The Euro’s Future Can Be Found in the Dollar’s Past

The Euro’s Future Can Be Found in the Dollar’s Past
September 12, 2011 Joseph Paris

I have been quizzed by some readers, “What do currencies in general – and the challenges facing the Euro and its member countries in particular – have to do with Operational Excellence?” For that matter, what do discussions that involve “geo-politics” have to do with Operational Excellence? Both are very fair questions.

Operational Excellence is a philosophy and approach that involves, at its core, leadership – and the ability of that leadership to gain alignment and instill the commitment necessary to face the challenges of today and tomorrow. Whether in the public or private sector, it is about leveraging this leadership in making continued and deliberate improvements in the processes and environments that constitute the human condition and its endeavors.

I can hardly think of processes and environments that affect the human condition more than those that involve geo-politics and all it entails.

There was a time in the not too distant past where the currencies of the world were made of precious metals – usually gold or silver – and carefully crafted into coins with specific weights to be used in trade.  Not only were the gold and silver coins tangible (you can “see and feel” the value) and useful (for jewelry, goblets, and the like), it was also rather rare; increasing its value.

For a variety of reasons (see video below), modern currencies issued by governments around the world are no longer precious metals, but are rather “faith based” in that any given currency has value only because people who accept it as payment perceive that it has value – and not because it is collateralized by anything tangible. Such money is known as “Fiat Money”, which is Latin for “let it be done”. It only possesses value because of government regulation or law and the faith of the people in that government.

Herein lays the source of the trouble with the Euro – an erosion of credibility and faith.

The Euro is in trouble. This is not the same as saying that Europe as a continent is in trouble or that the European Union (EU) as a government institution is in trouble. Only that the currency “Euro” is in trouble – and in serious trouble at that.

The document that defined the faith on which the Euro is based was the Maastricht Treaty, signed in 1992. This was the founding Treaty that led to the creation of the Euro. The Treaty specified that members wanting to join the Euro must meet certain eligibility criterion and make all necessary efforts to maintain compliance with such criterion in the future. The criterion included:

  • Inflation rate targets: No more than 1.5 percentage points higher than the three (3) best performing (lowest inflation) member States.
  • Government Finance
  • Budgets: Deficits could not exceed three-percent (3%) of Gross Domestic Product (GDP) except in exceptional – and temporary – circumstances.
  • Debt: Gross government debt could not exceed sixty-percent (60%) of GDP.
  • Exchange Rate: Applicants to the Euro must not have devalued their currency during the previous two (2) years.
  • Long-Term Interest Rates: Nominal Long-Term Interest Rates must not exceed two (2) percentage points higher than the three (3) lowest inflation member States.

The purpose of these requirements was to instill and maintain price stability and monetary discipline within members of the “Eurozone” – and there were significant penalties that were supposed to be imposed for those who violated the requirements.

There was only one problem with this Treaty – the “rootcause“; there was no effective means to enforce the penalties. Some of the first violators of the Treaty requirements were the Eurozone’s largest economies – France and Germany. Both countries violated the budget deficit provisions of the Treaty and both arrogantly ignored calls from the other members to take immediate corrective action or face the sanctions that were supposed to be imposed.

So when other members of the Eurozone violated the same (or other) provisions of the Treaty, they faced the same – which was nothing.

Without enforceability, the provisions of the Treaty became routinely ignored by the Eurozone members until their erosion and corruption was complete.

This leads us to the pernicious situation that the Euro faces today;

 How is the present mess fixed?

 How are future messes avoided?

 

As to the first question, “How is the present mess fixed?” Each of the practical and pragmatic options is painful and will require significant sacrifices from ALL of the countries in the Eurozone, but this is where the only hope of salvation for the Euro is to be found.

Option-1) Member Countries in Trouble Remain in the Euro. The only real answer for troubled countries wanting to stay in the Eurozone is that the debtor countries sell assets and are forgiven debt such that their Debt to GDP ratio is manageable going forward. You cannot reasonably expect to “tax them” out of their difficulties because people, and the companies they own, simply will not pay the taxes – but rather they will either evade or leave. This is already a reality.

The issue of tax collection and evasion is not limited to Greece. Italy has its own share of tax collection challenges – as do most countries where the taxes are stifling.

The key to this restructuring being a workable solution long-term is that the annual budgets of ALL Eurozone members must be balanced (or have clear, standardized budget deficit ceilings) going forward – except in extreme and temporary circumstances which are clearly defined, along with their available remedies (none of which can be punitive, but constructive so as to not exasperate the situation). This means that revenues must cover expenditures as a matter of routine and not exception.

All Eurozone States must adhere to the same Debt to GDP ratio – these ratios must be evaluated and derived by an external authority which is unbiased (at least as unbiased, or as balanced, as possible).

Option-2) Member Countries in Trouble Leave the Euro. Arguably no less painful than Option-1 above, as there will still be the required asset sales and debt write-offs, but the ability for the newly departed Country to run their own country’s affairs without such intimate oversight from an external body might be worth it to the citizenry of the country departing, and a long-term relief to the countries remaining.

Of course, unless the fiscal behavior of the newly liberated country (and the expectations of services from the citizenry) changes, the rest of the world should expect periodic write-downs of debt and the citizenry should expect a significant increase in inflation. However, that’s the price you pay for having all the government and programs you can afford (and even those you can’t).

And as to the second question, “How are future messes avoided?” For the Euro to remain viable as a currency, the roll and charter of the European Central Bank (ECB) must evolve so that it has central authority at the macro level – and the finances of all member States must be beholden to this central authority. Without these new powers, the faith in the Euro will never be to the level necessary for it to be considered a true Reserve Currency and the ECB will remain merely an aggregator of the finances of its member states and dealing mostly in the arbitrage of the individual personalities and egos of the ever-changing leadership in the Eurozone.  Ultimately, the risk of the Euro project failing will be significantly increased.

There is a historic precedent where a group of individual States, each with its own power over its currency, relinquished much of their fiscal sovereignty to a central authority to the betterment of all – and that precedent is the United States of America.

Immediately after the Revolutionary War, the Continental Congress convened and drafted the Articles of Confederation in 1776-77 and ratified in 1781. The Articles of Confederation defined a relationship between the member States and emphasized States Rights overFederalism – where the rights and powers of the States held weight over the powers of the Federal Government.

This is very similar to the way the European Union and the members of the Eurozone function today – with the rights and powers of the individual countries largely overriding the powers of the EU and ECB authority. This ongoing issue of “sovereignty” – the cultures that are at its core and the powers the EU Central Authorities have or don’t have now and into the future will ultimately determine the level of clout and influence the EU (and, separately, the Eurozone) will be able to wield and the role it will play on the world stage.

Can you imagine this fictitious scenario and it’s implications; New York’s Supreme Court (not the Federal Court) having a hearing and making a ruling as to whether some financial structure the United States Treasury was “constitutional” or not – and whether New York was prohibited from participating (as in the case of Germany and bonds issued by the ECB)? Or Florida refusing to participate in the channeling of monies or credits to Texas unless Texas collateralized the credit provided by Florida (as in the case of Finland being asked to help fund loans to Greece)? No; the way the Euro is structured now is fine when everything is going perfect, but “every man for himself” when there is a crisis.

Similar to the EU and Eurozone today, it was soon discovered that the entity at the heart of the Articles of Confederation was largely impotent – with no real authority or ability to act other than to what each State, individually, agreed to succumb.

This lack of authority was especially exaggerated in the matters of currency where each State, even each bank within the State, could issue its own currency – except for at the local level.This made trade extremely cumbersome as it had to be mostly accomplished by bartering – and it made the raising of taxes nearly impossible.

It didn’t take long before the leadership and constituency of the new country realized the weaknesses of the country that was formed and, just a few short years after the Confederation of States was created, the Constitution of the United States of America was adopted in 1787.

The Preamble of the Constitution acknowledges the weakness and peril in the Articles of Confederation and reads, “We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.”

This new Constitution gave specific and exclusive rights to the Federal Government, at the sacrifice of the sovereignty of the individual States, to regulate the currency and maintain the fiscal health of the country. Soon after, the Coinage Act of 1792 established the United States Mint which was charged with creating currency at the direction of the Federal Government.

The entire history of the US-Dollar – and the extended institutions and evolution that it has undergone in the over two Centuries of its existence – is much more nuanced than what I have consolidated into this article.But beyond argument, the single most significant event that took place was to consolidate the fiscal power of its governance to a central, Federal, authority.

This is not to say that the United States does not have its fair share of fiscal problems – because it most certainly does. However, it is far better positioned to cope with the problems due to its financial and currency structure than the Eurozone is.

Unless the members of the Eurozone can establish a similar authority and relinquish their sovereignty in matters related to the governance of the Euro to such an authority, the Euro will remain a currency in which credibility is tarnished, faith is diminished and in which potential is limited.

 

Joseph F Paris Jr is the Chairman of the XONITEK Group of Companies. With over twenty years as entrepreneur, academic and professional instructor, and strategic consultant – he is a champion of Operational Excellence (Lean Six-Sigma and Leadership) who has devoted himself to increasing stakeholder-value for his clients and constituents.

Contact him at parisjf@xonitek.com

 

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