EUROPEAN MONETARY UNION

Senior French and German officials have stated many times in recent months that the Euro will be a strong currency. We are told that the European Central Bank will pursue sound monetary policies and enforce the Maastricht criteria, thus ensuring stability. It is also being reported that around 30% of all financial assets and international trade will be denominated in Euros, making the Euro a reserve currency of equal standing to the US dollar.

The Euro may eventually achieve a status equivalent to that of the US dollar, although there are currently serious doubts about its future strength as indicated by the continued flight of capital from Europe to the US. Capital seeks out stability, but the uncertainties surrounding firstly the rates at which existing currencies will be converted into Euros, and secondly the mechanisms by which consistent economic policies will be maintained across a politically diverse collection of countries, have created an environment which is not conducive to long term investment.

A form of monetary union was attempted following World War II via the Bretton Woods agreement which established the US dollar as the world's reserve currency. The US dollar was made redeemable into gold at a fixed rate and all other national currencies had fixed exchange rates to the US dollar. Bretton Woods failed because it relied on the participant countries pursuing monetary policies which were consistent with the fixed exchange rates. This is the major problem facing EMU - differing political and economic issues will arise within the participant nations which will, in turn, necessitate differing monetary policies.

Other issues surrounding EMU include :

The strong socialist agenda of many European countries. Policies which attempt to create employment via increased government expenditure will conflict with the agreed EMU deficit criteria. In order to enact such policies the governments will have no alternative other than to increase taxation, which will in turn remove incentives to work, limit investment, and cause a further increase in unemployment.

The reluctance of countries to accept remote control of their monetary affairs. Money supply and interest rates are used as tools in the pursuit of short term political objectives (getting re-elected).

The European Stability Pact dictates that fines will be imposed if budget deficits exceed allowable amounts. The question is, how will the European Central Bank determine the "real" budget deficits of member nations ?

EMU Implications for US Debt

Uncertainty surrounding EMU is making it difficult for European governments and companies to sell their long term debt. Long term investment capital, which is essential for real economic growth, is currently voting with its feet and shifting to the US. The US is benefiting from this inflow of capital through low interest rates, a booming stock market, and a relatively strong currency despite high levels of money supply growth.

With 5.4 trillion dollars of Federal debt, a key aspect of the US Government's deficit reduction plan is the maintenance of low interest rates. To minimise interest expense the Clinton Administration has converted a large portion of this debt to short term, with 70% of all debt now at 5 years or less. This has, temporarily at least, reduced the Government's interest expense. The other side of the coin is that the interest rate risk is now substantially greater (changes in interest rates will have almost immediate effect on the Government's outgoings), making it imperative that rates be maintained at artificially low levels.

Unrealistically low interest rates, however, contribute to other problems such as spiraling money supply growth. Eventually (probably before the end of 1997) the US Federal Reserve will have to raise rates in order to reduce inflation.

As a result of the capital fleeing from EMU generated uncertainty, a window of opportunity is now approaching for the US Government to lengthen the term of its debt with little or no interest rate penalty. European money, seeking long term stability, will support US 30 year and 10 year debt. At the same time there will be pressure on short term rates due to continued high levels of money supply growth. The US Government may hence be presented with the opportunity of converting short term debt to long term debt with no adverse budgetary effects, thus reducing its vulnerability to interest rate rises.

EMU Implications for Gold

The greatest single threat to any sustainable gold rally continues to be Central Bank sales or, more importantly, fear created by the threat of CB sales. The selection of the initial participants in EMU, and the rates at which their existing currencies will be converted into Euros, will be confirmed in April/May 1998. Until that time it remains very likely that more sales of gold reserves by European CBs will be announced. These announcements, and speculation about such announcements, will provide a difficult obstacle for gold to overcome. However, we are fast approaching a time (April/May 98) after which CB sales will no longer be seen as a deterrent to owning gold as an investment. After this time gold is likely to see renewed investment interest from Europe due to on-going doubts regarding the viability of the Euro, and the bull market will be underway. (Note - gold is currently attempting to rally. In my opinion, the strength of this rally will be determined by how the gold price reacts to the next announcement of a CB gold sale. If the gold price holds firm in the face of such news then we can be sure that a genuine bull market in gold has commenced. Otherwise, goldbugs will have to be patient for another 8 months or so).

Conclusions

During its first few years of existence European Monetary Union will, at best, be engulfed in uncertainty. At worst, it will be perceived as an unmitigated failure. Whatever happens it will take a lot more than intense marketing by senior EC political figures to instill confidence in the Euro.

Assuming that economic sense will finally prevail in Europe, then the Euro will eventually attain an equal status to the US dollar as a reserve currency. This will present a large problem for the US in the form of a reduction in the demand for its currency. In the short to medium term, however, the US is likely to be a beneficiary of EMU as a result of European support for its long term debt.

Medium to long term, the only form of money which cannot
be manipulated, created or destroyed by governments
will be the greatest single beneficiary of EMU.

The reader is invited to respond to Milhouse's wisdom via email: sas@hk.gin.net

Milhouse

Hong Kong, 6 October 1997

Also by Milhouse:
US Money Supply and the Demand For Gold

US / Japan Trade - Reality Versus Perception

Is Gold Still a Store of Value ?

Central Banks and Their Gold

The Intrinsic Value of Gold

Gold & Disintegration of U.S. Economic Influence

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