The Languishing Euro

May 28, 2001

In ages past, the money markets of the world used to obey well-known classical rules. Whenever a country suffered substantial current-account deficits, for instance, its currency faced devaluation pressures. In recent months, this rule seems to have lost its force. The United States suffers huge deficits while the dollar sparkles in strength. And while European countries report large trade surpluses, which used to signal currency strength, the euro actually lingers in weakness. It now is worth less than 90 cents to the dollar.

Interest rates quoted by central banks used to affect the currency exchange rates. After all, interest rates guide credit markets, influence goods prices, and thereby move trade and commerce. A central bank that sets its rates below market rates used to weaken its currency. Yet, since the beginning of this year, the Federal Reserve System has lowered its rates five times, but the dollar has retained its old luster.

Economic expansion used to affect the exchange rates. Rapid economic growth not only attracted foreign investments but also exerted a downward pressure on goods prices and an upward pressure on the currency. But although European growth rates presently may be higher than the U.S. rate, they obviously fail to give support to the euro.

The currency markets seem to follow new rules, new cause-and-effect relations that confuse many economic analysts. The confusion is heightened by the heavy losses suffered on euro investments, which have bred deep distrust not only in the euro currency but also in European ability to reform and adjust.

It may take many months, perhaps years, of euro stability to recover a margin of trust. Some confused analysts now annunciate the very opposite of the classical rules. If only the European Central Bank would lower its rates in concert with the Federal Reserve System, they contend, the euro would rise and sparkle like the dollar. According to these market analysts, to imitate the Fed and expand credit is to give strength to a currency!

Actually, there are two important reasons why the euro in a state of chronic depression. First, the governments of the eleven euro-zone countries are using the introduction of the common currency as an opportunity to seize and confiscate funds acquired illegally. They are determined not only to prevent money-laundering—that is, making illegally acquired cash look as if it were acquired legally—but also to obstruct or even close the black markets, the illicit markets in which goods are sold in violation of tax laws, price controls, or other restrictions.

All euro-zone commercial banks, which are scheduled to handle the exchange of new money for old, therefore, are required to report every exchange of "large sums" to the authorities. No matter what they may report, many savers with illicit savings, no matter how small, may be fearful of being reported by name. They are seeking to avoid criminal prosecution and loss of funds by spending their savings or converting them into dollars. The euro is an unintended casualty.

Second, there are millions of people outside the euro-zone who are holding European currencies. Merchants, farmers, and workers in Poland, Croatia, Slovenia, Hungary, and other European countries have savings in trusted German marks. They may have heard rumors about the coming currency reform that will render their savings worthless, but they may not know where to exchange them for new euros. Their own governments may want to seize them, which are scarce foreign reserves, or want to tax them for reasons of tax evasion. Helplessness and fear may force the savers either to spend their holdings or convert them into dollars. The conversion itself is bound to be rather costly, as foreign commercial banks will have to work through euro banks and report the names of depositors to euro authorities. Only black markets which command high-risk premiums do handle the conversion without a question.

It is difficult to estimate the magnitude of both sources of funds seeking exchange. The amounts involved are huge. The black-market economy of the euro-zone has been estimated at some 16 percent of official gross domestic product (GDP). As it cannot use the banking system and is forced to use cash only, its stock of cash is bound to be way above the 16 percent of illegal GDP. If we assume it to be only 25 percent, with some 256 billion euros of bank notes presently in circulation (European Central Bank,Monthly Bulletin, April 2001), some 64 billion euros are serving the black market. A flight into dollars of such amounts alone would depress the euro.

In addition, the old stock of convertible money held in the non-euro parts of Europe is estimated at some 50 billion euros. (The outstanding German mark holdings alone are estimated between 30 billion and 45 billion.) Altogether the stock of European currency seeking U.S. dollars is significant; it is bound to depress the euro and lift the dollar.

The poor reception of the European currency could have been avoided if the euro countries had conducted a simple currency reform without waging war on money-laundering and black-marketeering. The war is a never-ending conflict that ensues from the very nature of political authority over the economic lives of individuals. No government has ever won it, however brutally it waged its battles. But such wars do irreparable harm to economic life and social cooperation. Since January 1, 1999, when the euro was launched, the conflict has cast much doubt on European productivity and the future of the euro.

Worst of all, it may inflict immeasurable harm on millions of individuals throughout Europe whose savings may become worthless or who are forced to exchange them at steep black-market discounts. The weak euro and the strong dollar are visible symptoms of this damage.

A simple currency reform would have exchanged old notes and coins for new currency without spreading uncertainty and fear. It would have avoided the three-year delay between the currency launch and the issue of notes and coins, and, above all, it would have extended the two-month grace period of exchange to five or ten years. It is inconsiderate and even harsh to demand that many millions of individuals deposit their old money in euro banks and exchange it for new euro notes within the short period of two months, in January and February of 2002. A simple reform would have been mindful of uninformed individuals in Poland, Croatia, Slovena, Hungary, and any other country of the world.

It undoubtedly is too late to speed up the exchange process, but the euro governments could at least rescind their reporting and naming orders and allow commercial banks to handle the exchange without acting as policemen. Such a rescission would lend instant strength to the euro and attract new capital to the euro economy. The European Central Bank (ECB) could develop clear exchange procedures for foreigners wherever they may live—procedures that would allow individuals to exchange their savings at their convenience. It also could devise procedures that would allow the new money quickly to penetrate the black markets inside and outside the euro-zone, which would reduce the extraordinary demand for U.S. dollars and remove the pressures on the euro.

Instead of limping after the Fed, which forever is trailing the business cycle, the European Central Bank could lead the way in averting the cycles by attaching its policy to the anchor of the ages: gold. Economic cycles made their appearance with the dawn of central banking and fiat money and have disrupted economic life ever since. There never has been a shortage of gold; but the world frequently has suffered from an abundance of paper money, which in many countries is counted by the thousands and millions of units.

The euro attached to gold immediately would overshadow the U.S. dollar, which is managed by seven political appointees. Instead of lingering at deep discounts to the dollar, a gold euro would soon rise to a premium and may even replace the dollar as the world's primary reserve currency. But such a policy undoubtedly is as alien to the Governing Council of the ECB as it is to the Board of Governors of the Federal Reserve. Guided by theories of central banking and credit management, both spurn the use of gold. It may take many more business cycles and monetary crises to appreciate the stability of gold. Experience may be the only teacher.

The 1849 Gold Rush sped up California's admission to the Union as the 31st state in that year.