Sunday, 21 July 2013

Why stay in the Euro anyway?

What are the advantages of being part of the Euro? This is the question many people, especially in Southern Europe, start to ask these days. The typical answer revolves around the following arguments:

1. The Euro eliminates transaction costs related to currency conversion from which both companies and consumers benefit

2. It enhances price transparency of goods and services across the Eurozone creating more competition among companies from which all Eurozone citizens (consumers) are beneficiaries

3. It eliminates exchange rate risk, which allows for a higher degree of certainty in terms of investment planning and fuels cross-border investments

4. It allows to smooth the disruptive impact of financial crisis by avoiding overnight currency devaluations and allowing Eurozone banks to access ECB's refinancing mechanisms

5.......and we could go on with more technical arguments along the lines of the previous ones

They are all valid arguments. And the perfect example of the adverse consequences of too much focus on detail and complete lack of big picture thinking: in the big scheme of things these arguments are, on aggregate, valid but irrelevant. Peanuts.

The overwhelming reason to be part of the Euro is another one: a sustainable and continuous rise in living standards.

Let's see why:

1. The only way to increase living standards sustainably over time (which necessarily involves increasing real salaries sustainably over time) is via a continuous increase in productivity

2. A continuous increase in productivity requires continuous investment in both human capital (formal education, training / re-training on the job) and physical capital

3. What to do to incentivise companies to continuously invest in human and physical capital?  Simple: put them under constant competitive pressure. Only constant competitive pressure will force them to be innovative, come up with new and distinctive products, improve their production processes and reduce unit production costs. All of which, in turn, require a continuous re-investment of part of the annual profits generated in the business, i.e., in human and physical capital.

4. How to put companies under constant competitive pressure? By having a "strong currency". Meaning: a stable currency, that doesn't devalue as soon as there is some loss in the countries external competitiveness. The moment that the corporate sector realizes that it will not benefit from currency devaluation to restore potential losses in competitiveness, it will do everything it can not to lose competitiveness in the first place. And therefore, instead of paying out the entire annual profits in dividends to buy a few new Ferraris and yachts, entrepreneurs will reinvest part of the profits in their businesses. In human and physical capital.

Over a 1 or 2-year period buying another Ferrari or reinvesting part of the profits in human and physical capital won't make a big difference. Over a 10-period the difference will be like day and night. It will be the difference between a country with unchanged living standards, relying on currency devaluations to stay competitive, and a country with highly competitive and innovative companies able to pay high and rising salaries to its well-educated and well-trained workforce.

5. How to "create" a strong currency? Have a fully independent central bank whose only mission is to keep price stability. Such a central bank will not be subject to political pressures. Will not monetize public debt. And its single goal of ensuring price stability will translate into a "shadow goal" of exchange rate stability. A "strong currency". Thus, very low exchange rate risk for international investors. This in turn will translate into low interest rates.

In a nutshell: a stable currency ("strong currency") will create i) the incentives for a permanent high level of investment in physical and human capital by the corporate sector and ii) the conditions for these incentives to be materialised by generating a low interest rate environment. The mid to long-term result of this mechanism is economic prosperity.

This is THE reason why the Euro should be embraced by the citizens of its member countries.

But let's not fool ourselves: short-term, staying in the Euro will continue to impose heavy pain on Eurozone's peripheral countries. However, the fact that a currency devaluation is not an option, is building up a phenomenal amount of pressure on the countries to reform. Without the option of a currency devaluation, mismanagement by the political-administrative apparatus becomes suddenly very obvious and visible. The pressure to change the system is there and will not go away. The system's "fat cats" are and will continue to be under fire. This is very good news.

Especially when taking into account the power of history in shaping the future: countries, political systems, corporate cultures don't change easily. Just like people's behaviour doesn't change easily. For change in behaviour to happen powerful incentives have to be put in place.

The Euro is the most powerful incentive mechanism for change that Eurozone deficit countries could wish for. With it in place, structural change and a break with the past "modus operandi" are real possibilities. The younger generations being the main beneficiaries of it.

Boys and girls, the Euro is your friend. Embrace it!

PS Ludwig Erhard, Germany's legendary post-war II economics minister (1949 - 1963) always defended vehemently a politically absolute independent central bank (Bundesbank) and a stable currency ("the strong Deutsche Mark"). Now we all know why: to keep the competitive pressure high on the German industry and eventually rise German citizens living standards. Sixty years later, we all know the results.

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