What is the Purpose of the Euro?

What is the Purpose of the Euro?
May 13, 2011

(This item originally appeared in Forbes.com on May 13, 2011.)


What is the purpose of the euro?

Based on their speeches and actions, I doubt that even the eurozone’s leaders could properly answer this question. This confusion could soon lead to some unfortunate results.

The purpose of the euro is to provide a common currency throughout Europe. That is all that it does. There is no need for fiscal integration or any other sort of oversight or control.

Europe’s countries are small, and since they are all on the same continent together, they have all been involved in trade with one another for a long time. Greece has a population of only 10 million, less than Los Angeles. Denmark has half of that, at 5.5 million, which is about the same as Miami.

Can you imagine if Los Angeles or Miami had its own currency, which floated independently of the dollar? With its own central bank policy board, interest rate policy target and so forth? This would cause endless difficulties for anyone in Los Angeles who wanted to do business with anyone outside of Los Angeles. Eventually, businessmen might say: Let’s dump the Los Angeles peso and just use the dollar, like everyone else.

This would be particularly true if the Los Angeles peso had a poor history of currency decline, and thus the interest rates on L.A. peso-denominated debt was very high, compared to U.S. dollar debt. Businessmen would wonder: Why am I paying 15% on my peso loan, when people in Texas can borrow at 6%?

Thus, Europe’s countries have always been drawn toward an arrangement that, at the very least, provides fixed exchange rates between currencies. Most of the time, this was accomplished with a gold standard system. When all the currencies are pegged to gold, then of course their exchange rates with each other are stable and unchanging. Later, this was attempted through various agreements such as the European Exchange Rate Mechanism. But these were rather poor kludges, so they eventually landed on the idea of simply using one currency throughout the continent.

This seemed like a foolproof system: There would be no exchange rates at all, so nobody could mess it up.

However, fools are often underestimated. For some reason, they love to overcomplicate this very simple idea.

For example, let’s take the most recent situation with Greece’s central government. Let’s say that Greece’s government defaults on its debt. So what? All this means is that some people won’t get the payment that they were expecting. What does this have to do with the euro? The answer should be: nothing. And what if the governments of Portugal, Ireland, Spain and so forth also default and restructure their debt? This just means that they reorganize their schedule of promised payments.

The crux of the problem seems to be this: If a government defaults, possibly leading also to bank insolvency, people are afraid that the value of the euro will decline.

This is a rational fear, because apparently nobody told the fools in charge of the euro how to actually manage the currency they created. They seem to think that it is mostly a matter of making carefully worded statements in press conferences. Unfortunately, as they have already discovered, this wishing-and-hoping-and-lying technique is really not very effective.

However, it is in fact very easy to support the euro’s value, if there was a tendency for it to fall. You simply reduce the number of euros in existence: The ECB would sell euro debt, take euros in return, and make them disappear. If you like, you could even sell dollar debt, then sell the dollars in the foreign exchange market and buy euros, and make those euros disappear. Either way, if you reduce the supply of euros, then the euro’s value would be supported. This would have to be an “unsterilized” adjustment, to use the rather strange terminology common today.

Once we see that the ECB can effectively support the euro’s value, then it does not matter whether this government or that defaults. Default away! This is how capitalism is supposed to work.

The euro is supposed to be a common currency in which people can do business. Sometimes, business involves default. It’s not supposed to be any more complicated than that.

What if the city government of Los Angeles defaulted on its debt–as may in fact happen soon? Would that mean that Los Angeles should then abandon the U.S. dollar, and issue a Los Angeles peso? It is as if the solution to a default involves dousing yourself in gasoline and lighting yourself on fire. May I suggest that this is perhaps a bad idea.

Over time, the eurozone leaders might discover that, although the euro facilitates trade by providing a common currency, that alone does not guarantee currency stability. The euro’s value might rise or fall, with major economic effects.

Eventually, they might rediscover why Europe always used gold as their monetary foundation. Gold is stable in value, so if you link your currency to gold, the currency is also stable in value. This is much better than hoping the present collection of bureaucratic mediocrities will somehow get it right, by dumb luck.

Once the decision is made to link to gold, the ECB would use the same technique as before: if the euro’s value is too low compared to its gold parity, then the euro base money supply is contracted. If the value is too high, the euro base money supply is expanded.

This is a mechanism identical to today’s currency boards, which is why I say that a gold standard system is like a “currency board linked to gold.” It is also the effective mechanism by which gold standard systems have operated in the past, throughout Europe.

A common currency should be the simplest thing in the world. The euro has no “inherent problems,” except for the incompetence of its managers. Once they learn how to do their jobs correctly, the fiscal situation of Greece, Portugal, et. al., becomes irrelevant.