EUROPE
Europe’s last chance to save the euro
Spring 2011
In just a few decades the Chinese renminbi and the U.S. dollar may be the only two reserve currencies, warns Krzysztof Rybinski. He sets out the stark choices for Europe’s policymakers if the euro is to survive
Can the euro survive? Will eurozone banks suffer crippling losses after marking to market large holdings of Greek, Portuguese, Irish, Spanish and perhaps Italian government bonds? These are the questions on the front pages of most financial newspapers, and obervers like France’s Jacques Attali predict that eurozone will go broke within next ten years. A number of prominent American economists suggest that the European Central Bank (ECB) is fighting the wrong ghosts with its single mandate against inflation, and so may yet push the euro into the abyss.
But only a few years ago the consensus of ideas ran in a completely opposite direction. Well-known economists like Menzie Chinn and Jeffrey Frankel believed that if the UK and the EU’s new member states were to join the eurozone, then the euro would by 2020 replace the dollar as the major international reserve currency. I myself argued in 2008 in a book I published in Poland that within 20-30 years the world will have switch from today’s dollar dominated model into a multicurrency model where the dollar, the euro and the Chinese renminbi would all play much the same role in trade invoicing and financial transactions.
Data collected by the IMF shows that the allocation of national financial reserves still has a relatively stable currency structure, with around 62% invested in U.S. dollar denominated financial instruments and 26-27% invested in euro. So what justification is there for the recent shift in economic thinking about the future of the euro? I believe there are four major factors that will determine the euro’s role: The sustainability of public finances in the EU; the European Union’s own vision and strategy; the course of actions to be taken by China; and the policies and decisions that will be taken by the central banks of the world's largest economies.
To begin with EU countries' public finance prospects. Between 2007 and 2010 public debt in the EU went from under 60% of GDP to over 80%. Studies of long-term fiscal sustainability suggest that if we do not reform pension systems in Europe the costs of aging will cause public debt to increase to around 500% of GDP by 2060. In other words, unless European governments introduce such radical reforms, as raising the pension age from around 60 years to, say, 70, public debt will grow to become unsustainable. But European public opinion seems unready to accept such reforms. So if a radical reform scenario is impossible, political leaders will have only two other options for avoiding sovereign bankruptcy. The first is a massive increase in taxation levels, meaning that the costs of today’s unsustainable policies will mainly be shouldered by the young generation that must look forward to paying much higher taxes in the future. Their second option is inflation, which would erode the real value of the public debt. In this scenario the greatest cost burden would be borne by those people who have accumulated savings, notably the middle-class and senior citizens who will see their personal wealth eaten away by rising inflation.
Of these scenarios, only that of radical reform could secure a significant role for the euro in the years ahead. High taxes would imply low growth in Europe, and would limit governments’ ability to repay high public debt in the future. High inflation in the eurozone implies an increased risk to investors who would be holding the euro as a store of value. In both scenarios, international investors might well prove increasingly unwilling to consider the euro as a credible international currency.
In the meantime, it is perhaps worth mentioning that the only country in the EU that has managed to put its pension system on a sustainable footing is Poland. Poland’s pensioners now enjoy the fifth largest replacement rate in the EU, with the ratio of the average pension to the last average wage standing at 56%. The pension reform enacted in 1999 will, however, result in a falling replacement rate in the state pension system to 25%, and for private pension schemes the replacement rate will have fallen to around 30% by 2050, or roughly half its present level. And because Polish replacement rates are to fall faster than the aging curve will rise, Poland is the only country in Europe with declining cost of aging as a ratio of GDP, and this despite the fact the Poland together with Germany is going be the fastest aging country in the EU.
The demographic and public finance challenges facing the European Union need to be met decisively by Europe’s leaders. Both the Lisbon and Maastricht treaties should be amended to ensure the EU’s future fiscal sustainability. It makes no sense to measure existing public debt and compare it to 60% of GDP when the European Commission is at the same time forecasting that unfunded pension liabilities will push public debt to 500% of GDP. The sad truth is that the Union today lacks the charismatic leaders that would be capable of leading Europe through these painful times. The choice of the Commission’s Portuguese chief and the European Council’s Belgian president illustrate the point; figureheads from small countries are no threat to the leaders of large states like Germany, France or the UK. But weak leadership produces poor outcomes, while EU treaty changes require all the member states to agree with national patriotism now flourishing more than ever. There is no sense that Europe is accelerating towards a truly common market, most notably in services, because on the contrary many major business decisions in the EU have had a strongly nationalist dimension, especially when it comes to jobs. Nor is there an effective common EU immigration policy after the failure of the blue card project. Instead, we read about France forcibly repatriating Romanian immigrants. Put simply, short-term political objectives are making it next to impossible to create a new vision that will make Europe stronger, better able to combat its demographic problems and capable of facing the rising Chinese challenge. European political short-termism is not giving the euro the support it needs to become a trusted global currency.
While Europe wastes time, China is making enormous progress. It is spending more on R&D than Europe in relation to its GDP. It has already produced the world’s most powerful computer, stands ready to flood the world with new, reliable and relatively cheap cars and a decade from now will be threatening the survival of both Boeing and Airbus. The ability of the Chinese to think in strategic terms gives China a clear advantage over Western states blinded by their four-year election cycles. Sometimes the Chinese used this advantage in a very brutal manner, such as when China monopolised the world’s production of metals and rare earth minerals, using this monopoly power to force global businesses to move their high-tech production to China.
China also has a very effective strategy for creating large and liquid financial markets in Asia. And it has signed bi-lateral trade agreements with many countries in which the renminbi is the invoicing currency, which will lead to a gradual internationalisation of the renminbi. Step by step, the renminbi is becoming an international currency, even though it will take decades for it to challenge the dollar’s supremacy. It may take rather less time, however, for the renminbi to challenge the euro as the world’s second most important currency.
The central banks in major economic areas have many of them adopted similar strategies to weather the economic crisis, but this may no longer be the case going forward, which could well have far-reaching implications for the future of the world currency system. The U.S. Federal Reserve will exercise its dual mandate of printing dollars while keeping real interest rates negative for as long as it seems necessary to getting the U.S. economy back to a 3% growth rate, even though it currently faces the risk of a prolonged period of stagnant 1-2% growth. The Bank of Japan will continue its fight against stagnation and deflation with zero-interest rates, currency interventions and money printing. The Bank of China has more room of manoeuvre as it sets monetary policy within its regime of capital controls, which makes monetary policy more effective. And China is back on a 10% growth path and has already hiked internal rates. Finally, the ECB, built on the tradition of the German Bundesbank, has been forced by Europe’s politicians to buy government bonds of the beleaguered southern EU member states, and of the Irish, but now seems more concerned about inflation than growth.
These different attitudes and cultural backgrounds seem likely to lead to different monetary policy choices that could generate wild currency swings. If the U.S. chooses to implement an inflationary weak dollar policy, and the Asian countries intervene to prevent the appreciation of their own currencies, the euro could become the victim. A very strong euro could force Germany’s export-based economy into recession and so could threaten the entire eurozone’s recovery. Paradoxically, a strong euro could in the short run threaten the longer-term role of the euro as an international reserve currency because it would increase the likelihood of a serious public debt crisis in Europe.
It is still too early to pronounce the euro dead. Europe continues to have choices. If European leaders abandon their short-termism and begin to think in strategic terms, both Europe and its euro will have a fighting chance to remain world leaders. But if we fail, if reforms stall amid social unrest, if “economic patriotism” replaces sound EU-level economic policymaking, both Europe and the euro will fail. We are moving from a dollar dominated world into a multi-currency world, and it remains to be seen whether in just a few decades there will be three global currencies, or just the renminbi and the U.S. dollar.