Ok, the sun is shining nicely down here in Barcelona right now, so maybe this is a good moment to come out and provoke a storm. The euro: something gives, but what? Actually it is perhaps ironic that I have chosen today of all days to write this, since for once it seems the euro may fall rather than rise: well to someone who is accustomed to marching out of step, this almost seems par for the course. Never mind, tomorrow, or the day after, we will be back to normal, and the seemingly unstoppable rise will continue. The only remaining question really is: where is breaking point, and what will happen when we get there?
But lets step back a bit. Let’s go back to the origins of the euro, and part of its raison d’etre. I think it is difficult to avoid here the hard reality that part of the thinking behind the launching of the euro (in addition to the abolition of transaction costs and internal exchange rate risk) was getting a piece of the action that the Americans were perceived as having. You see during more years than it’s worth remembering, the United States has been able to pay for its imports by exporting little pieces of paper known as dollars. We were, as it were, on a dollar standard.
It has been able to do this, not simply because petroleum transactions were denominated in dollars, but because some other countries, and particularly some key Asian ones, were running trade surpluses, and the relevant central banks decided to hold their reserves in dollars.
Then along comes the euro, with the unspoken agenda of in some way replacing the dollar as the international reserve currency. Nothing wrong with that in principle, at times in the nineteenth century there was bitmetallism: a gold and silver standard in parallel. Now all of this might well have run sweet and smoothly had history been a linear process where all thing get to move in one direction only. Unfortunately life, at least economic life, isn’t that simple.
Nations, and economies with them, rise and fall. You only have to look at the last century and do a comparative study of Argentina and Japan to see the sort of thing that can happen.
Now one of the problems with sending out all these dollars and euros (and perhaps it is worth noting that each and every one of them was conventionally signed on the reverse face with a declaration by the central banker to pay the bearer on demand, a declaration which now I take the trouble to look has been conveniently ommited on the euro notes: in their haste this eventuality was obviosly not foreseen) is that it represents a declaration of faith in the idea that economics is a game played out in abstract state space. It is curious indeed to note that many of the best known criticisms of standard neo-classical theory revolve around the question whether market mechanisms unaided reach an optimum output solution. This is an interesting, but IMOH secondary question. There is a much more interesting one which comes from the classics but which has somehow got lost in the wash: whether economics is a game played out in historical time, with evolutionary processes entering as part of the backdrop – is the game structured by meta parameters which lie outside the game (the so called exogenous variables). And what if one of these is our own species reproductive dynamic – our demography. We don’t have any problem whatsoever with this when it concerns the ecological dynamics of other animals, but somehow we are rather retiscent to look carefully at our own behaviour in the reflective mirror.
Well maybe it’s time to start doing this. Because maybe those dynamics are about to make their presence felt. Where for example are the Argentinas of today, and where the new Japans? Well it isn’t too hard to see that, at least in relative terms, Europe and the US are on the way down, whilst China and India are evidently on the way up. So what this means is a major relative re-alignment in currency values. Now this could be unproblematic – if done gradually enough – and if one (or now both) of the downward adjusting currencies weren’t the measure of value of all the others. So here it’s not a particular that’s being corrected, but the measure itself.
The realisation that this was always going to be a problem isn’t new: the American economist Paul Davidson gave a presentation to the G23 finance ministers in 1999 suggesting that it was time to do something about this, a suggestion which he tells me was well received in January, and forgotten in March. Well the problem just came back to haunt us.
So what is happening now, well…….. egged on by all the euphoria about new global powers and outsourcing controversies, a realisation is dawning that the dollar must come down (in fact, that it was ever so high was already a symptom of the problem waiting to happen. The situation is also complicated even further by the quantity of liquidity in the system, all that money waiting to find an investment need. This is not a chance occurence, but must have some relation or other with all those boomers topping-up the pension funds in anticipation of the retirement to come.). But in the coming down there must be a going up, here is the problem. So up goes the euro, in a way which clearly bears no relation to any known economic fundamental. All because of this damned reserve currency business.
We are getting our piece of the action alright, I only hope we’re going to like it.
So what can be done. Well……… again as I suggest at the begining of this post the rise does seem to have halted today. Trichet is letting it be known he might intervene, and the market is ‘reflecting’. Well he may try to stop the rise, but if setting currencies values was that easy central banking would be a doddle – and if you are in doubt on this, please ask the Japanese who are currently spending a fortune, more or less, in vain. Sure the markets will pause for thought, but it seems unlikely that the downward drift of the dollar will be staunched.
This is because behind all of this there lies another unspoken problem (as if we didn’t have enough already!): the real, or perceived, deflation threat. And here matters get well and truly interesting, because there is a kind of seismic divison with a very peculiar line up. On the one side there is Krugman and the ECB who are essentially warning about the looming inflation, on the other is Ben Bernanke, Alan Greenspan, Stephen Roach and yes, little ol’ me. And unfortunately it is impossible to make any sense whatsoever of all this without understanding this backdrop. I guess this must count as one of the most difficult ‘calls’ in recent times, and it is one which really must leave the layperson feeling very economically challenged indeed.
Bernanake, Greenspan, Roach and me (we will stand and await reinforcements) clearly think the deflation is the real risk.
This is where Bush’s crazy tax cut really comes in like a billion dollar note pinned to the inside of the Fed’s waistcoat, just for a rainy day. It fits the need like a glove. Of course this wasn’t the original plan……
But the looming monster-tax-cut is focusing everyones eyes – including K’s – on inflation, which is exactly where Bernanke and Greenspan want them to be. (Incidentally my feeling is that Bush is essentially irrelevant here: they are calling the shots down at the Fed). In a way it’s a nice inversion of a set of proposals made recently by IMF economist Gauti Eggerston: only instead of the central bank becoming prisoner of the mad government as he suggests – the mad government is giving everyone the impression of being in control, while the pupeteer (not Malkevitch this time but Greenspan) is really pulling the strings.
What I am trying to say, is that while the US position is far from comfortable, it does seem to be sustainable at a price: since they are not afraid of inflation they can happily keep printing money till the cows come home.
Did I mention that all this pleasure has a price: well yes it does, and it is we in Europe who are destined to pick up the tab. This is where it can all end in tears. Where is the ceiling? $1.40, $1.50? You tell me, but somewhere out there there is a limit, and we are just about to go and give it a test.
Of course, some of you will say, couldn’t this all be sorted out by the various parties acting like gentlemen and sitting round a table to iron things out: well maybe it could, but please remember that other wild card which is lying around on the table: Iraq. Are the European leaders in the present environment in any position to ask the US for a favour, a favour which might mean that it is the US and not Germany which enters deflationland first. I ask you: think again.
Incidentally, the real Bernanke speech you need to read is here. In it you will see among other things, that the Fed even had plans to control what is known as the yield curve, in an attempt to keep long rates below a given threshold. Are they doing this, well they wouldn’t be telling us, now would they?
Anyway this is where you can see what really might be going on. Of course it isn’t in the references to Bernakes other speech, the one he made last week, and which has caused so much confusion in the markets. IMOH if it has caused confusion there is one good explanation: it was meant to.
Now I apologise to those of you who have come this far and are not economists, and I apologise equally to those of you who are and still aren’t with me. These are what they are: my opinions. Now go and check them out with the facts.
This article appears of part of my guest column in the Money Files.