As if they don’t have enough on their plate right now, euro area policymakers are in for another dangerous surprise. The world is waking up to the inherent flaw of the euro in a particularly nasty way.
And I’m not so sure that those living under the euro’s constraints and consequences will put up with it once they realise their common currency is the cause of their inflationary and deflationary woes at the same time.
Here’s how I explained the inherent flaw in my book How the Euro Dies:
The basic idea of monetary policy is to smoothen the business cycle. A country with a struggling economy gets a kick-start thanks to lowered interest rates. A country with a booming economy, high inflation and low unemployment needs to be slowed down with higher interest rates to prevent inflation, bubbles, speculation and too much debt.
But what if you persistently set the wrong monetary policy in a country, deliberately?
Incorrect monetary policy was responsible for the financial crisis of 2008. In the United States, the Federal Reserve and its former chairman Alan Greenspan copped the criticism for this. Many commentators now agree that interest rates were kept “too low for too long” in the 2000s, inflating the housing bubble with cheap debt. In other words, the central bank financed the sub-prime bubble with low interest rates, fooling people into borrowing money they couldn’t afford when interest rates returned to normal.
But, in Europe the one-size-fits-all monetary policy of the ECB [European Central Bank] was never blamed for the housing bubbles in Ireland and Spain. Those countries should’ve had higher interest rates when their property markets boomed before the 2008 crash. But Germany’s economy was the “sick man of Europe” at the time, requiring low interest rates. So, the ECB split the difference and set interest rates somewhere in between.
Politicians call this a compromise. I call it the worst of both worlds. It left Germany with an interest rate that was too high, and Europe’s booming economies with an interest rate that was too low. This financed the housing bubble’s excesses in the peripheral countries and kept Germany in the doldrums.
The reverse happened after the 2008 financial crisis. Germany benefited from interest rates that were far too low for its booming economy. A few years ago, the former German finance minister estimated interest rates should be at 6% for Germany given its unemployment, inflation and GDP growth.
But the ECB couldn’t raise rates on the struggling Italians and Greeks. So, the 0% interest rates are inflating bubbles across central Europe right now. Especially housing bubbles, as in Spain and Ireland before 2007. That’s because house prices are especially interest rate sensitive.
My German grandmother is rather thrilled about the effect on her property portfolio. But Germany’s many renters aren’t happy with the inequality this creates. And they’re already creating political problems for Germany’s chancellor.
This is one form of the fatal flaw of the eurozone. One monetary policy for all those different countries means the wrong interest rate applies everywhere. Let’s examine more closely the damage this does over time. Understanding it will help you make investment decisions in the future.
How the ECB is destroying the eurozone
It’s no surprise that Europe has seen the lowest economic growth of any continent since the introduction of the euro. It’s had the wrong monetary policy applied, practically everywhere.
Imagine if Mark Carney, former governor of the Bank of England, had implemented monetary policy wildly out of synch with Britain’s economy. If he’d kept interest rates far too high or far too low, there would’ve been furore. We’d have accused the Canadian of sabotage. But in the eurozone, it’s an inherent part of the system. Because all those countries with their completely different economies share the same interest rate.
In the countries that are struggling, the interest rate is too high. In the countries that are seeing speculation, inflation and dangerous debt blooms, the interest rate remains too low.
Over time, this incorrect monetary policy in each country inside the eurozone is leading to enormous economic instability and inequality. Not to mention anti-euro sentiment. Not a good combination for the future of the euro.
It also leads to divergence in economies and investment prices – precisely the opposite to the integration that was promised by the euro’s creators.
In countries experiencing a boom, the ECB’s loose policy will lead to economic instability when the bubble bursts. In countries suffering under needlessly tight monetary conditions, it leads to anti-euro sentiment thanks to an eternal recession. In other words, instead of monetary policy smoothening the business cycle, it is worsening it.
And that’s what’s happening now, as Bloomberg points out:
Inflation is soaring across the euro area, but it’s also diverging by the most in years in a further complication for the European Central Bank’s ongoing pandemic stimulus.
How quickly consumer prices are rising depends on where you are inside the 19-member currency bloc. In Estonia, where energy costs are surging, the 2021 rate is forecast to be 4%; in Greece, where they’re regulated, it’s seen at just 0.1%.
While differences between euro area countries are nothing new, that’s the widest gap since the region’s sovereign-debt crisis — underlining the shortcomings of a one-size-fits-all approach to monetary policy.
How do you set a single monetary policy for 0.1% inflation in Greece and 4% in Estonia?
If you impose an awkward in between of monetary policy – too high for Greece but too low for Estonia – then you make inflation in Estonia worse and impose excessively tight monetary policy on Greece. Your one-size-fits-all approach worsens the crisis on each end – the deflationary and the inflationary too.
Thus, divergence is a consequence of euro area membership. The euro is the cause.
If inflation continues to diverge and people begin to realise this is an inherent part of euro area membership… well, people will have to choose between keeping the euro and keeping the value of their money.
Which will they pick?
Funnily enough, European Central Bank staff have cottoned on to all this. This story from Bloomberg had me cackling away:
As the European Central Bank waits for the spike in euro area inflation to moderate, its staff is proving less patient.
The institution’s trade union — known as the International and European Public Services Organisation, or IPSO — is demanding that this year’s general salary adjustments for staff be topped up. The ECB’s proposed raise of 1.3% “no longer protects our salaries against inflation,” IPSO wrote last week in an email to employees that was obtained by Bloomberg.
Indeed, a 1.3% pay rise is not much help when inflation in Frankfurt, where the ECB is based, is at almost 6%.
And the trade union isn’t happy: “The ECB is not able (or willing?) to protect its own staff against the impact of inflation!”
If this is discontent playing out inside the ECB, imagine what’ll happen on the streets when the rest of euro users wake up.
Editor, Fortune & Freedom