Euro: An Imbalanced Marriage

February 24, 2010

To join Europe’s common currency, nations are required to meet five economic stress tests to ensure suitability.  The standards are rigorous but count only for a brief moment in time.  A Stability and Growth Pact, separate from the Maastricht Treaty that established the common currency, was meant to ensure that countries do not stray far from the fiscal standards that entitled them to initial membership, but its recommended penalties have proven unenforceable.

Without continuing discipline, a gauge of the intrinsic viability of European Monetary Union in a single currency can be found from how the various national currencies performed over the quarter century before they were melted down into the euro.  For that examination, I’ve used the dollar as a control against which to chart the euro’s components from the first quarter of 1973 when the dollar floated to the end of 1998 when the euro was born.

The German mark was the hegemon currency of Europe before the creation of the euro.  The U.S. dollar fell 2.24% per annum against the mark on average during the 25 years prior to the euro’s launch.  While that rate of dollar depreciation was less those against the Swiss franc (3.49% annualized) and yen (3.42% per annum), the mark in turn performed much more strongly than its present EMU partners.  In fact, almost all of them fell against the dollar.  The greenback advanced 9.05% per annum over the 25 years against the Greek drachma, for example, and recorded annualized gains of 4.16% against the Italian lira, 3.52% against the Spanish peseta, and 0.62% versus the French franc.  Only the last of these performed better over those 25 years than the British pound, against which the dollar rose 1.47% per annum.

Based on their long histories, not a couple of years in the 1990s that saw a rush to convergence with a variety of tricks, the marriage of the mark to ten other currencies was clearly not a wedding of equal partners.  Germany had been through a similar experience in mid-1990 when the West German Deutschemark and East German Ostmark were bound irrevocably together at an unrepresentative 1:1 parity.  With that earlier experience under its belt, German officials knew what would need to be done in the new European monetary environment to keep German goods and services competitive.  The other participants in EMU were just happy to lock in lower interest rates and did not understand the responsibilities that went along with the new benefits. The inevitable pressures that caused the mark to advance chronically against other European currencies before 1998 didn’t go entirely away.  The present EMU crisis, which saw Greek-German ten-year yield spread widen sharply further again today, is forcing the members of EMU to negotiate how the burden of keeping an intrinsically unstable marriage intact.

As a common denominator of unequal partners, one would expect the euro to perform worse than the mark but better than the drachma, lira or peseta did.  Since the European Central Bank inherited the anti-inflation and monetarist ideology of the German Bundesbank, one would also surmise that the euro’s performance against the dollar would resemble the mark’s more closely than those former currencies of the other participants in EMU.  And so it has been.  Since the end of 1998, the dollar has dropped 1.04% per annum against the drachma, which joined EMU at the start of 2001, and by 1.34% per annum against the euro.  The yen and Swissy continue to outperform the euro (and by implication D-mark).  The greenback has lost 2.12% per annum against the franc and 2.05% per annum relative to the yen.  Interestingly, these currencies have also been not as strong since end-1998 as they were on balance over the 25 prior years.  In contrast, sterling has done better in the more recent period, which saw the dollar appreciate just 0.66% per annum against the pound on balance.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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