Analysis: Euro strong but endangered

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  Nov. 21, 2003 at 6:40 PM
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WASHINGTON, Nov. 21 (UPI) -- The Cato Institute's 21st annual monetary conference Thursday, on the future of the euro, achieved more or less unanimous consensus: the euro can be expected to be very strong against the dollar in the next two years, soaring to $1.50 or more, but is in severe danger of disintegration in the long term.

As Kenneth Rogoff, former chief economist of the International Monetary Fund said, ther euro was "a religion" and many of the reasons for inventing it in 1998 were non-economic. Nevertheless, it has had a fairly successful first 5 years, and now looks likely to be very strong against the U.S. dollar, because of the U.S. trade deficit, now 5 percent of gross domestic product, and the likely increase in the share of central bank reserves denominated in euros. According to David Hale, former chief economist for Zurich Financial Services, the euro was now the currency of 30 percent of international bond issues, up from 25 percent in 1999, and 25 percent of global bank liabilities, up from 20 percent. The largest non-government borrowers in euros were American, with Fannie Mae having $45 billion of euro liabilities (presumably the majority having been swapped into dollars.)

As the foreign exchange markets for euros deepen, and the U.S. current account deficit continues to increase, the euro is likely to be startlingly strong. The United States now has foreign debt, net of foreign assets, equal to 25 percent of gross domestic product and that figure is increasing by 5 percent per annum because of the trade deficit. Hale pointed out for comparison that Britain, holder of the world's last reserve currency, had in 1914 net foreign assets of 150 percent of gross domestic product. With Japan's public sector debt rising above 140 percent of its gross domestic product, thereby causing continuing credit problems, and China facing a banking crisis, extreme strength of the euro appears inevitable.

Rogoff suggested the likelihood of a 40 percent rise over the next 2 years, above $1.60, a figure with which Hale and University of Virginia professor Leland Yeager appeared to agree, although National Bureau of Economic Research's Anna Schwarz was somewhat less bearish on the dollar. This is quite contrary to current market expectations and would have a huge effect on world trade patterns.

In the longer term, however, the euro has serious structural weaknesses, because of the unfounded pension liabilities in a number of eurozone countries. This would not be such a big problem if all countries of the euro zone had the same problem; the currency would simply enter a period of serious structural weakness and substantial inflation, as the problem was overcome.

Jose Pinera, Chilean health minister 1978-1980, and instigator of the world's first privatized pension system pointed out that in the eurozone this was not the case. Some eurozone countries, Finland, Ireland and Luxembourg, have sound public finances, and others, such as the Netherlands (and, outside the eurozone, Britain) have substantial well funded private pension systems. However, there are a number of core eurozone countries, in particular Germany, France, Italy, Spain and Austria that have pay-as-you-go public sector pension systems, which appear attractive in their early years but the bills for which are now coming due as baby boomers retire and birth rates have fallen substantially below replacement levels. Immigration may mitigate the problem somewhat but is unlikely to solve it, since a solution would require that in 2030-50 young immigrants would be paying very high taxes to fund the social costs of aged locals -- a prospect unlikely to be politically feasible.

The long term solution to this, according to Pinera, is for these countries to move to a privatized, fully funded pension system, similar to that now found in 23 countries, and abandon the pay-as you go system, originally invented by German Chancellor Otto von Bismarck, who now "threatens to damage Europe in the 21st Century by this invention as much as he damaged it in the 20th by his other invention of a militarized German super-state."

Laurence Kotlikoff, former assistant secretary of the United States Treasury, presented the results of a study in which he had been involved while at Treasury, which showed that the United States' net unfunded deficit, taking into account Social Security and Medicare liabilities, was $45 trillion, or four times gross domestic product. The eurozone countries with unfunded pension systems have relatively an even larger problem, for two reasons: they allow much earlier retirement than in the United States (often at 50-55), and they do not benefit from the U.S.'s replacement level birth rate and high immigration.

In the short term, the eurozone countries with unfunded pension problems will start to run into serious budgetary difficulties around 2010, at a level that will make the current problems of budget deficit overruns above the levels of 3 percent mandated by the euro's Stability Pact seem tiny. At that point, those countries will need inflation to reduce the real value of their liabilities (though this will be difficult because many of the liabilities are indexed) and will seek through the common currency to offload costs on other euro members which don't have pension problems - an asymmetric shock, in other words. Because of its asymmetric nature, this shock is likely to result in either a breakup of the euro or massive fiscal transfers between countries, only possible within a wholly united Europe.

As Nobel laureate James Buchanan pointed out the euro, because it is now in existence, is "constitutionally efficient" and is unlikely to disappear other than through an enormous economic trauma. However, he welcomed the continuing existence of competing European currencies, sterling, the Swedish krone, and the Swiss franc, since they would provide a convenient alternative store of value and means of payment in case of difficulty.

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