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Whither the Euro?

Where is the Euro going? The coins and notes are nicely designed and it is convenient not to have to keep bags of different currencies when travelling abroad. That is of course trivial; the real benefit of the Euro is that trade within the Eurozone takes place without the burden of the cost of currency exchange and the associated risk of changes in exchange rates. Neverthless, we have always been sceptical about the long-term viability of a currency shared by many sovereign states. The ultimate question is who is responsible for issuing the currency?

For most of the time since its inception in 1999, the Eurozone has done well, and on the whole it has held up strongly against the US and UK, following the series of financial earthquakes which began in 2008. But the stresses are now appearing, first with the collapse in Ireland, and now with troubles in Greece, Italy, Portugal and Spain. Ireland, Greece and Portugal are tiddlers within the Eurozone as a whole and therefore relatively unimportant. The countries to watch are Spain and Italy, which are not.

Greece and Ireland have agreed to take drastic measures in an attempt to take control of their government deficits, but even if their governments succeed in driving through their measures, it is unlikely that their economies will recover their former buoyancy for a long time. All of the weakling countries lie at the geographical fringes of the zone, which puts them at an immediate and permanent disadvantage due to transport and other energy-related costs. In Ireland, as a result of an inflow of funds from the EU, but entirely predictably, land values became absurdly high. A residual problem is that bank loans, many of them possibly unrepayable, remain secured on these unrealistic values. The associated problems will not be easily resolved.

Spain likewise suffered from a heavily overheated “housing market” (land market) and now 20% unemployment as well. The Italian government continues its tradition of being unable to collect the tax to pay its expenses. Add up all the little weaklings in the Eurozone, plus Spain and Italy, and the result is a millstone.

On the other extreme there is Slovakia with its 19% flat tax (VAT, tax on wages and corporate tax), which is still growing and outperforming all the others. This is an exception, as the country is still recovering from its low position when the country was part of the Soviet empire. Their land price bubble has still to happen. The bust is bound to come unless they do the right thing, which is unlikely. It will then go the way of the Baltic republics which also had flat taxes, experienced a period of frenzied growth, followed by the inevitable land price bubble and collapse. That affected the Swedish banks which had fed the Baltic bubble and has now weakened the krona.

Where does this leave Germany, the strongest economy in the zone? As an export nation, Germany has no interest in a higher Euro. In the days of the pre-unification Deutschmark, the result of years of successful exporting was a strong currency. With a culture of saving and a permanent balance of payments surplus, German investors had no option but to purchase property abroad, with manufacturing being transferred to countries with weaker currencies and lower labour costs. Countries that export successfully for years on end up with a strong currencies no matter what is done to try and stop it. In the end, the process is self-limiting as those countries’ goods become too expensive and at that point, their companies set up factories abroad where employees can be paid in local, low-value currencies.

Thus it is in Germany’s interest to retain the Eurozone, since 55% of its foreign trade is within the zone – provided that it also retains its purchasing power.

Permanent trade imbalance

But even within a single currency zone, it is not possible to have imbalanced trade for years on end between a strong economy and weak ones without serious problems starting to develop. Wealth tends to get sucked towards the stronger economies, and the weaker ones lose the purchasing power they need to buy from the stronger ones. The tendency will be for the whole thing to grind to a standstill, with chronically depressed economies at the fringes. With different currencies, there is the possibility of adjustment. In the middle ages, it was unusual to find gold coins circulating in north-west Europe – the main currency was silver – whereas gold was commonplace in the more prosperous Mediterranean region which was then the centre of world trade.

Differences within countries

Of course there are big differences even within individual countries. Hamburg is rich, whilst its neighbour Schleswig-Holstein is poor. Baden-Württemberg has a huge trade surplus while Berlin has a abysmal trade deficit. And then there is the former East Germany.

This could be used as an argument for having different currencies in, say Hamburg and in Schleswig-Holstein, or Baden-Württemberg and Berlin, or south-east England and the rest of Britain. Without them, the long term effect is that existing differences are intensified, poor areas become poorer, wealthier areas become wealthier. It does not however, need different currencies but the tax mechanism inside a country needs to recognise geographical advantage and disadvantage, otherwise the tendency will be towards splitting off of the marginal areas, accompanied by internal tensions as happens in the UK.

Ricardo’s Law applies

So what is really going on? The explanation lies, as so often, with Ricardo’s Law of Rent. Every busker on the London underground knows that the top spots are Victoria, Oxford Circus and Tottenham Court Road, the busiest stations where several lines intersect. It is not worth performing at the end of the Central Line. And there are some places where it is only just about worth the effort – places like Hammersmith and Camden Town, perhaps. These are the marginal locations and set what are in effect rental values for all the better pitches. That is classic Ricardian theory.

At a glance at the map of Europe, it is obvious that the strong economies are those countries closest to the centres of population, where all the transport links converge, with cities like Munich, Frankfurt, Milan, Paris and Cologne. The economies of Portugal, Spain, southern Italy, Scotland, Ireland and Greece are in an analogous situation to the outer fringes of the London underground, considered as sites for busking.

UK anomaly

The British situation is anomalous. The country has remained outside the Eurozone, wisely, in our view. Had we joined, the lower interest rates when the Eurozone was established would have led to an even bigger house (land) price bubble and an even bigger and more damaging collapse. But the UK’s membership of the EU also creates difficulties for the country’s economy. The trouble is the high proportion of trade with other EU countries, which puts industry in the north and west of the country at a disadvantage due to the cost of transport. Before the UK was in the EU, there was relatively more trade with countries outside the zone. This was particularly beneficial to the west coast port cities such as Liverpool, Glasgow and Belfast, because once goods have been placed in the hold of a ship, it costs little more to send them half-way round the world than it does to send them to, say, Rotterdam, a lengthy voyage round the tip of Cornwall and up the English Channel, with the alternative being to transport them over congested roads via Felixtowe or through the Channel Tunnel. Given the relative economic disadvantage these regions now suffer, Ricardo’s Law does its job, leaving many cities in a state of chronic economic depression.

Both with countries and at a wider scale, the same rule applies. At the more central locations, input costs, mostly energy costs associated with transport, are lower. There is nothing that can be done to alter that. The best that fringe countries can do is specialise by providing services or high value items, which is how the Scandinavian countries succeed in overcoming the odds. The ability to do that, however, depends on cultural factors which are not always present. Thus, Finland, with its highly educated population and technology-based economy, apparently manages to thrive in the Eurozone.

Levelling the field

Within a country, it is possible to even-out locational differences by collecting the annual rental value of land and using it as the main source of public revenue. In or out of the Eurozone, countries should pursue this policy. But only by the use of a similar mechanism across the Eurozone as a whole would it be possible to establish a level field. However desirable it would be, it is not a practical political proposition, and for this reason, it is unlikely that in the longer term, the southern European fringe countries can remain in the Eurozone. Economic forces will drive them out of the club.