Comment 83 : The Cause of European Crisis is Euro, the “Currency Manipulation Plot of the Third Kind” (October 1, 2011)


Many are misled by so called experts into believing that the cause of current European crisis is the governmental budget deficit of Greece, so if only Greek people has the determination to tighten the belt and balance their budget, then everything will be fine. Unfortunately this is not so. Even if Greece does balance its budget the crisis of Europe will persist since the root cause of the crisis is Euro itself. Let us see why it is so.

How Does Euro Polarize Trade Imbalances

Let us first consider a stand alone currency of Country X, and see how the trade balance and the valuation of the currency of Country X are related. Suppose Country X has a burst of innovation and productivity gains compared to its trading partners, and as the result starts to run meaningful amount of trade surplus. Country X will see a net inflow of foreign currency, say U. S. Dollar. Since U. S. Dollar is not the legal tender of Country X, manufacturers of Country X must sell the surplus U. S. dollars for their own currency to continue their operation. It is the process of selling surplus dollars that drives the currency of Country X higher vs. U. S. Dollar. Higher currency of Country X then reduces the competitive power of its manufacturers. The currency of Country X will rise to the level until the trade surplus of Country X disappears. During the period of rising trade surplus, Country X will be able to accumulate substantial amount of foreign currency reserve, either in the hands of the government or in the hands of its private sector, as the reward for its innovation and productivity gains, but the continued rising trade surplus requires continued bursts of innovation and productivity gains.

If Country X runs a trade deficit, it must sell its own currency for U. S. Dollar to foot the net outflow of U. S. Dollar. Thus the currency of Country X will fall vs. U. S. Dollar. As its currency falls, imports become more expensive and its consumption curtailed, whereas products from Country X become less expensive on the global market to boost its exports. The currency of Country X will fall to a level that will wipe out Country X's trade deficit. Of course, the foreign currency reserve of Country X will decrease until its trade deficit disappears. From the discussion of the previous paragraph and this paragraph we can see that a free floating currency market has the built in mechanism to prevent unchecked runaway trade imbalances.

Now suppose Germany has a burst of innovation and productivity gains, and starts to run trade surplus. If German Mark is a stand alone currency, it should rise 15% to bring German trade to a balanced position. With German Mark pegged to Euro, can Euro rises by 15% to make German trade surplus disappear? Of course not, since other countries in Euro region are not running trade surplus as Germany. Suppose Euro can only rise 7.5% due to the surge of German trade surplus. The 7.5% rise is not enough to stop German trade surplus so its trade surplus just surges ahead beyond the amount it is entitled to if Germany had not joined Euro. On the other hand what is going to happen to other Euro region countries? Let us take the weakest link, Greece as an example. Greece is under-developed compared to Germany, and relies on its inexpensive labor to manufacture low quality goods to export and balance its trade. In other words Greek products are competing with products of similar level from Asia, notably from China. The 7.5% rise of Euro will cause damage to Greece's exports and will force it to run trade deficit. Since Greece is in Euro region, Euro cannot fall to eliminate the trade deficit of Greece so Greece's trade deficit keeps expanding. Thus due to the existence of Euro, it can not stop the trade deficit of Greece nor eliminate the trade surplus of Germany. Of course, the burst of German innovation and productivity gains do not need to stop at one burst only. The continued bursts of German innovation and productivity gains will further complicate the problem of the lack of check and balance by free floating currency market exactly due to the existence of Euro. As the consequence, German trade surplus will explode and so is Greece's trade deficit.

The Reality Check

Now let us turn to actual data to see how the trade balances are for Germany and Greece. In the graph at the right the annual balance of payments, officially known as the balance of current account, of Germany, Greece and Japan (for the purpose of comparison) are plotted as the blue, red and green curves respectively. Euro has started officially at year 1999, and Germany is, of course, its initial member. Up to year 2000, Germany had run a slight balance of payment deficit as the blue curve shows. Then from 2001, the balance of payment surplus of Germany has exploded upward. Compared to the green curve of Japan, the explosion of German balance of payment surpluses is so impressive that the explosion can be attributed to the polarization effect of Euro. Greece has joined Euro in 2001. After the joing of Euro Greece's modest balance of payment deficit has turned into a torrent, again thanks to the polarization effect of Euro as discussed before.

The Evolution of Greece Crisis

Before the joining of Euro, Greek Government had a currency reserve, probably mostly U. S. Dollar and mixed in with some Euro. At the time of joining Euro, Euro Central Bank, based on the prearranged exchange rate between Euro and Greek currency of that time, has issued same amount of Euro as Greek currency in circulation. Greek people then exchange their own currency for the Euro issued by Euro Central Bank. As Greece runs balance of payment deficits, the amount of Greek currency reserve and Euro held in the private hands diminish. That means that the currency in circulation in Greece drops. If nothing is done, Greece will have an economic contraction, turning into a recession, into a depression and finally the whole Greek economy will be wiped out. The only way for Greece to avoid the fate of annihilation is to borrow from outside to maintain its currency in circulation. The logical candidate to lend to Greece is German banks that are sitting on the pile of U. S. Dollar and Euro due to the explosive balance of payment surplus of Germany, thanks to the polarization effect of Euro. That unrestricted lending to Greece continues only to the day when German banks realize the danger of lending to Greece since there is no way Greece can turn around as long as Euro exists. In the current case, the 2008 crash finally has opened the eyes of German banks and thus ushered in the Greek crisis.

What Should Be Done?

The attempt to induce Greek Government to balance its budget, by increasing taxes and cutting back social safety net spending, is to reduce the consumption side, but will not increase the exports of Greece. To increase the exports of Greece, the average wage of Greek workers needs to drop. Ironically, if Greece succeeds in reducing its balance of payment deficit, the achievement itself will boost the value of Euro, and thus will increase the cost of production of Greece, requiring more cut back of the wages of Greek people. Thus Greek worker's earning will spiral down to zero. The problem is not how to induce Greek people to earn less and less, but to find a way for Germany to curb its runaway balance of payment. No matter how to look at it, it has been a real disaster for Greece to join Euro at the first place. If outside Euro, and if Greece runs huge balance of payment deficit, its currency just plummets and its competitive power against Asian countries restored and the balance of payment deficit reduced.

Greece is not the only country within Euro region that is facing serious problem due to the poisonous nature of Euro. Other countries like Portugal, Spain, Ireland and Italy are facing similar crisis as Greece though at somewhat lesser degree. Eventually any other country whose economic strength is lesser than Germany will face the same problem. It will be pure stupidity for the Euro region to commit to open ended aid to those countries in crisis as urged by economic powers outside. The urgently needed is for Euro region to realize the fatality of Euro, and design a way to dismantle poisonous Euro as orderly and as early as possible.