fredag, december 07, 2007


Why was the euro created?

I quote Bloomberg News.

"ECB Executive Board member Jose Manuel Gonzalez-Paramo this week opened a debate on whether rate cuts might be warranted in Europe, saying they would be justified if financial-market turbulence slows growth and inflation. At the same time, ECB council members including Germany's Axel Weber are pressing for higher rates to curb the fastest inflation in six years. "

In the good old days the Bundesbank would have raised rates had the Bundesbank seen any signs of excessive credit expansion or inflation in Germany. Weak currency countries within the good old Exchange Rate Mechanism would then all the sudden have faced the choice between devaluation or raising their interest at least as much as Germany.

That caused some problems for Germany since the Bundesbank not seldom had to purchase weak currencies because of Germany's obligation to support weak currencies within the ERM. That in turn offset some of the deflationary effects stricter German monetary policies were aiming at with regard to domestic conditions in Germany. To put it simple, Germany had to print D-marks to maintain liras, pesetas et cetera at rates above their purchasing power parity against the D-mark.

In my opinion most German monetary economists were too much concerned about the problems associated with the obligation of a hard currency country to support weak currency countries. They forgot that the Bundesbank purchased weak currency below the central parity of the weak currency and they also forgot that weak currency countries, once they had faced a run against their overvalued exchange rates, had to pursue extremely strict deflationary monetary policies. If one studies the price of one Big Mac during the time at which there was a strong pressure against the grossly overvalued Danish krone, one can observe that the price of one Big Mac was falling in Denmark whilst it was rising in Germany. It is not untrue to say that the Bundesbank had lost control of German inflation, but the Bundesbank certainly did control the Danish inflation rate and, perhaps unintentionally, controled it extremely well.

But the greatest mistake of those German monetary economists was that they did not realize that although an intervention in support of a weak currency within the ERM increased the supply of D-marks it decreased the supply of weak currency even more. In my opinion the extremely low domestic inflation rates of for example France and Denmark substantiate that their commitment to fixed and, yes, overvalued exchange rates and Germany's somewhat futile attempts to lower it's domestic inflation rate in effect made the domestic quality of Danish kroner and French francs outperfomance just about anything.

The euro was created as the result of an unholy alliance between the inflationists of weak currency countries and those German monetary economists who did not realize that Germany without any long term threats to domestic stability could continue to purchase weak currencies within the ERM given that the central banks of those weak currency countries were willing to raise their lending rates as much as the commitment to fixed exchange rates required.

I agree that it was disturbing for Germany to have to purchase enormous quantities of weak currencies, but as long as the domestic quality of those externally weak currencies was acceptable to the high German quality requirements and the countries in question were willing to play in accordance with the rules of the game, I think that the good old ERM was far better than an ECB where the hardliners are easily outvoted by inflationists.

In my opinion only a free banking system based on gold is better than the good old ERM. The only problem I think has been eased through the creation of the full monetary union is that the euro tends to be slightly less overvalued against the dollar than the D-mark actually was.

For Germany it had been much better to continue to purchase weak currencies as long the weak currency countries were willing to pursue strict deflationary policies, since that problem had been of limitied duration and ended once purchasing power parity had been established. As far as the Netherlands and Germany were concerned, purchasing power parity had been established and exchange rate tensions had ended. I think that it had been possible to achieve an ERM where all price levels had converged without any realignments of nominal exchange rates. That would have been far better than the present situation where inflationists are in charge of the ECB, and it would also have been better than a perfectly isolated D-mark or an ECB controled exclusively by German monetary economists, since most German monetary economists favour a policy of moderate inflation.

I believe that the mutual and multilateral commitments to fixed exchange rates in time had forced to particating countries to 0% inflation or even less.

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