Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

C'est la vie; c'est la guerre; c'est la pomme de terre . . . . . . . . . . . . . email: jpalmer at uwo dot ca

. . . . . . . . . . .Richard Posner should be awarded the next Nobel Prize in Economics . . . . . . . . . . . .

Sunday, March 20, 2005

Is It Time to Short the Euro?

The continued success of the Euro as a world currency depends crucially on the fiscal discipline of each of the constituent gubmnts. If only a couple of the member country gubmnts runs prolonged, serious fiscal deficits, those countries will put inordinate pressure on the Euro and/or threaten to withdraw from the common currency.

The countries will naturally claim that they want the flexibility to address short-run macro weaknesses in their economies. And that is exactly what is happening now.

European finance ministers are meeting in Brussels on Sunday to discuss changes to the Growth and Stability Pact governing the euro.
The agreement limits the size of a nation's budget deficit and has been criticised for not letting governments boost economic growth by spending more.

France and Germany are pushing for greater freedom to break the rules. This is being strongly opposed by smaller member states, such as the Netherlands and Austria.

...France and Germany have bust the 3% deficit limit in every one of the past three years, and along with Italy are calling for greater freedom to increase state spending.

They argue that the rules were put in place when economic growth was stronger and make no allowance for more difficult times.
As economies sputter governments are faced with higher costs relating to payments such as unemployment benefits, as well as pressure from voters to act as a catalyst for growth.

The failure of the European Union to sanction France and Germany for their oversized deficits has led some observers to state that the Pact is effectively dead in the water.
Italian Prime Minister Silvio Berlusconi, facing a bleak economic
picture at home, told business leaders on Saturday that he would put up a "great fight" to get the Pact relaxed.

If France, Germany, and Italy are successful in getting the Pact relaxed, the growing individual country debts will put increasing pressure on the Euro. It might not happen for quite a few years, but the seeds are being sown for the coalition to break down. The Euro is, after all, the result a coalition with no single entity having the power to enforce it. Such coalitions can be unstable over time. As BrianF, who sent this to me, adds,

I think this is what's known in macroeconomic theory as a time-inconsistency, precommitment problem. Which in general parlance means that a committment from a politician is not worth the paper it's written on.

If this trend continues, the Euro will not be a good candidate to replace the U.S. dollar as a world currency reserve; foreign central banks, especially in Asia, will continue to hold U.S. dollars, but only because there is no good alternative, thus staving off the decline in the U.S. dollar that we might otherwise expect.
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