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The ECB, Not Greece, Threatens the Euro

The commentary below is for the benefit of our readers from opinion makers and writers not associated with Euro Pacific. We do not guarantee the accuracy and completeness of third-party authored content. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific, or its CEO, Peter Schiff.
Louis Woodhill
January 18, 2011

Rahm Emanuel spoke for progressives everywhere when he said, "Never let a crisis go to waste." What he meant was, "Never pass up the opportunity that a crisis offers to expand the size and power of the State and to make it less accountable to the people." Right now, the progressives in Europe are doing their best to use the so-called "euro crisis" as an excuse to force European nations into a "fiscal union," which will conveniently have the effect of transferring power over budgets and tax rates from member-states to the Brussels bureaucracy.

In his December 9, 2010 essay Bond Plan Could End the Euro Crisis, Wolfgang Münchau stated the progressive gambit as follows: "A fiscal union is both a necessary and a sufficient condition for the long-term survival of the euro."

Nice try, but a "fiscal union" is no more necessary for the long-term survival of the euro than it is for the long-term survival of the metric system. "The euro" is a unit of measure, like "the meter". It is the unit of market value used within the euro zone.

Because the euro is a basic unit of measure, the bankruptcy of a European government—or even all of them together—cannot threaten it. Only the entity that defines a basic unit of measure can destroy that unit of measure. Accordingly, only the ECB, which issues the euro, can destroy the euro.

The current threat to the survival of the euro is the result of three mistakes made the ECB: 1) seeking to control the value of the euro by targeting short-term interest rates rather than the price of gold; 2) permitting banks to "discount" (borrow against) the government bonds of all EU member states at the same interest rate; and, 3) buying assets of questionable value, like Greek government debt.

There are historical and political reasons that the ECB operates the way it does. However, from the standpoint of creating and maintaining the euro as a currency, these are unforced errors. If the euro collapses, it will be because of the ECB's operational mistakes, not because Europe lacks a "fiscal union."

A number of foreign states, including Ecuador, Panama, and El Salvador, use the US dollar as their currency. The US has no "fiscal union" with these countries, and none is being discussed. In addition, no one believes that the bankruptcy of any, or even all, of these states would have the slightest impact on the viability of the US dollar. This is because the Federal Reserve does not own any of these "dollarized" countries' debt, and does not lend to banks against it.

Some economists have suggested that countries like Greece could solve their economic problems by abandoning the euro. This is insane. Germany could (conceivably) go back to the deutschmark, but Greece cannot revive the drachma. If it were to do so, the Greek economy would simply go (farther) underground and continue to conduct commerce in euros, while the real value of Greek government revenues would implode. The mere threat of a return to the drachma would precipitate bank runs and the collapse of all Greek banks. No one—and definitely not suppliers of imports—would be willing to hold the drachma, which would be a currency designed to be devalued. A "drachmaized" Greek economy would simply disintegrate.

The fundamental economic problem faced by "weak" European countries like Greece is slow economic growth. Countries, like other borrowers, borrow money against the present value of their future income stream. For a country that pays 3% (real) interest on its debt, a decline in average annual real economic growth from 2% to 1% will reduce the present value to the infinite horizon (PVIH) of its future GDP by 50%.

The immediate problem faced by countries like Greece is the extremely high interest rates on their government debt. These high rates are largely the result of low economic growth and the depressed PVIH of their future income, which creates a high likelihood of ultimate default. For a nation growing at 1% real, an increase in real interest rates from 3% (Germany) to 10% (Greece) will reduce the PVIH of future GDP by 78%.

Going from 2% growth and 3% interest rates to 1% growth and 10% interest rates would have the combined effect of reducing the PVIH of a nation's future GDP by 89%. No nation with existing debts equal to more than 100% of current GDP can remain financially stable in the face of such a drastic reduction in the PVIH of its future income stream. Such a nation will either be bailed out, or it will default, or (ultimately) both.

The first step in solving any problem is to restore integrity, because, "Without integrity, nothing works." And the first step in restoring the integrity of the EU is to stop using ECB-issued fiat money to paper over real economic problems. By compromising the integrity of money and contracts, inflationary money-creation actually makes matters worse. As the monetary authority, the ECB needs to focus on providing a stable currency. Fiscal authorities must deal with fiscal problems. As first steps, the ECB should start targeting the price of gold in euros and stop buying assets of questionable value, like Greek government bonds. If the ECB were to do this, speculation about "the collapse of the euro" would cease.

Europe must reject the progressives' arguments for "fiscal union," which is just a ploy to raise taxes and move power to Brussels for the sake of financing temporary bailouts. Instead, the "weak" countries of Europe, like Greece, should put themselves through the equivalent of Chapter 11 bankruptcy.

Their reorganization plans should focus on generating rapid, sustained economic growth. The prospect of fast economic growth would make it possible for these countries to attract private capital at reasonable interest rates. Yes, fast economic growth is possible for countries like Greece.

Greece has high personal and corporate income tax rates, but Greek income taxes bring in surprisingly little revenue—less than 20% of the total (7.7 percentage points out of a total of 40 percentage points of GDP). Greece would be better off financially if it simply abolished its income taxes. At a "normal" interest rate for a country like Greece (4% real, which is 1 percentage point above what the US and Germany pay), increasing average annual real economic growth from 1% to 1.6% would pay for (on a PVIH basis) cutting taxes from 40% of GDP to 32.3% of GDP. Of course, it is likely that abolishing all Greek income taxes would result in economic growth rates considerably higher than 1.6%.

The ECB, not Greece or the other PIIGS, is the real threat to the survival of the euro. The ECB should focus on providing a stable euro and the economically weak EU member states should focus on economic growth.

Louis Woodhill, an engineer and software entrepreneur, is on the Leadership Council of the Club for Growth.

Article originally published on January 18th, 2011 at realclearmarkets.com. Louis Woodhill, the Club for Growth, and RealClearMarkets not affiliated with Euro Pacific Capital, Inc. Euro Pacific Capital does not guarantee the accuracy and completeness of third-party authored content.