Thursday, May 13, 2010

Euro Defence Fund

Recently, the EU announced a policy to build up a substantial Euro defence fund (upto $1trillion) (link). To protect against speculation, countries would contribute funds to be able to buy Euros in case the Euro 'came under attack' and started to devalue. The scale of the reserves is quite impressive and acts as a disincentive for speculators hoping to make profit by betting against Euro. It also may prevent a sell off of Spanish / Portugese debts raising interest rates and creating more alarm through the European financial system.

The UK decided not to take part, and was criticised for this. Should the UK have taken part so we might be able to receive help from Euro members when the Pound comes under attack.

Firstly, I am not convinced the EU have the right approach to the value of the Euro. Using a measure of fair value, the Euro is still slightly overvalued against the dollar. If the Euro was to fall, it would help the Euro area. It would provide a boost to the export sector and stimulate the sluggish growth performance.

There is a strong fear in the Eurozone of inflationary pressures from a weak Euro. But, inflation is one of the few problems the EU doesn't have at the moment. The European economies have other more serious problems at the moment.
  • Sluggish growth. (Forecasts for the Greek economy suggest it could take several years to regain the same level of nominal GDP). This is a huge burden and will make reducing the debt / GDP ratio very difficult.
  • Growing government debt, and markets fear over repayment schedules
  • Continued levels of mass unemployment.
With this kind of economic situation, the EU should not be worrying about a devaluation in the Euro.

It is true, market speculators often get things wrong (e.g. Stock Markets crashing on a 'technicality' and then recovering straight away). At times, currency speculators can create instability when it is not justified on economic fundamentals.

However, if a currency is under pressure it is foten related to some economic weakness. For example, a weak currency could be due to:
  • Inflation
  • Excessive government borrowing
  • Poor forecasts for growth e.t.c.

To provide a defence fund for buying the Euro doesn't tackle these fundamental economic problems. It is like treating the symptom and not the cause of the disease. This is why I feel, schemes to protect currencies though buying and selling foreign currency reserves are of limited value or at least, they only can prevent certain effects rather than solve fundamental problems

At best, they can protect against short term speculation. But, as the UK found out in 1992, you can't always permanently buck the market, - no matter how large your foreign currency reserves.

If Britain does get into a situation where the Pound is collapsing, it will be because something has gone horribly wrong (e.g. defaulting on government debt). In that instance, having European countries deplete their foreign currency reserves by buying pounds may be a nice act of solidarity, but, is hardly going to resolve the underlying problem.

For a while, I feel that the EU and ECB in particular should adopt a less stringent view to inflation targeting. If this causes a fall in the Euro - no harm. If the economy was booming and inflationary pressure was increasing, then it would be a different matter. But, no matter how hard I look I can't see any sign of a European economic boom.

Are Speculators Not The Cause of Instability?

It's a difficult question to answer satisfactorily. In many cases, speculators can create instability and make business more nervous other investment. The Euro defense fund goes someway to reassuring markets and business that the Eurozone is committed to stability. This is a beneficial effect. But, it should be remembered you can't speculate against a sound economy. It is easy to criticise speculation when it is more a symptom of the problem.


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