Tuesday, 23 August 2011

Why Germany Has To Leave The Euro

There are several aspects to the current global mess, but one is the near bankruptcy of many of the poorer Euro-zone countries. If they default, that will bring down the banks, again, and this time there is no one to prop them up, so we might as well get on with eating each other. How did we get into this mess and how can we get out of it?

The perception in the wealthy countries of Europe is that this is a simple morality tale. The North has worked hard, the South has sat on its arse, is now bust and begging for money. This is only very faintly true. There is a mechanism that allows an industrious country to get richer without beggaring its neighbours, and it is the Floating Exchange Rate. The Euro has removed that option, and that is why the Germania is now bankrupting the Club Med countries, and why Germania must leave the Euro.

Here is how it all works:

Let's take a simplified Portugal and Germany, of equal size. They use, respectively, the Portuguese Currency Unit (PCU) and German Currency Unit (GCU). One GCU can be traded for one PCU. A multinational car company, call it GM, has a factory in each country called Opel, making a car called an Astra.

The Astra costs 10,000PCU or 10,000GCU to make, including profit, and sells for the same sum.

Next year, the Germans become twice as efficient and can make the Astra for 5,000GCU. Now clearly at that point all production moves to Germany and Portugal goes broke.

But no. Instead ONE GCU becomes worth TWO PCU. Now in Germany an Astra costs 5,000GCU regardless of which country it is made in. And in Portugal it continues to cost 10,000PCU, regardless of which country it is made in.

The Germans win big, because having bought their Astra, they still have 5,000GCUs left over to buy other things they want. This is the reward for hard work.

The Portuguese win too. Some of those newly enriched Germans will use their spare dosh to go to the Algarve and spend it there.

So, with a flexible exchange rate, when the Germans get more efficient, they become a lot richer and the Portuguese become a little richer. Everyone wins.

What happens without that flexible exchange rate?

Go back to the original assumptions, except there is no GCU and PCU, only the Euro, which starts as being worth one of each.

When it costs €5,000 to make an Astra in Germany, and €10,000 to make one in Portugal, production will move to Germany. To keep going, the Portuguese will have to borrow money. Off whom will they borrow it? Well who has it? The Germans, obviously. Eventually someone will ask how the Portuguese can pay it back, and stop lending. Then Opel will go bust because now it can only sell half as many cars. And the German banks will go bust because the Portuguese cannot pay them back because they have no work. And, of course, the Portuguese will go bust.

This is the current situation.

There are three solutions:

- The Germans subsidise the Portuguese: a Transfer Union. This is what happens in the UK. The South East of England transfers vast sums of money to the rest of the UK. This is accepted because we are All British Together. The Germans don't want to pick up the tab though. They've already done it with East Germany, and they don't see why they should it do it for the Greeks and the Portuguese.

- The poor countries leave the Euro - the solution that redtop German papers promote. This is no good though, because their currencies will halve, and their debt is in Euros, so they will owe twice as much, hence even while their economies recover without the drag of German exchange rates they will still go bust (ironically, this is the situation Germany was in, in the 1920s, and look how THAT ended). They will have to default, which will cause worldwide economic collapse - and the collapse of Germany too, if Spain or Italy joins them, and at least one of those will.

- Germania leaves the Euro. The Germans have not even considered this, and if they ever do, they won't like it, because the debts are in Euros and The New Mark will be worth much more. They won't get all their money back. But, tough because the only other solution is that everyone, including the Germans, starve.

All this was obvious before the Euro started. It has been even more obvious since. The Germans think they have been doing well because they run a massive trade surplus within the Euro-zone, that is to say they sell more than they buy. And they think Club Med has been doing badly because they have massive deficits - they buy more than they sell. But within a currency union, there are no good imbalances. A surplus is as bad as a deficit, because one country's surplus is another country's deficit.

Unless the German government plans to go and bang on people's doors and force them at gunpoint to buy Portuguese wines and Greek cheeses, the exchange rate between Germania and Club Med will have to move. And that means the Germans must leave the Euro immediately.

Nobody Planned This

I've been riding big motorbikes for thirty years, and I know that when accidents happen there are generally several factors. When some fool pulls out in front of me, I am normally expecting it, have my escape route ready, and the only casualty is my laundry bill. The big accident will come the day I am tired, and going too fast, and not looking properly.

By the same token a housing crash in the US should not have brought the West to its knees, but it did so because the banks outside the US, largely in the UK, were already wildly overstretched, and the Southern countries of Europe had over-inflated their economies.

These things tend to be interconnected however. When I am tired it may well be that I have had too little sleep, got up late, and that will also be why I am hurrying, and being in a hurry, in turn, will be why I am fiddling with my jacket zips instead of concentrating on the road.

The economic crisis is the same - all the causes are linked to other causes.

Many people wish to finger "Greedy Bankers". That is plain wrong, and an attempt to shift the blame for the real error, politicians in each major Western Block pumping money into the system until asset prices were so high they went pop. Individuals and companies went bust, passing their debts to the banks. The banks went bust and passed on their debts to the governments. The governments of the more exposed countries went bust and are, at the time of writing, trying to pass their debts onto the richer countries. When they go bust, do we hope for aliens to bail us all out?

So although the ultimate villains are politicians pursuing ruinous mercantilist policies (China and Germany), attempting to redistribute wealth without considering the consequences (The US under Clinton), or trying to buy the votes of voters with their own money (the UK), they could not have got away with all these stupid decisions without a variety of interlinked special factors, and would not have even tried in the first place without some interesting aspects of human psychology.

Undoubtedly there are individual villains, like Gordon Brown, Fred The Shred, the senior management of Goldman Sachs, and those who foresaw the disaster the Euro would bring but believed that said disaster would be beneficial. In general however, everybody just did the best they could.

Over the coming posts I will attempt to explain:

- What is happening.

- How it is happening.

- What might happen next.

Much of this I will do by illustrating some of the fundamental principles of economics with which either journalists don't care to bother you, or else don't understand themselves.

By the time I've finished, if you've bothered to read along, you may well not agree with my conclusions but at least you'll be able to argue the toss without looking like what most people expressing an opinion do at the moment - ignorant jerks pontificating with no actual knowledge whatever.