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.

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