Europe The London Financial News – April 21, 1997


April 21, 1997

View Across the Pond

In its Present Form, EMU could Prove to be the EU’s Undoing, Says Martin Armstrong

The debate over European Monetary Union has largely been argued both emotionally and technically from a theoretical perspective. Nonetheless, there is a much more serious issue of concern for EMU that has been totally ignored by the political parties throughout Europe, one giving rise to that old maxim—“a little bit of knowledge is dangerous.” While EMU, on one hand, is talked up an insurance policy against future war within Europe, it could very well result in the complete collapse of the European Union. While the economic success of the United States has been argued as a case for both a single currency and a strong federal government within Europe, the very trend of centralization has not been closely examined.

The current monetary system of the world is purely an experiment of postwar vintage. There was a system in place prior to the Second World War in the US, which proved to be perhaps the most sensible ever devised. The late 19th century and early 20th century was a period of high economic instability. Financial panics were becoming commonplace almost every two to three years. In 1906, the great San Francisco earthquake struck. In 1907, a major financial panic took place on the East Coast due to the fact that the insurance companies were located in New York and the claims were lodged on the West Coast. The payment of those vast claims caused a cash shortage in the East resulting in band failures and the panic of 1907.

In response to that event the US Congress held hearings, which resulted in the birth of the Federal Reserve system and its 12 regional branches. It was discovered that the US economy differed hugely from one region to the next. Each branch of the Fed maintained its own distinctive independence. Therefore, in an effort to stabilize the economy as a whole, each branch maintained its own discount rate. Consequently, when cash shortages would begin to appear in one district, interest rates at that branch would rise. When excess cash appeared in another, interest rates would decline. Capital flowed between one branch and another, thus ending the sudden panics. The free market would naturally begin to arbitrage the differences, thereby reducing volatility for the nation as a whole.

In 1927, the independent powers of the Federal Reserve were usurped into a single national policy and the regional management focus was transformed into an international management scheme. This feeble attempt at manipulating world capital movements backfired, contributing to the Great Depression and the widespread government defaults throughout Europe in 1931. With the advent of the Second World War, political power was further federalized.

Those regional disparities still exist in every country: the US appears to have four separate regional economies and most other nationals have at least two. The UK, Italy and Japan tend to very north-south while Canada and Australia are east-west. These regional difference are growing each year and are the root cause of many separatist movements such as those in Canada, Scotland, and even within England. When the Bank of Canada was raising interest rates to fight inflation and property speculation in Toronto, they were forcing farmers in Alberta into bankruptcy. in the US, these regional differences can be seen even in property prices: they peaked in New York in 1987 while California continued to boom into 1989. The southern states of the US had been Democratic for 100 years following the Civil War, but the regional disparities have turned the South into solid Republican territory making demands for less federal intervention. The problem for the Fed is its focus on the industrial North to the exclusion of economic trends in areas such as Texas.

EMU threatens to further divide Europe in much the same way. Should interest rates be raised because of fear of inflation in Germany while simultaneously forcing Britain, Spain and Italy into a deeper recession? The UK economy contrasts with that of Germany much as those of Texas and New York in the US. When the UK booms, Germany is going bust and vice versa.

Federalism is widening the disparities between regions by trying to impose its one-policy-fits-all. Little wonder then why political trends are changing and pitting one region against another within every country. Attempts to establish a minimum wage are equally dangerous because they assume that the cost of living is the same within all parts of a nation, no less throughout the entire continent.

EMU, in its present form, represents the greatest threat to Europe by increasing these natural regional disparities throughout the entire continent. This is indeed the same problem facing all industrialized nations, including Russia and China. The problems of today cannot be solved by greater federalism. We can return to a single currency—even one which is global in scope—as the gold standard once was long ago. We cannot, however, surrender national sovereignty. This was the Russian model of a strong, centrally controlled economy. We simply must move back towards a regional economic focus and stop punishing one region for the excesses of another.

If EMU is allowed to go through in its present form—with or without Britain—it could very well prove the EU’s undoing. Such a system will unquestionably pit one nation against another through centralized economic planning that will be as biased as the Federal Reserve is in the US to its most industrialized regions.

Martin Armstrong is chairman of Princeton Economics International.