Wednesday, February 2, 2011

Is Euro following fate of Bretton Wood’s Gold standard!

Before going to Euro, I would like to touch upon the Bretton Wood’s Gold Standard for the benefit of my readers. Bretton Wood’s gold standard came to existence from a war (2nd world war) and ironically dissolved with a war (Vietnam War). After 2nd world war, to build the International economic stabilization, certain countries came together to form a monetary system for trading, exchanging mutually tradable currency and etc. The main designers of this system were Briton’s Sir John Maynard Keynes and America’s Harry White. Even though Keynes had an Idea of new reserve currency called “Bancor” but that idea has been rejected by White and others, indicating people moving towards US rather than UK! So countries which came together, agreed to peg their currency to US dollar and US dollar in turn will be pegged to Gold, $35/Ounce and formed the organization called IMF (International Monetary Fund). The entire system was based on some condition for member countries like subscription quota for membership, trade deficit maintenance like balance payment issues and etc. But after some time due to macro economical cycles, certain changes in the world economy like, recovery of Europe, Cold War between US & USSR, globalization of banking/currency system, fast emergence of Japan, Vietnam War and balance of payment issue with US made the cracks in the gold system, making it to fall out in 1971, by then US president Nixon unilaterally withdrawing the pegging the Dollar to Gold. Which is popularly know as Nixon Shock!

Now coming to Euro, it came to existence in 1992 for most of the European Union countries as the member. The Euro formation was on some conditions like such as a 1. Annual government deficit: The ratio government deficit to GDP must not exceed 3%
and Government debt: The ratio of gross government debt to GDP must not exceed 60%.
2. Inflation rate: Not more than 1.5% higher than the average of the three best performing (lowest inflation) member states of the EU.
3. The interest rate must not be more than 2% higher than in the 3 lowest inflation member states.
4. Exchange rate: countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devalued its currency during the period

But at present some of the European countries don’t look to fit any of the above conditions except currency condition for example…

Country

Government Deficit to GDP forecast

Government Debt to GDP

Inflation and Interest Rate

Ireland

10%

120%

0.6% & 1%

Greece

7%

140%

5% & 1%

Italy

4.5%

120%

1.8% & 1%

Belgium

5%

100%

3% & 1%

Spain

7%

65%

2.5% & 1%

Portugal

5%

85%

2.5% & 1%

From the above table we can say all troubled European countries like Ireland, Greece, Spain, Portugal, Italy and Belgium are

àFacing government deficit to GDP is more than 3%, which is the minimum requirement condition for EURO/EU.
à Government debt to GDP required condition is less than 60%, but each country’s debt to GDP easily exceeding the prerequisite condition. And also from country perspective Debt to GDP ratios of 120% (Ireland) and 140% (Greece) are not good. We have present example of Japan’s Balance Sheet problem due to which it lost two decades of growth and witnessed lost decade.
àNow coming to Inflation and Interest rate, see the real interest rate of each country. As ECB decides the Interest rate of the region, countries with different inflation (particularly too high and too low) will be under tremendous pressure. This might push them currency devaluation/revaluation which is again restraint condition

--- will be continued...

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