The Euro May Be Riskier Than You Think

February 27, 2015

Finance ministers in the Eurozone appear to have had a free lesson in game theory from Professor Yanis Varoufakis, the Greek finance minister. At the time of writing Greece's future in the Eurozone is far from secured, but it appears that Greece has achieved something.

He gave his fellow finance ministers a deal they dared not refuse, though it still has to be ratified by some parliaments, including Germany's today. Varoufakis almost certainly understands that the Eurozone is in a weaker position than the bureaucrats and finance ministers themselves believed. It was important for them to become aware of this reality, which was central to his approach. It appears that under the Lisbon Treaty, Eurozone states cannot expel Greece: she can only leave with everyone's unanimous agreement, including her own. And they probably didn't realise that playing hardball against Greece would force the ECB to write off debts approaching ten times her equity capital of only €10.8bn. This would require all member states to increase their capital subscriptions, including the other Eurozone states subject to austerity packages.

Equally, Varoufakis would have known that he could not push his opposite numbers too far because the Brussels establishment also have their national parliaments to consider and the positions of Italy, Spain, Portugal and even Ireland. A revolt against previously-agreed austerity packages by any of these other states would have untold ramifications not only for the future of the Eurozone, but the euro itself.

In the wake of this episode the status of the euro as money is likely to be increasingly questioned, not just in the foreign exchanges, but by its users as well. This should be put into context by referring to Ludwig Von Mises's regression theorem. Put simply, the theorem states that the validity of any currency as money is based on its history and the basis of the value it had before it was accepted as money. This unfashionable view is demonstrably true of gold and silver, but is it true of paper currencies?

The US dollar and pound sterling have both survived more than one hundred years, having based their original value on extended periods of gold convertibility, and in the case of sterling long before that on silver. This in the minds of the users gives them a pedigree few would question. However, they are very much the exceptions in today's fiat currencies which are the motley survivors of some 57 hyperinflations, and there are plenty of examples of how a lack of regression coincides with a temporary character. Look no further than the Ukraine, which is suffering its second hyperinflation in 25 years. After Britain gave her African colonies independence in the 1960s, the value of all their currencies fell sharply in black-market dealings (the sole exception being Botswana which didn't introduce the pula until long after independence).

Logic, if not familiarity, suggests that there is something in the regression theorem, which brings us back to the euro. Like the Kenyan shilling, the Zambian kwacha or the Ukrainian hryvnia, the euro lacked any pedigree on its creation. There was no period when people had a choice of national currencies to aid the transition. While bonds and financial instruments were denominated in euros from January 1999 onwards, notes and coins replaced national notes and coins three years later overnight.

So, if Von Mises's regression theorem has any validity, holders of euros should be considering their options. It is also unfortunate timing that the ECB is about to embark on its most aggressive bout of monetary expansion to date, which could end up sealing the euro's fate. If so, the euro will turn out to be the Achilles heel of the global monetary system.


Alasdair Macleod | Head of Research

Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.

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