Euros are no longer all equal

This is my Perspective column from this week’s Fund Strategy magazine.

When is a euro not a euro? The question might sound philosophical but the Cyprus crisis has posed it in brutally practical terms.

Recall that the eurozone is meant to be a currency bloc. Therefore, at least in theory, a euro in, say, Germany or Finland, is meant to be the same as a euro in Cyprus. In that sense there should, strictly speaking, be no such thing as a German euro, Finnish euro or Cypriot euro. They are all simply meant to be plain euros without any national prefix.

The advent of capital controls in Cyprus has changed all that. It has clearly violated one of the fundamental tenets of a currency bloc: that money and capital should be able to flow freely within its borders.

As Eurointelligence, an internet news and analysis service, has noted on its blog: “The only thing that a Cyprus euro has in common with a euro from now on, are the similar looking banknotes, and a one-to-one exchange rate for small denominations.”

Of course these are the parts of the euro most visible to everyday users so the difference many not be evident immediately. But, as Martin Wolf, the chief economics commentator at the Financial Times, has pointed out there is a much larger amount of euro-denominated bank liabilities than bank notes. So the value of a euro in a Cypriot bank is backed by the solvency of the bank itself and behind that the government of Cyprus. In practice it is therefore likely to be worth significantly less than a euro in a German bank or indeed a French one.

Admittedly there was always an element of fiction to the idea of truly pan-European euro. The country codes on eurozone banknote are a thinly disguised giveaway. For example, the serial number on German notes starts with an X and Cyprus notes with a Y. Evidently the eurozone authorities wanted to retain a national marker without making it clear it was there.

However, it took about a decade from the advent of the euro in 1999 – initially as a cashless currency – until large cracks began to appear in the façade. Initially it seemed that there was, more-or-less, one euro across the region.

Companies of similar credit-worthiness could borrow at roughly the same rate across the eurozone. The national premium paid by borrowers from weaker countries virtually disappeared. In effect the stronger economies were implicitly underwriting the weaker ones. If, say, Greece got into trouble it was assumed that Germany and others would not hesitate to bail it out. For years everything appeared to be going smoothly.

Yet as successive countries got into difficulties in 2010 the gap widened dramatically. The spread between yields on German Bunds and the debt of weaker countries increased. There was the first indication that a euro in one country was not necessarily worth the same as a euro elsewhere in the region.

Since then sovereign spreads have proved volatile. But significant differences between the yields on bonds from different member states remain. It is no longer true that all eurozone member states are more-or-less equal in the bond markets.

However, the recent events in Cyprus have taken the monetary divergence in the region a step further. For the first time euros in one particular member state cannot easily be transferred to another.

The opening of differences between different national euros reflects wide divergences between different national economies. Some countries are far more productive than others (see chart). This discrepancy can be covered up in the short-term, indeed it was obscured for several years, but it has started to reassert itself.

For years the northern Europeans, in effect, lent money to the peripheral countries to keep their economies going. But eventually the time would come when the bubble had to burst.

Nor were Germany and other core states propping up weaker eurozone economies for altruistic reasons. For one thing the strong economies were, in effect, subsidising their exports to the periphery by keeping the euro artificially weak. They were pursuing a mercantilist economic policy.

The medium-term effect of this arrangement is becoming clear. An overtly two-tier set-up has emerged in what was supposed to be a unified community.

The emergence of two levels of currency is only one manifestation of this division. Another is that a small core of countries, particularly Germany, is dictating the terms on which the eurozone operates. An elite group of technocrats based in Brussels and Frankfurt are more than willing to help them in this task. In effect this is a new form of colonialism with the eurozone core, along with EU institutions, ruling over the periphery.

Such developments point to great uncertainty ahead both for the eurozone and for outside users of the currency. The eurozone has become something fundamentally different from what its founders envisaged. Although it set out to be a community of equal participating nations this vision has clashed with economic reality.

Nowadays it seems that all euros are equal but some are more equal than others.