Is the Euro-zone headed for a break up ? (2/3) – Fundamentals
May 11, 2011 2 Comments
The EMU has brought enough positives to be defended
The Euro has by no means been a disaster. It has met its main goal of price stability, did help to get lower interest rates and probably helped growth by helping capital flows. Had it not existed, the European Union would in the past two years have been convulsed by a more extreme version of the currency instability that rocked it in the early 1990s. The single market would have been under serious threat.
There are quite a lot of arguments suggesting that the EMU will not break-up. A simple yet powerful one is that no political party is suggesting that any country should leave the Euro. Some economic indicators show that the break-up of the EMU is a lose-lose proposal. For instance, the cost of Spain, Greece and Portugal leaving EMU could be $400bn, considering the assets of those country that European banks own and the devaluation following the exit. This would be the cost for core Europe, therefore they can certainly spend this amount to keep the countries inside the EMU.
Greece will restructure when it is safe to do so, which means after 2011. European banks make $300bn of pre-provisioning profits every year. Assuming a recovery rate of around 30%, a Greek debt restructuring would cost around $100bn, thus bearable by European banks. Finally, Greece and Spain’s can only leave the Euro and default after they run a primary budget surplus, which won’t be the case until 2012 and 2014 respectively, leaving time to resolve the fundamental imbalances.
The final and major argument is that, as explained above, Germany has a huge interest in keeping the EUR alive. Despite their public position as a ‘victim’ of the profligate nations of the periphery, Germany is in fact a major beneficiary of the existence of the euro-zone. Therefore it is in its interest to act for the survival of the EUR. Germany will certainly want to push for a future in which the euro-zone survives and peripheral countries adjust successfully, and given its weight in European politics, we can assume it will succeed. The counter argument for this is that the capital outflow (to finance peripheral Europe spending) was detrimental to investments in Germany, which slowed down German growth. However, in the environment of cheap and abundant money of the 00’s, it is hard to believe that investment in Germany was crowded out. More likely explanations include weak domestic demand, rigidities and globalisation.
Looking at fundamentals, the EMU is headed for a break-up
The European debt crisis has mainly been described as a solvency crisis, however it is probably more accurate to call it a currency crisis. It has shown that the EUR is unworkable in its current format. It has done what single currency systems normally do : imposing restrictions and vulnerabilities on the member nations. The solvency issue is a simple byproduct of the inefficiencies within the system itself. George Soros described the euro as “patently flawed. A fully fledged currency requires both a central bank and a Treasury”. But the problems are running deeper than Soros’ analysis: in addition to these political flaws there are enormous trade imbalances. The trade surplus of Germany is directly transferred as deficit to the surrounding nations. Germany views this as a sign of their economic strength, they are in fact imposing severe strains on the deficit nations.
After joining the euro, peripheral countries enjoyed a sudden drop in real interest rates, which fuelled huge spending booms. High domestic demand lead to inflation, increasing unit-wage costs relative to other euro-zone members, hurting export competitiveness, and creating large current-account deficits. The euro was the main mechanism of transmission of these unbalances, and now stands in the way of an adjustment, as euro-zone countries cannot devaluate. Euro skeptics point out that it shows that the economies of the euro area are too different to use the same currency and too conservative to adjust to when imbalances strikes.
Accepting membership in a single currency system exposes a country to four new risks :
- As a single currency means a single monetary policy, it denies individual countries the mean of dampening business cycles by expansionary monetary policies. In the case of the EMU, the monetary policy is determined to fit the “global good” of the union, which means Germany, France and Italy. Other countries need to adapt to their business cycle.
- A common currency means a fixed exchange rate, preventing the natural adjustments that maintain national competitiveness when productivity evolve in different ways.For instance, Germany’s exports were helped by Asian growth, but if Germany still had the mark, its currency would have appreciated with these events. It would have limited their trade surplus, and increased the real incomes of German workers. The opposite reasoning could be made on the Greeks and their drachma.
- Membership in the EMU incentivize countries to have large fiscal deficits. Lower interest rates looked like free money to countries used to high rates, and they acted as such, indebting themselves both publicly and privately.
- The lack of a country-specific exchange rate makes it very painful to reduce excessive fiscal deficits. This reduction is achieved by cutting government spending increasing tax collection, which will reduce the GDP and increase the unemployment in those countries. Out of the EMU, they could devalue their currencies, and the resulting increase in exports and import reduction would raise GDP, counterbalancing the business cycle.
Germany, by its fiscal austerity and high competitiveness, is threatening to drag its neighbours into deflation, opening a long phase of stagnation. This usually leads to nationalism and social unrest, which is good news neither for democracy nor for the affected populations. By its ‘virtuous’ economic policies (cutting budget and no wage increases) Germany is actually making it more difficult for the other countries to regain competitiveness.
The Euro crisis could be considered a condemnation on single currency systems such as the gold standard. The gold standard and single currency systems have all failed in times of hardship, whether economic or geopolitical. Trade deficit nations are at an intrinsic weakness when trying to answer to a recession because the trade imbalance results in increased unemployment and falling GDP and prices – an inherently deflationary environment. With a domestic currency this imbalance would disappear over time, but under a single currency there is no possibility for the floating exchange system to bring balance back. An other example is that Greece is risking default, a risk that doesn’t exist for a sovereign issuing its own currency under a floating exchange system, as euro denominated debt acts as foreign debt
However, it could be argued that as the EMU is a political construct, it is unlikely to be destroyed by purely economic reasons. Even though it does make the EUR more resilient, that is unfortunately not a defensible position. Indeed, if the economic costs of this union become too high, it will trickle down on the political environment, pushing governments to pursue alternative solutions.
As a summary, there are many fundamental reasons that could lead towards a break-up of the EMU. This type of event has happened in the past, and even though history certainly doesn’t repeat itself, it does rhyme. If nothing is done to mitigate the tensions created by the EMU, a break-up, partial or total, is a near certainty. However, if Europe manages to wake up from its slumber, plenty of solutions are available to reduce the probability of such an event.
Next : Part 3 – Solutions