If the EU fails to formulate a coherent response to the debt crisis, things are likely to turn very ugly for the Euro going into its second decade. The twin effects of a painfully slow recovery in major advanced economies like US and Japan and a persistent state of insecurity about the cohesiveness of the currency bloc and integrity of its member nations would drag on the economic fortunes of the distressed union. While the dawn of the decade gone by was marked with a thrilling sense of exuberance about the world’s first optimal currency area, the end of the decade has bought a painful reality check for the region and the test seems to be only getting tougher. Without a lot more political integration in Europe and a sense that all the EZ countries are "in this together", the ordinary folks in Germany, France, Netherlands would be extremely non-plussed at having to underwrite the fiscal ineptitude of other member states who didn’t even deserve to be a part of the EZ in the first place. There have been talks about the possibility of some countries, most notably Greece leaving the euro area and some see this as a clear signal that having a single currency among such a diverse group of countries was a bad idea. At the end of it, monetary union will only work with political and fiscal union over a longer term. Will the Euro survive this rough tide then?
The Euro came into being on January 1, 1999 with 11 countries abolishing their national currencies in favor of the Single currency-as it was popularly termed in the years to come. Euro was being looked at as a perfect currency to break the decade old dollar hegemony and the forecasting community around the world predicted that the currency would replace greenback a decade down the line. At its birth, single currency was called as "the most ambitious experiment since the launching of the Bretton Woods system at the end of World War II”. Euro did well over most part of the next decade, gradually appreciating against the US dollar- the world’s reserve currency. The Euro area GDP grew steadily and the global currency reserves were slowly getting diluted into Euro. In fact, the Euro reined supreme when the global crisis stuck, much to the extent that a collapse of the US housing market and a slide in global equities in 2008 hastened many observers to push the Euro as the next global reserve currency. However, this was not to be. What started in a localized part of the US mortgage market spread to virtually every corner of the global financial markets and the concomitant flight to safety bought back US dollar much like a phoenix.
The euro's great achievement has been to provide a stable means of exchange for the world's largest single market. The single economic space anchored by the euro has also forced European policy makers to compete for people, goods and capital with improved policies. However, now that the cracks have come wide open, a much relevant factor is the ability of the Euro to survive under testing global conditions. This is where things began to look shaky for the Euro. The crisis is sharpening antagonisms within Europe and pushing the Eurozone to the breaking point. Despite the single currency, government bonds of different countries attain widely different values on the financial markets. Some countries—like Spain, Portugal and Greece—have to pay much higher interest rates because of growing doubts about their credit worthiness.
The economic position of the individual Eurozone countries is extremely diverse. At the beginning of the 1990s, the so-called “stability pact“ was adopted on the insistence of Germany. The introduction of the euro seven years ago was tied to firm conditions concerning financial policy. Each accession country had to commit itself to strict budgetary discipline. The annual deficit of a country was to be limited to a maximum of 3 percent and its total debt to 60 percent of the country’s gross domestic product (GDP). First and foremost, it was Germany that urged the adoption of these criteria as a means of maintaining the stability of the euro. The euro was to be strengthened not only to compete with the US dollar, but also to ensure the dominance in Europe of the German economy, which was certain to profit from a stable currency owing to its position as the leading exporter.
What started in Greece has given birth to a new crisis of the eurozone as a whole. While there is no denying that the major responsibility rests with the Greek authorities who mismanaged their economy and then deceived everyone about the true nature of their budgetary problems. Financial experts in Brussel’s European Union (EU) Commission assume that the deficits of the sixteen Eurozone states will increase to 4 percent of GDP this year and 4.4 percent the following year–although such figures have to be corrected upwards almost every day. The stability pact’s 3 percent cap on debt is being exceeded in all the Eurozone countries.
It should be stopped because failure to do so could set in motion an unstoppable process of contagion that would affect the entire banking sector of the EU.
For those thinking that a coordinated response to the Eurozone debt trouble would be a good sign for the European banks, its safe to regard it as hallucination. The STOXX® Europe 600 Banks index, which captures the performance of the top 600 banks in Europe, has never been in a recovery mode in last four and half years since topping out at 541.27 points in April 2007. Mind you, the index topped out much before the European credit markets froze and borrowing costs witnessed an unprecedented increase. The index slumped to, would you believe it- 87 in March 2009 and quotes around 150 right now. Haven’t the banks witnessed enough pain already? This is not going to alter even if Greece gets his share of the troika funding eventually as banks have already agreed to take a haircut to the tune of 50% on their outstanding Greece debt.
A country should not participate in either a common-currency regime or a common monetary standard if its own public finances were too weak. If its government needs to retain control over issuing its own currency in order to extract more monetary seigniorage from the financial system—possibly through inflation—than a common currency regime would permit, then no fixed exchange rate regime is feasible or advisable. More subtly, by owning its own central bank, the government becomes the preferred borrower in the national capital markets. Because the government alone owns the means settlement on interest-bearing debt denominated in the domestic currency, it can float public debt at the lowest interest rates in the domestic capital market. This preferred access to the domestic bond market also allows the national central bank to act as a “lender-of-last resort” for domestic commercial banks- something the ECB has expressedly stated it cant be. .
The laxity obersed regarding the budget deficit criteria when Greece was allowed to be a part of the currency block is playing itself out in the most vicious manner now. This is made worse by the lack of labor mobility in the Eurozone. Language and cultural barriers prevent labor migrating to where they are needed the most, creating more internal imbalances. The PIIGS enjoyed the upside of lower rates while keeping the higher rate of inflation for wages they had before the Euro. Now, they have to choose between a deflationary adjustment or devaluation. Most people cannot stomach the former
So, with monetary union, but not fiscal or political union, the PIIGS are free to create a socialist utopia with all of the trappings. Massive social pograms, state provided care from cradle to grave, complete security provided by the state etc even when the fiscal conditions of the goverrnment are not good enough to provide for them. Meanwhile, in order to prevent the PIIGS from crashing the system, the northern neighbors will be forced to buckle down and work harder, ever increasing the productivity gap between the PIIGS and the so called "core" of the Eurozone i.e. Germany and France. Bailout will follow bailout with no end in sight, until there is the political will among the member nations to make the most distressed nations in the region in the to abandon the Euro and swing the clock right back to where it all started.
This is essential because the inequities among the countries cannot be sustained in any sort of free market system, and the longer the attempt is maintained the worse the inequities will become. Again, when you are in water, you have to either swim or sink. You cannot stay afloat hanging at the back of others forever. Let us back up a little bit. Germany and France would very well rather have Greece leave the Euro, convert its debt in local currency, then devaluate, and finally work its way up the economic recovery slope- the way its normally done. Once Greece works its way back to economic normalcy, yet again it could be absorbed as a new member.
And there is a good reason why this needs to be done on an urgent basis. The soaring costs of borrowing for the other nations in the Euro zone, notably Italy have been ballooning up, hitting more than 7% and well on their to elevate even more as the uncertainty premium builds up and economic momentum slows down around the world. There is an acute sense of uncertainty as to how many German and French banks would be wounded if Greece goes belly up and does default on its debt. Informed guesses reflect that 73% of the Greece debt is owned by foreign investors, mostly German and French pension funds.
Will this be possible but? The interest of these bondholders could be large enough to pressurize the governments to initiate detested public measures. Again we are witnessing the 99-1 rule being played here. All along the last few months, German officials have played it very smoothly, never committing on anything concrete, never appearing not to. They have not dejected any plans to support Greece despite knowing fully that Greece is not working efficiently towards a recovery.
The bigger question to ask is, would the Euro have survived and triumphed had it not been for the global crisis? These past 9 years, with debt plaguing the performance of the dollar, have been quite interesting, watching the US debt exploding to the upside, and the dollar imploding to the downside. But now, the Eurozone has been trapped in its own debt problems, and the investors are looking for a safe haven. The Euro/US dollar exchange rate is a dance that is going to be a drag for a while and it will be interesting how Germany takes it. The prime economy in the region has turned in a very good performance in last couple of years though its export heavy model has done little to address to the intra regional imbalances in the Eurozone.
We can safely say now that Germany has been extremely dependent on the survival of the euro than any other country in the region. The export powerhouse—largest exporter in the world until China overtook it last year—thrived because Eurozone countries could borrow unlimited amounts of euros to buy German goods. And Germany has never cared much about diversifying their export destinations. Since mid 1990’s, the share of Europe in has held mostly steady in 44-48% range with last two years witnessing a mild drop-mostly because of the severe credit crunch faced by households and corporates in Europe.
Its too late for the Eurozone to turn back now and a dissolution of the EMU could spell disaster not only for the region for the entire world as it would be coming at the worst possible time. As for the public protests, it would be just a mater of time before the frenzy takes an ugly turn. The world has already seen how the public uprising in Arab spring evolved this year. First of all, the EU leaders have to acknowledge the fact that with 93% probability of a default on Greece debt already priced in, even if the country fails to pay its creditors either in part of full, the impact of it might not be very severe in strictly financial terms. They have to let Greece leave the currency bloc, let the creditors take a haircut and focus on ensuring that the others debt laden economies do not witness a run on their debt. This would at least give the Euro a chance to survive. The stubbornness to keep Greece in the union is acting like a slow poison for the financials of other economies with Italy having dole out an unsustainable 7% for acquiring debt.
Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. Euro is at its Rubicon and some dire measures are needed to show to the world that the optimal currency project was not just a failed attempt by Europe's socialist nanny states to piggyback on the strength of the Deutschmark
