Friday, 14 May 2010
The Coming Fall of €uro
The Market is heaving a sigh of relief over the rescue package announced for Greece. The euro-area governments themselves (so this doesn't include Britain) have pledged €440bn in loans or guarantees. A further €60bn in loans comes from the European Union's budget (includes UK). And there could be as much as €250bn from the IMF (which includes UK, as well as all the American and Canadian taxpayers who might be wondering what did they do to deserve this).
On top of all this, the European Central Bank (ECB) has said, effectively, that it'll step in as a lender of last resort, buying government and corporate bonds where it feels it's necessary. This is not the same as the quantitative easing (i.e. printing money) that the US and Britain have undertaken as it is not financed by printing more currency. The purchases are will be financed by selling for e.g. German bunds.
This deal won't save the euro
“We shall defend the euro whatever it takes,” EU Commissioner Olli Rehn said after the 11-hour meeting (meaning EU taxpayer´ last cent). But in the longer run, this deal is not a solution. And it's not good news for the euro.
All of these moves, assuming they work, do not make for a 'strong' currency. Europe has now decided that "member countries have to jointly put their resources at stake to support the weaker members." In other words, the euro can now only ever be as strong as its weakest member.
And that will be pretty weak. Austerity programmes might be necessary, but they tend to stifle economic growth. Meanwhile, the ECB is likely to have to keep interest rates low for the long term as it shepherds all these weak economies through their hard times. That's not a great recipe for currency strength, the euro will still fall, and any bounce now is a good opportunity to get short.
The trouble for Greece is that there is limited scope to boost growth. And thus it cannot really boost its tax revenues immediately. In particular, as Greece is in the euro area, it cannot devalue in the way that, say, the UK has, to correct the major loss of competitiveness it has suffered in recent years. Of course, devaluation would only partially help Greece. The reality is that Greece, like a number of other smaller European countries, has deep structural problems and probably should not have been allowed into the euro in the first place.
Effectively, it has to deflate its economy. The trouble is that this does not reduce the deficit as much as one might think: cutting spending when the economy is already suffering weakens it further. It is like chasing one’s tail. Moreover, as we are seeing in Greece, this austerity message is not going down well locally, as evidenced by strikes and riots. Thus, the economic crisis is already becoming a political and social crisis.
Greece is in a debt trap. Its debt is greater than the size of its economy, at 126% of GDP, and the interest it pays on its debt is higher than its rate of economic growth. Even with this bailout, its debt-to-GDP ratio is expected to rise, peaking at 149.1% in 2013, according to officials. It might even be worse. Greece may still default. The 'contagion' risk remains.
How big is the problem?
Who are the weak countries? They are called the PIIGS: Portugal, Italy, Ireland, Greece and Spain. Yet Ireland is taking the tough medicine that Greece is resisting, and politically, it does not want to leave the euro. The worries are centred on Spain – a much bigger economy and one that is in trouble, where one in five is unemployed and prospects for growth are minimal, as economic growth before the crisis was driven by a construction boom which is unlikely to return. Let’s take look at the Europe’s web of debt.
[Source: NY Times, May 1, 2010]
The bail-out package is big, but it's not that big: "€750bn is just over one-year's new borrowing by eurozone members and a bit more than 10% of eurozone government debt. So it's certainly not enough if investors were to start losing confidence in the ability of some big countries – such as Spain or Italy – to honour their debts."
Europe has bought some time. The best bet now is for it to look for realistic ways to restructure the debt of troubled eurozone nations, and get ahead of the problem, before the issue rears its ugly head again.
Is monetary union sustainable without the political union?
The arguments are the same now as they were then. Monetary union requires labour mobility and fiscal flexibility in the form of a single Treasury. Rich regions need to bail out poor areas when needed. This is easier to implement if they are part of the same country. It is much harder to justify across a monetary union. Asking hard working German tax payer to pay for the laid back early retired pensioner in Greece is not likely to go down well!
The basic problem with the euro is that one interest rate does not suit all the countries. The economies are so different that they need their own monetary policy and the ability to set interest rates in line with their economic cycle. One size does not fit all. So ahead of the recent financial crisis, the euro contributed to an even bigger boom in the smaller European economies. Hence, they have seen a bigger bust.
All of this demonstrates the fragile underpinnings of the euro area. A monetary union makes sense for Germany and its satellite economies, including France. But the PIIGS need a competitive boost. They need devaluation and structural change. But because they cannot leave, the markets are pushing yields up, creating domestic problems. A bailout does not solve the problem. It just gets us by, with some hope and prayer, until the world economy is stronger and the markets are better able to cope, even if Greece eventually defaults.
The European economic and monetary union (Emu) may need to become a political union to survive. This is one lesson from a historical analysis of monetary union in the 19th and 20th centuries. Monetary unions of large sovereign nations which do not have political union eventually fail, sometimes after a long time.
Monetary unions have succeeded where there has been a political union. The German unification is a good example of this. Monetary unions of small countries can survive without political union, provided there has been economic convergence. Two examples are the Union between Belgium and Luxembourg and the CFA franc zone in West Africa, which have survived..
Once the political system binding it together collapses, the monetary union fails e.g. the collapse of the Soviet system.
The lesson is monetary unions of politically independent, large sovereign nations can fail, particularly when there is an external shock, causing the economic environment to change. It is easier for unions to survive when the economic cycle is favourable.
The Exchange Rate Mechanism (ERM) worked well in its first phase, from 1979-87 because the system was flexible, with 11 frequent realignments. The second phase, between1987-92, appeared to work well. There was only one realignment, when the Italian lira moved to a narrow band. Yet all that happened was that problems built up below the surface. Nominal exchange rates did not change, but real rates moved badly out of line, providing the catalyst for the system’s near collapse in September 1992. Flexibility is important for any currency system.
Previous experience of monetary unions in Europe is that they can last for some time, but ultimately Emu must become a political union to survive.
With such diverse socio-cultural, economic and politically independent sovereigns, that may remain a distant dream. Meanwhile, the coming fall of €uro is getting increasingly forceful……this story is beginning to read like the ‘Tower of Babel’.