Friday, October 7, 2011

The Euro: In Danger of Collapse?

Amidst the reckless fiscal behavior of not only Greece, but also other countries, the future of the euro, whose viability is now being tested, appears to be bleak.

The global financial crisis that originated with the collapse of several US investment banks in 2008 got to do with the European Union’s common currency area. Although there is no direct linkage, the same kind of risky borrowing practices that triggered the former crisis, are also at the core of the debt crisis in Greece. Virtually, all European nations are facing a terrible debt and deficit problem. The situation is crucial indeed for the euro and Europe because there are no collective structures to deal with. It could spell disaster not only for the continent, but also for the rest of the world.

Europe is entering into a serious unprepared economic crisis and the nascent global recovery could easily collapse going by unsustainable government in weaker countries. When the euro was created in 1999, proponents claimed that it would narrow the economic differences between member countries of the monetary union. They thought that unemployment rates would converge as would other macroeconomic variables like fiscal deficits, government debt, unit labor costs and productivity. After the euro’s first decade, however, there was increased divergence rather than rapid convergence. The difference between member countries have become larger during the euro’s first decade. This has become the norm in eurozone today as tensions on economic policy are causing growing rifts within member countries. Therefore, the euro became the common currency of very wealthy economies like Germany and the Netherlands and poorer countries like Greece and Portugal.

These differences have become a complicated issue for the newly formed European Central Bank (ECB) as it has to determine the desirable interest rate for members; the so-called one-size-fits-all policy. However, the size of each country’s fiscal deficit, results from the spending and taxation decisions of its own sovereign government.

Of late, the financial media has been dominated by reports about the swelling public deficits in Portugal, Italy, Ireland, Greece and Spain (PIIGS). Greek, a relatively small economy, is running a budget deficit of 12.7% of GDP. The immediate problem is that default dangers in Greece, where euro 20 bn of debt falls due in April and May this year, are making creditors think twice about lending to other cash-strapped governments.

This contagion could spread to Spain, Portugal, Italy or Ireland—all of whom suffer the same ballooning budget deficits and overburdened consumers. Ratings agencies have downgraded these nations credit rating because of a huge burden of public debt and a large budget deficit. The eurozone is now enveloped in its first, full-blown crisis since
its birth on January 1, 1999. The debt crisis plaguing Greece is an acid test for the eurozone members to stick together and solve their problems as it is facing the prospect of bankruptcy which could threaten the euro. Critics argue that the worst is yet to come and there will be more unemployment and inflation down the road and that when they come the eurozone will collapse.

With 16 nations using the euro as the common currency, the problems are reverberating across the euro area. George Soros, hedge fund billionaire says that the euro’s collapse is a perfect example of ‘overshooting’ where markets move irrationally in the absence of direction by governments. He claims that the euro may not survive and is in danger of total collapse, given the sovereign risk threat from Greece and the growing debt burden of other member states.

Cracks in the Euro
The launch of the euro was a major milestone in the process of European Federalization. In a short span of time, it has become one of the world’s strongest currencies since its introduction over a decade ago and the second most traded currency after the US dollar without a unified political set-up has always been considered a risky proposition.

The euro has largely succeeded in creating the will for a federal Europe among the member states, but citizens have voted repeatedly to maintain their countries independence since 2005. Since hitting its 2009 peak versus dollar on November 26, 2009, the euro has weakened by about 10% since the beginning of 2010. Europe was already on the wrong track when the latest global financial crisis struck, which did not cause the continent crisis, but simply brought it forward.

Strategists at the Paris-based Société Générale claim that the euro is headed for total collapse. They say that any bailout of the stricken Greek economy would only provide ‘sticking plasters’ to cover the deep-seated flaws in the eurozone bloc. The dwindling euro in the currency markets along with dire growth figures, have raised the prospect of a ‘double-dip’ recession in the embattled zone. Experts say even if Greece receives a one-off bailout package, it would not solve the real problem as huge differences in competitiveness exist between eurozone’s richest and poorest nations. To even out these differences, the EU would need a single budget and common taxes to redistribute resources. Critics say the single currency is not working because member governments have no incentive to keep their public debt under control while there is too much incentive for countries to run up big deficits as there is no feedback until a crisis.

Beginning of the end?
Could the Greek crisis be the beginning of the end for the common currency? Bob Hancke, an expert on European political economies at London School of Economics says, “I think it is quite possible we could see the euro gone in several years—or at least to a currency only used by France, Germany and a few small nations keeping it alive.” Reports indicate that there would be difficult times ahead following the collapse of the Greece economy and serious problems over debt would plague Spain, Italy and Portugal. Even a Greece bailout will not prevent a collapse of the euro. However, supporters of single currency maintain that such an outcome is mere conjecture.

They say Greece accounts for only 3% of the 16 member states’ combined GDP and has lower debts than some of the banks bailed-out during subprime. A loan of euro 20 bn (£17.5 bn) would do the trick. That’s less than what the British government injected into either Lloyds or the Royal Bank of Scotland. Though such analysis sounds vaguely plausible, it is naïve and politically dishonest. The single currency was built on political dishonesty. There was always a fundamental disagreement, one that the architects of monetary union never dared to address. Bob Hancke explains: “The problem is that monetary union was never followed up by political union to coordinate budget and taxation practices and create eurozone institutions and capacities to help member economies adapt to changes and turmoil. The result is member governments are left very few ways to deal with the current attack on Greek debt and the severe pressure that it is putting on the euro.”

The dark side
The founders of Europe’s single currency blessed a currency union that contained the seeds of its own destruction. Unlike other big monetary unions like the US, the euro is not an economic union and still less a political union. Euro has no standard and has never been a monetary union, putting out a fiat currency, composed of independent states. Against this backdrop, critics say the euro is going to be a big source of problem,  not a source of help. Fiat currencies are simply paper. They exist because of the other paper—law. Like paper currency, law is just some words on paper.

The strength of the paper depends on the strength of the institutions and their ability to change. In the case of euro, what is most often overlooked is the importance of the rules of the game. Moreover, eurozone is not an optimal currency area. For example, if New York was in recession, it is argued that people in New York could move to New England and get a job. However, it is difficult to move within a diverse region like Europe. Moreover, there are more barriers to the movement of labor and capital in eurozone. The member countries require a common monetary policy and more importantly, they should have similar levels of national debt, or else they may struggle to attract enough buyers of national debt. This is a growing phenomenon in Mediterranean countries like Italy, Greece and Spain who have large national debts. In the absence of an integrated European fiscal policy, member countries find loopholes to avoid proper scrutiny by EU institutions.

This may weaken the single European monetary policy over time. Financial analysts argue that smaller economies in Europe would be better off without the euro, as they would then have the flexibility to depreciate their own currencies and increase their competitiveness internationally.

Critics say though the ECB has enough reserves to stabilize the euro, it lacks the political will to intervene. Notwithstanding, William Gamble, President, Emerging Market Strategies says that one of the consequences of the Greece crisis will most likely be a change in the powers of the ECB. The ECB’s monetary policy of one-size-fits-all is not the problem. It is the fiscal policies of the sovereign members. The EU has to come up with mechanisms for enforcing fiscal discipline. In a way, they have.

Latvia’s debt has raised its outlook on Latvia’s debt from negative to stable and its current account deficit has turned to a surplus, thanks to supervision from the EU. It is the same supervision that will help the situation in the PIIGS states. European Central Bank Governing Council Member Axel Weber, who is also President of Germany’s Bundesbank, opines that the debtstricken Greece’s difficulties are not the problems of the eurozone as a whole and the euro will not become a soft currency.

The ECB took a small step towards unwinding its extraordinary support for the eurozone economy recently, but left much of its cash buffer for banks in place as it forecast a fragile recovery. For years, it has set rates low to suit France and Germany which has made life difficult, causing dangerous debt bubbles, in smaller and more inflationprone eurozone members. If Greece is to take the exit route from the union, the governments of several other single currency members would come under intense pressure to do the same. Therefore, eurozone’s vital cohesion would be seriously undermined. The question that arises at this juncture is: Is the union heading towards ultimate breakup? Or at least shrinkage to a Franco-German rump would only be a matter of time. William Gamble observes: “despite the problems, there is too much of an economic incentive to maintain and even expand the eurozone.”

Euro vis-à-vis dollar
Michael Markowski of bear market warns that the recent increased volatility between the euro and the dollar is extremely troublesome because the reasons behind it are different from what caused the increase in volatility for the two currencies in 2008. The dollar spike in 2008 was caused by the US subprime crisis, but it rallied significantly all other currencies during the second half of 2008 because of the widespread fear that the problem and its contagion would be the impetus for the collapse of the global banking system.

The current rally in the dollar is due to a weakening of the euro which revolves around the sovereign debt of five of the 27 EU members. Michael Markowski says, “This time the spike in the dollar is directly attributable to a sell off of the euro due to European economic woes and not the US. This revelation is significant. It means that the trend of the euro versus the dollar is not likely to reverse from a negative one to a positive one until there is a significant increase in employment for the European economy.” At this juncture, belt tightening of the PIIGS is likely to cause social unrest and a political repercussion in region. In a worst case scenario, this could threaten the utilization of the euro as a currency.

As the problems of Greece and other European countries continue, the future of the euro currency is in question. Reports indicate that the troubled eurozone economies face years of prolonged depression and deflation unless EU leaders fix the fiscal and monetary policy. George Soros suggests that the European Union needs more intrusive monitoring and institutional arrangements for conditional assistance. More importantly, a well-organized Eurobond market is desirable. Even if fiscal adjustments will help the situation, one part of the solution is to have more expansionary monetary policy in other member nations.

Economists suggest that in order to restore competitiveness, troubled economies must reduce their real wages and also need some growth in nominal GDP in order to deal with their rising debt burdens. Regardless of any policy changes, however, they expect EU will likely see slower growth for several years. Against these predictions, euro could possibly fall to new all-time lows versus the US dollar by sometime between now and the end of 2011. John Browne, Senior Market Strategist, Euro Pacific Capital envisages that the future of the EU is being tested severely, which will draw the EU member states into a covert political struggle over the future of Europe. As this battle ebbs and flows, both the euro and the US dollar likely will suffer great volatility. Those investors who parked in the safe harbor of gold may benefit greatly from this transatlantic turbulence. 

                                                                        – N Janardhan Rao