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The Eurozone Crisis - Dec 2011

The Eurozone Crisis: Four Solutions for a Riddle

The current crisis of the Eurozone has its roots in the fatal flaw made in 1999, when the single currency was created. The flaw consists in having a monetary union without a fiscal union (or even a plan to gradually introduce one). Instead governments tied themselves to a stability and growth pact, in essence limiting national deficits, which in times of crisis is a pact for recession, rather than for growth. The lack of a clear response by European governments is having a negative impact on the economies and financial systems of many countries (after the PIGS, France, Austria and Belgium are being targeted by international speculation on public debt). The situation has been made worse by the on-set of a global double-dip recession. To add insult to injury, liquidity in the funding markets has tightened significantly in recent weeks, with banks exposed to Southern European bond markets bearing the brunt and becoming increasingly reluctant to lend. So far, the recipes proposed (or imposed in some cases) by Brussels to overcome the crisis have been limited to austerity and deficit-cutting measures, which have exacerbated the problems instead of solving them, as economic growth is choked as a result. As the crisis intensifies, what are the realistic outcomes?

Adherence to EU austerity measures: The current austerity packages imposed, for example, on Greece, will require a decade of economic pain, with high unemployment, deflation and partial surrender of sovereignty. Without devaluation, growth prospects are severely limited by the high labour costs compared to the core Eurozone, which were allowed to spiral out of control in the past decade, affecting the competitive position of many European peripheral countries. This situation is similar to that of Hong Kong following the Asia crisis of 1997-1998. The territory endured six years of deflation in order to become competitive again with its Asian neighbours, many of which had devalued by up to 60%.

Weaker countries default and leave the Euro: While this was unthinkable until few weeks ago (for political rather than economic reasons), it might actually be the less costly solution for the defaulting governments. A new currency would be introduced overnight and a “corralito” or control on bank deposit withdrawals would be put in place. The advantage of this strategy is that, through a deeply depreciated new currency, it restores growth, thereby generating the revenues to pay back debt in the future (although at higher rates). Defaulting countries would be barred from the international debt markets for many years to come, but, as evidenced by the 2001 Argentina’s default, real GDP growth could resume within two years (although this would depend on the overall state of the global economy and appetite for these countries’ exports).

Weaker countries default (but stay in the Euro): Such scenario implies, for example, a Greek default of a larger magnitude than the one currently envisaged. This would however mean large write-offs for many European banks (and possibly their bailout by EU authorities – achievable through a TARP-like programme). This would not be however a possible solution for a large-scale default, like Italy or Spain, and in any case would not restore competitiveness for the defaulting country (stifling the export-led growth that would enable such country to start servicing its debt). 

The “United States of Europe”: Political consensus building is accelerated by the depth of the crisis and a full fiscal union is achieved (over a period of, say, ten years). In essence, Germany and the other core economies assume the outstanding debt of the weak peripherals countries, while other institutions (a central European Treasury, centralized tax collection and government expenditure, joint issuance of Eurobonds) would be gradually put in place. According to the OECD, the net financial debt of such “United Europe” is around 60% of GDP – putting Europe in a better position than the US, UK or Japan.

Ultimately, all these scenarios have undesirable financial and political side effects, but we now live in a world where a perfect solution is no longer on the menu. The bottom line is that greater fiscal integration and the gradual emergence of a fiscal union are strongly needed to support the monetary union. If this is not addressed with equally strong political will, further disruption through defaults and eventually exits from the Euro are conceivable. Overall, the Euro area retains tremendous financial strength and its role in the new millennium (which already sees Asia as the new center of global power) lies in a fast resolution of this riddle.