Wednesday, December 14, 2011

A Primer On The Euro Crisis

The Euro is the official currency of the "eurozone," adopted as the national currency by 17 of 27 of the member states of the European Union. It is the world's second largest reserve currency as well as the second most traded currency behind the dollar. All monetary policy for the Euro is set by the European Central Bank (ECB).

The Euro officially became an "accounting currency" subject to ECB control in 1992, with members of the Eurozone normalizing the value of their currency to a "Euro" standard. The euro as an actual physical currency didn't occur until 2002.

Nominally, the adoption of a single currency was sold on several theoretical benefits. It would eliminate the currency exchange fees from the cost of doing business between the European states. It would encourage competition by allowing quick comparison of prices. And by encouraging stability and efficiency, the hope was that the euro would stimulate economic growth, reduce the unemployment rates in the eurozone, and encourage international investment.

The reality has proven that the downsides were not sufficiently examined. Because all monetary power, including the power to set EU wide interest rates, resides with the ECB, this poses a huge problem for nations with weaker economies during times of economic downturn. One way in which weak nations have been able to survive such problems is to intentionally devalue their currency by speeding up the printing presses. While such a move brings inflation, it gives the nation a window in which to pay off its debts. The flip side of such a drastic action is that, if there is not enough discipline in the government to carefully limit the presses and pay off the debts, you end up with Zimbabwe.

It also poses a problem for nations that need to stimulate growth. Normally, a sovereign nation that wants to stimulate growth will lower its prime interest rate. But again, that is not something that the individual member states of the EU can do. They are stuck with whatever ECB decides for the eurozone as a whole - and the ECB is avoiding inflation like the plague. That leaves only tax policy to stimulate growth among the troubled eurozone members, but at this point, each is being pressured - and indeed, has agreed - to raise taxes in an effort to lower its sovereign debt.

Several people, such as Robert Samuelson, have painted the Eurozone crisis as simply a failure of the European welfare state model. Others, on the left, such as Paul Krugman, have claimed that the crisis has nothing to do with the welfare state model. Setting that argument aside for a separate post, it seems clear that the high cost of the welfare state has played a role. But there are also systemic issues, mentioned above, that are combining with a host of issues unique to individual countries such that at least five Eurozone member countries sit on the brink of fiscal ruin. Greece, Italy, Spain, Portugal and Ireland are all in danger of defaulting on their sovereign debt. The general rule of thumb is that, when a country cannot sell 10 yr. bonds with a rate of return below 7%, the likelihood of an eventual default becomes real. With the exception of Spain, all of the troubled EU nations have crossed the 7% level. Spain is flirting with it.

In the cases of Greece and Italy, deficit spending on a bloated public sector and overgenerous welfare state drove their national debt significantly above 100% of GDP (Greece - 142%; Italy 119%). Ultimately, this drove their cost of borrowing above the magic line - 7% on 10 year bonds.

Portugal is Greece without the international press. It has a debt to GDP ratio of 93%, much of it coming from deficit spending over the past decade on the welfare state. Their cost of borrowing reached a high this month of 13.47% on ten year bonds. That said, Portugal is in the midst of cutting public sector benefits and increasing taxes.

Italy, unlike Greece and Portugal, has a strong manufacturing base and a relatively frugal population. Nonetheless, Italy "suffers from an overall failure to implement reforms needed to boost productivity and growth," which, when combined with the size of their national debt, is proving toxic.

Ireland is also in dire straights. Ireland's welfare state was not overlarge, and indeed, Ireland was running a budget surplus through 2005. But today, Ireland has a debt to GDP ratio of 94.9% and is having to borrow over 40% of every Euro to finance its government spending. What drove Ireland into its hole was an ill advised easing of credit standards and a housing bubble that burst in 2007. The Irish government than stepped in and nationalized the bad debts being held by the banks, causing a massive increase in publicly held debt. Ireland's cost of borrowing is today 7.74% on ten year bonds.

As to Spain, it's national debt was a comparatively paltry 61% as of last year, though much of that has come with recent increase in deficit spending. Spain's true problems are massive privately held debt and a horrendous economic outlook. Unemployment at or near 20% combined with both a housing bubble that makes the U.S.'s look small by comparison and a country that, because it does not produce any domestic energy, is subject to extreme shock when the price of oil jumps as it did in 2008, have all combined to make Spain's economy look extremely weak. All that has driven Spain's cost of borrowing rising, recently to a high of 6.7%:

In many ways, the economic situation in Spain is now even worse than the economic situation in Greece. Spain's unemployment was already above 20 percent even before this recent crisis. There are now 4.6 million people without jobs in Spain. There are 1.6 million unsold properties in Spain, six times the level per capita in the United States. Total public/private debt in Spain has reached 270 percent of GDP.

The BBC has a very good article on Spain's deep economic troubles and how its problems do not fit the mold of profligate welfare state spending.

It is safe to say that, in each of these countries, the fact that they cannot manipulate their currency or make monetary policy has removed the traditional tools of the sovereign for saving their countries from economic disaster. To explain in greater detail, this from Edward Harrison:

Now that crisis is upon us, the currency trilemma of a currency union that is the Impossible Trinity of fixed exchange rates, independent monetary policy and free movement of capital has reared its head. Hands are tied; in a currency union, there is no devaluation to recoup competitiveness, no room for fiscal freedom, and no control over monetary policy. This leaves so-called internal devaluation and/or sovereign default as the remaining ways to escape crisis. The political will to go through this is impaired because internal devaluation (across the board wage and price cuts) leads to a long and arduous depression . . . And default leads to massive creditor losses – not just in Ireland but also in Germany. So the Eurozone is trying to figure out how to keep its union together while minimizing costs – with the ECB and IMF integrally involved.

On the flip side of the coin, there is no central authority overseeing individual nation's budgets or taxes, as if the EU were a true sovereign. So, essentially, the Eurozone presents the worst of all worlds.

In an effort to save the Euro, those five nations in trouble are being forced to adopt significant "austerity" measures. Those measures, across the board, mean a significant reduction in the size of government and their welfare programs. For example, in Greece, the public sector is set to be reduced in size by and all public sector wages are being cut by almost a third. Collective bargaining is limited. The pensions of public sector workers are being sliced by 20% to 40%.

Further, all nations in the EU, led by Germany (the rise of the Fifth Reich), are meeting to consider systemic changes to the eurozone in an effort to save the Euro. This from Reuters:

Germany - Europe's biggest economy - was intent on changing the European Union's treaty to enshrine stricter budget discipline and penalties for countries that failed to adhere to them, to ensure there could be no repeat of the current crisis. From the German perspective, only by reforming economies, cutting social benefits and working longer would the indebted members of the euro zone and the single currency project itself emerge from the turmoil. Printing money would buy only a temporary respite and would remove the incentive to reform.

As to whether the Euro can be saved, the general consensus seems to be that it cannot. That said, a detailed analysis from Goldman Sachs concludes that the Euro may be salvagable, but that all ways forward are problematic. Ultimately, the eurozone countries must either come together in a much tighter economic union with a structure much like the U.S., or Germany and other core nations are going to have to weaken their economies in favor of the "peripheral" nations. In any event, Goldman Sachs paints the consquences of the failure of the Euro as dire - with the seizing up of credit and equity markets as the first step.

But the Euro crisis is also having another, much more insidious impact. The European Union is anti-democratic, and that this monetary crisis has been the springboard for actions that are direct assaults by the EU on democracy in the European states. Indeed, both Italy and Greece have been subject to coups at the direction of the EU.

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