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The Eurozone, only half a solution                                                                                     Print this essay

Posted at: Jun/07/2012 : Posted by: mel

Related Category: Economics, World Watching,

Let me paint a background. It is June of 2012 and the great recession has been under way for 4 years. Economist and politicians claim the recession ended nearly 2 years ago, but for those of us in the real world those words are merely words. As tough as things may seem in America, they are worse in Europe. Ireland has adopted austerity rules imposed by Germany and is currently borrowing at over 7%. Spain, Portugal and Italy are broke and Greece is teetering on default (bankruptcy for the rest of us). Germany might have lost World War’s I & II, but 60 years later as the bankers of Europe, they seem to have found a way to dictate and rule the continent indirectly through their banking and lending.

There are a variety of forces at work here.

Socialism, while wonderful on paper has proven too expensive to sustain. After decades of governments rising and falling every couple of years, a socialist government came to power in Greece promising a short work week and comfortable retirement for everyone. With these promises in place, the government lasted for over 20 years. Unfortunately, Greece’s social programs only worked as long as the economy kept growing so that more people were paying in than taking out. When the economy slowed the only way they could maintain the status quo was by borrowing from Germany. Anytime you borrow, eventually you have to start paying back and Greece is broke.

In simple terms, Greece is busted. There is realistically no way that the country can pay the debts that it currently owes. Whether today, tomorrow, or 4 years from now…Greece will have to default on its sovereign external debt, they just owe too much. Greece has been an independent country since 1823 and spent nearly half the years since then in fiscal default. Hopefully their current debt condition doesn’t really surprise anyone?

Sovereign defaults are unfortunately much more common than most would care to admit. In the last decade Uruguay, Ecuador and Argentina have all defaulted on their debt obligations. A little research indicates that there have been many hundreds of sovereign defaults since records started being kept. For those of us on the outside a default on this scale has very little impact on day to day life. For those living inside, a sovereign default can make life very tough with rocketing inflation making basic goods and services difficult to obtain.

Despite assuming the current role of arm-twister as they coheres countries like Greece to execute austerity plans, Germany has a big role in Greece’s debt. It was Germany who continued to make low interest loans available to Greece and other countries even when it was obvious they could not sustain their spending ways. There is a lot of parallel here to the home loans made in America to people who should not have every qualified for a loan. The 17 countries that have adopted the euro as a common currency are now experiencing a crisis of credit.

Another significant issue looming in the back is that the European Central Bank has allowed their member banks to hold European sovereign debt as if it has zero risk of failure. When a debt is deemed to have zero risk of failure, no capital reserve is required. With the banks undercapitalized, the losses will carry repercussions for the entire European financial system. Confused, the fancy words mean that the major banks holding European debt have been allowed to fully extend themselves without any cash reserve as would be a common requirement in the American banking systems. This effectively means that if a sovereign country defaults, when the dominos start falling some banks will go under.

Five of the euro zone countries have implemented austerity program. Austerity is a fancy name for cutting the size of the budget by cutting programs and expenditures. Unfortunately, their austerity plans may have exacerbated the problem by starting a vicious economic cycle of smaller budgets, slower growth, less tax revenue leading to more required budget cuts. Remember, an economy is an engine fueled by the movement of money. If government distributes less for capital projects, government salaries and social programs, there is less money circulating through the economy. Austerity may be a self-fulfilling prophesy.

Solutions have been slow and for the most part inadequate. The European Central Bank has purchased some of the Greek, Italian and Spanish sovereign debt. The International Monetary Fund and some Eurozone countries have pledged nearly $300 billion in aid to Greece. There is also a bailout fund called the European Financial Stability Fund that has initially been seeded with $630 billion in pledges. All of this sounds good on the surface, but none of it really attacks the root issues.

There are really two issues that need to be addressed. The first is austerity. Austerity of social programs and assistance services along with pensions has to happen, but austerity of general spending such as for roads, bridges, ports, etc. is wrong and will only lead to economic contraction. Cutting back on pensions and assistance services means that the gap is destine to widen between those who have and those who don’t. Widening the social/economic gap is likely to lead to unrest, unfortunately the current level of assistance bordering on socialism in many European countries is not sustainable. If the economies of these indebted countries continue to contract, so will their ability to pay anything against their outstanding debt. As stated, austerity by its very nature can become a self-fulfilling prophesy (look at Japan in the 1990's). The desired reduction in spending occurs, but contraction leads to a smaller economy generating less revenue to pay whatever obligations and reduced levels of assistance services were planned.

The second issue for the Eurozone countries is fiscal or monetary policy. Unlike the United State where one currency is issued by one central bank with one central monetary policy, the euro does not have a single and focused response. Each of the 17 member countries have adopted different fiscal policies with respect to taxes, spending and borrowing independent of each other. 17 different fiscal policies mean no cohesive solution. Unfortunately, having a single policy would mean challenging the sovereignty 17 different governments being able to make decisions about their individual destiny. This was the battle that the euro faced at its inception more than a decade ago. While the member countries have a common currency trading internationally at a uniform rated, their internal policies and responses all vary widely. Do you see the problem here? Germany has a strong manufacturing sector and a relatively healthy economy. Greece is effectively a socialist country. Despite being different countries with radically different fiscal policies, they share a currency. For the EU member nations to adopt a central bank and central fiscal policy would mean each country giving up their sovereign authority to decide monetary policy.

Politicians like power and nations like to maintain unique identities. I was a skeptic a decade ago, and am convinced now that the Eurozone is not viable without the member nations giving up their individual identity for a true “European Union.” This lack of common fiscal policy, taxation policy and central bank is why I view the Eurozone as only half a solution.

I am not good at the crystal ball thing, nevertheless…I suspect that before the dust settles some countries will be leaving the Eurozone and others will be left holding the chit for the money they have loaned to their European brothers. If there is a lesson here, it is the need for common fiscal policy and authority when you have a common currency. This may not matter much when times are good, but these policies matters a lot when times are not so good.

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John F. Kennedy
The one unchangeable certainty is that nothing is unchangeable or certain.
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