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Sunday, 27 November 2011
Europe: What fate for the beleaguered euro?
The European Commission’s index of consumer confidence fell for the fifth month in a row this November, signalling to a likely return to recession in the euro zone. The growing financial pressure in this area is increasing the likelihood of government defaults which may trigger the break-up of the euro zone.
In the not so distant past, to question the stability and solvency of the European single currency would have been thought sacrilegious. Upon the entry into circulation of euro coins and banknotes on 1 January 2002, the euro was widely regarded as a legitimate trading alternative to the US dollar. Confidence in the success of the euro was so strong that no provision for the exit of member states from the single currency was ever written into EU legislation.
The once unthought-of possibility of euro-zone disintegration is fast becoming a reality. Last week Germany’s conservative Christian Democratic Union party passed a resolution calling for changes to the Lisbon Treaty to allow euro-zone members to voluntarily exit the monetary union without giving up membership to the broader European Union.
Increasing unemployment in the euro zone means lower tax receipts and increases in welfare payments, rendering it more difficult for European governments to reduce their deficits. The foreseeable failure of governments to reach deficit-reduction targets will cause markets to question member states’ solvency to an even greater degree than previously.
The unwillingness of investors to fund sovereigns and banks is also undermining confidence in the euro. During the credit boom, cheap foreign loans were purchased in Greece, Spain, Portugal and Ireland to finance housing booms and trade deficits. Consequently, these countries’ net foreign liabilities are close to 100 per cent of GDP. The majority of this debt is financed in the form of bonds sold to investors in creditor countries. While the latter tend to have low bond yields, debitor countries with large international debts have a high cost of borrowing. This amounts to an internal balance-of-payments crisis, which means the economic discrepancy between euro-zone countries is only likely to widen as debitor countries pay ever-increasing interest rates on their debt.
If a euro-zone member is forced to default, it will likely have to reinvent its currency. This would enable the country to write down the value of its debts, while also cutting its wages to give the country a competitive edge over those still in the euro zone. In addition, this would largely eliminate monetary shortages, because the countries’ national central banks would be free to bail them out, something which the ECB has thus far refused to do for ailing euro-zone members.
This currency reinvention comes at a price. If a member state were to pull out of the euro, it would have grave consequences for other weak economies. Governments would have to limit bank withdrawals and introduce capital controls, as depositors rushed to take out their savings to avoid losing money in a forced conversion to a weaker currency. Furthermore, the lack of investment security would disincentivise investment and lead to a credit shortage. Governments would be forced to find other sources of funding to bridge the gap between tax revenue and public spending.
While it is difficult to pre-empt how a disintegration of the euro-zone might come about, let us speculate. In advance of his resignation some two weeks ago, Mr Papandreou, the former Greek prime minister, proposed a referendum on Greece’s membership to the euro zone. Although the referendum was killed off by threats from the EU to withdraw the latest instalment of bail out money, a similar future fall-out between Greece and its creditors (the EU, the ECB and the IMF) may prompt Greek withdrawal from the single currency. Or perhaps it will be a failed bond auction that tips the applecart and leads to a euro-zone member leaving the monetary union. Italian bonds worth €33 billion and €48 billion will reach maturity in January and February respectively. Given Germany’s recent troubles shifting its sovereign bonds, it is not unlikely that Italy will also struggle to sell its debt off to investors.
If the euro zone does disintegrate, the consequences would be disastrous. The region would be torn apart by government defaults, a drying up of available capital, bank failures, and the imposition of capital controls. More broadly, the demise of the euro zone would endanger the future of the European Union itself.
Nevertheless, the euro zone can still survive, but only with strong policies and swift action. The ECB, hitherto unwavering in its refusal to act as a lender of last resort, should launch a comprehensive programme of bond-buying to avoid the euro zone plunging into a deep recession. However, to attract investors back to government bonds, the euro zone also requires more than just ECB support. Analysts stress the need for a solid debt instrument which would, in some form, share liability for government debts. Germany’s Council of Economic Experts has proposed mutualising all euro-zone debt above 60 per cent of each country’s GDP, and allocating a percentage of tax revenue to paying it off over a 25-year period. The German administration has nevertheless rejected this idea, fearful that it would be their country bearing the burden of weaker states’ economic strife.
One thing is sure: the attitude in member states’ governments needs to change. And fast. Otherwise the euro will certainly die a very painful death.
By Sonia Jordan