Twelve years ago, when it was decided to create the euro, I predicted, like several other economists outside Europe, that it would one day disintegrate. But the euro lasted, and even strengthened, for many years. As a result, the cost of breaking up the euro, if that should happen, has swelled to monstrous dimensions.
A break-up is still not inevitable. Swift, correct action by all members of the euro block, and, more importantly, by the European Central Bank (ECB), could perhaps still rehabilitate the euro. However, given the slow, uncertain responses by these entities, especially Germany, Greece, and the central bank, this is probably a vain hope.
How did we get here?
To help in understanding how the euro block arrived at its present position, here are one or two facts. A few weeks ago, it emerged that Greece's shaky financial state was far worse than was known up to then. Greece hid the truth with the aid of financial and accounting ploys. The euro block, led by Germany and France, opened up discussions with Greece. The discussions proceeded sluggishly, and it looked as though Germany was putting off a decision until after the state elections at the end of this week.
At first, Germany and France refused financial assistance from the International Monetary Fund (IMF), and Greece refused to submit an official request for help. In the end, the IMF was brought into the picture, and Greece was compelled to agree to a savage budget cut amounting to 5% of GDP. In return, it was promised aid of €110 million over three years. At that stage it looked as though Greece would need some €150 million, and that the cost of it leaving the euro and forgiving its debt would be about the same. So the decision was easy. If it's possible to help and to stabilize the euro for the same price, why not? On the face of it, a simple decision, but here some unexpected complications arose.
Yesterday, rumors started going around about aid requests from the weak economies of Europe (Portugal, Ireland, and Spain). As far as Spain is concerned, for example, the rumor had it that it would need about $400 billion. Could that really be? After all, the Spanish government's entire external debt is about this amount.
Nevertheless, the Spanish government might need such an amount if depositors in local banks withdraw their money to deposit it in better banks, such as German, Swiss, or US banks. In that event, the government will have to inject massive amounts of liquidity into the Spanish banks. In addition, it could be that the Spanish lenders who have lent to their government by buying Spanish bonds will decide not to rollover the debt, and that will further raise the government's finance needs.
Of course, the ECB can finance such sums, against which there is surely suitable collateral… or maybe not? And ECB governor Jean-Claude Trichet, who until two months ago was fighting against non-existent inflation, will he agree to a cash injection like that, which means printing new money? Lastly, what is the true sum required? There's no knowing.
If Spanish prime minister José Luis Rodríguez Zapatero, who has denied all need for financial aid, manages to act in full coordination with Trichet, and the same kind of thing happens in Greece, Portugal, and Ireland, there could perhaps be a solution that does not involve the break-up of the euro. It could be of course that Spain's depositors and lenders will not take alarm and will not try to withdraw their money, and there are also other positive scenarios for the euro, but the chances of all this are not high.
In Greece, the aid program also includes a large allocation for assistance to the banks with capital and liquidity. The core of the plan is a massive cut in the fiscal deficit through a wage reduction in the public sector, tax rises, and layoffs of workers in the private sector as well. Germany and the IMF extracted from the Greek prime minister a budget cut amounting to 5% of GDP and an undertaking to make further cuts as required. Clearly, such a cut in the government deficit will reduce private incomes by the same amount, and will therefore cause a sharp drop in consumption and investment. This of course will reduce tax receipts, which will mean a further cut in the deficit, and so on.
The Greece rescue plan assumes that the economy will shrink by 4% this year, that is, just a little more than the current rate. It also assumes an improvement next year, and growth starting in 2012. These are highly optimistic assumptions, and it is doubtful whether they will materialize. Therefore, the Greeks and their unions who are demonstrating and striking against the plan are quite right.
It seems that it might be better if Greece were to leave (or be expelled from) the euro block, declare a temporary or permanent debt moratorium, and recreate a local currency with a value that will of course be lower than the equivalent in euros so that the Greek government's liabilities will drop at one blow. In short, Greece could carry out a devaluation and an interest rate cut and generate inflation (i.e., an expansionary monetary policy). All these are of course steps it cannot take as long as it remains a member of the euro block.
Germany has still not ratified the rescue plan. It might be good for Germany too if Greece leaves the euro block, but given the additional problems in the weak members, it might very well be better for it to leave the euro block itself (perhaps with France), and thus bring about the block's final disintegration.
Where do we go from here?
How such a thing might be carried out is not clear, because those who built the euro block did not bother to spell out how a country leaves it. For Greece, this might not be a severe problem if it decides to declare bankruptcy and a debt moratorium. German chancellor Angela Merkel has apparently discovered the problem recently; she announced this week that the relevant agreements would be amended. For present purposes, this is of course too late, but the fact that Merkel is thinking about it seems to indicate that she is already weighing up the idea of abandoning the euro.
To sum up, a few remarks: First, like Greece and Germany, other euro block countries also need to consider leaving in order to be able to conduct their own monetary policy. Secondly, the damage to Europe's economies is already great; what the damage will be if the euro collapses is hard even to imagine. Thirdly, if the euro block does break up, the damage will not be limited to Europe alone; the global economic and financial systems will also suffer. Fourthly, on December 20, 2009, I wrote here that the dollar would rise and that the euro would fall. At the time, the working assumption was that the euro could fall to what was then its true value, about $1.10/€. It should be stressed that the dollar also found it hard to strengthen, because the US has huge deficits in its budget and its trade balance, and a huge and growing debt to the rest of the world. Since then, the euro has fallen by several percentage points. In the present situation, it is hard even to guess how far the euro exchange rate might fall, if indeed there is such an exchange rate at all.
The writer is an economist.
Published by Globes [online], Israel business news - www.globes-online.com - on May 5, 2010
© Copyright of Globes Publisher Itonut (1983) Ltd. 2010