Wednesday, November 18, 2009

Eurozone Faces an Uncertain Future
Joe El Rady

Certainly, the US economy faces fundamental and structural long term problems that may eventually erode the value of the dollar and jeopardize or even end its reign as the global reserve currency, but that’s a story anybody can tell—a glance at even unsophisticated financial journalism provides that view. The truly sophisticated analysis, however, prompts a very careful examination, and even rejection, of the knee-jerk reaction favoring the Euro.

The Euro’s recent strength against the dollar stems mostly from the recent strengthening of global financial markets, which have once again begun to attract investors who shifted to the safety of the dollar and dollar denominated government instruments during the recent global financial crisis. While the ending of the “flight to safety” and the “flight to liquidity” usher renewed strength for the Euro, the short and medium term technical causes for the strengthening—capital flows—will eventually yield to the long-term macroeconomic and fiscal realities facing the Eurozone.

Short and medium-term macroeconomic analyses provide cheer for the Eurozone. Euro interest rates clearly evince allayed investor fears of any debt default by a member of the European Union’s currency zone. Furthermore, France and Germany have emerged from recession. The longer-term macroeconomic analyses, however, portend serious problems for the Euro, specifically the differing economic patterns of the currency zone’s members.

Italy, Greece, Portugal and Spain (we’ll call them the slower kids in the family) will likely grow very slowly for years, rendering their debts harder to pay. Spain’s predicament illuminates the potential problems. When Spain joined the European currency zone, it instantly began to enjoy lower interest rates due to the uniform European monetary policy set by the European Central Bank (ECB) in Frankfurt. In fact, the ECB’s key rates were lower than Spain’s inflation rate. Any rational consumer, even one without an economics education, knows that borrowing rates below inflation means you borrow as much as you can. Spanish households did so. Spanish household debt grew to 130 percent of disposable income, fueling rampant consumption (sounds familiar eh). Cheap money engendered a construction bubble (wow, really sounds familiar). Of course, this raised costs for Spanish businesses and eroded their global competitiveness against other European economies. Fast forward: today, due to an expensive Euro, Spain fails to find markets for its exports, its economy continues to shrink (approximately 4 percent this year) while unemployment remains at 18.5 percent, the highest in Europe.

Unfortunately for Spain, it cannot employ the common cure for countries seeking to return to competitiveness: currency devaluation. Spain can no longer set its own interest rate nor does it possess a currency to devalue. Italy has famously used the devaluation technique in the past, but like Spain, can longer do so.

These problems, by the way, stamp into relief the difficulty in managing monetary policy for 16 separate countries. California faces a somewhat similar problem stemming from a similar cause. A huge GDP (GSP actually) for a region, let’s call it what it is—a Nation State—that has no independent monetary policy, and as such, no ability to set interest rates and print money. Schwarzenegger himself pointed to this when he lamented California’s inability to “print our own money.”

Without monetary levers, Spain must restore its global competitiveness in an excruciating manner, by decreasing wages and prices to a lower point than those of its fellow European Union members, serious pain for Spanish households that had grown accustomed to increasing living standards. Trade imbalances within the Eurozone, however, create major obstacles. Greece and Spain have large trade deficits while Germany and others have large trade surpluses. The tenability of this situation rests on the availability of credit. Without credit, consumption will fall, exerting pressure on exporters such as Germany. This forces rebalancing. Germany must absorb a higher share of exports, but it can only do so if Italy, Greece and Spain restore their competitiveness. If such a rebalancing does not occur, the slower kids in the family (Italy and Greece entered the financial crisis with large levels of debt and Spain will need to float large levels of debt in the coming years) could buckle under large public and private debt. Currently, no Eurozone member faces this danger, but a prolonged period of stagnation would catalyze the reaction.

If Germany and the other net exporters in the Eurozone fail to rebalance, the internal trade imbalances would likely cause a debt crisis. Once that occurs, the solutions would prove more ghastly than the rebalancing that could have prevented the crisis (an ounce of prevention and all that…) A Eurozone debt crisis could be solved by a full political union that would issue bonds centrally and distribute funds to members. This true and effective economic solution would likely prove politically untenable to the stronger members of the Eurozone. Failing full political union, one of the weak links such Spain, Italy or Greece, fatigued by low growth and insurmountable debt, could exit the currency and default on its Euro denominated sovereign debt. Investors would demand far higher rates of return on all Euro denominated debt, forcing a domino effect that would topple the next weakest link and so on. Such a chain reaction would likely force a bailout, putting France and Germany in a very uncomfortable position with their own taxpayers and likely forcing austerity measures (IMF style) on the bailed out states. And you thought the dollar was the only major currency facing problems…