In the wake of the financial crisis the euro has faced an unprecedented existential threat. How did it end up in this difficult bind and will it survive? By Joe Sarling and Chris McCarthy.
Since the global financial crisis erupted in 2008 there has been much speculation over whether the euro will survive. Joe Sarling (@joesarling) and Chris McCarthy analyse the provenance of the euro, how it became engulfed in troubles and what the future holds.
Where did it start?
The introduction of the European common currency – the euro – was the manifestation of a movement for greater economic cooperation and collaboration that began in the late 1940s with the Council of Europe, soon followed by the establishment of the European Economic Community in 1957.
The embryonic mechanisms for a common currency were introduced in 1979 with the European Exchange Rate Mechanism (ERM) and the European Monetary System (EMS) in an effort to induce monetary stability and manage exchange rate fluctuations.
Britain would famously leave the ERM following ‘Black Wednesday’ in 1992 when speculation over pound sterling drove the currency down despite desperate efforts to keep the pound afloat – billions were spent buying up sterling that was being traded with alarming speed and the base interest rate rose to 15% to attract investors.
Momentum towards establishing the euro (formally agreed with the Treaty of Maastricht in February 1992 though the name ‘euro’ would not be adopted until 1995) was not arrested, however, though Britain’s damaging dalliance would feed an attitude of scepticism that persists amongst the political and public psyche today.
The euro was formally adopted on 1 January 1999 with 11 member states. It’s now the official currency of 17 countries and prior to the financial crisis was tentatively proposed as a competitor to the US dollar. In September 2007, then US Federal Reserve Bank Chairman Alan Greenspan said it was “absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency.”
Events of subsequent years would not only render that forecast obsolete, at least for the near future, but plunge the euro into an existential threat from which it has yet to emerge.
Politically and economically there is a lot at stake even at home – the IMF estimates that UK banks are exposed to over £100bn worth of bad debt in Ireland. It is in our interests to ensure the crisis doesn’t become a calamity and encourage the necessary reforms to bolster Europe’s ability to weather future risk.
How did the euro find itself in trouble?
The subprime crisis that originated in the US started the chain of events that would expose the fragility of interlinked, globalised economies. Though the problems it faced were not dissimilar to others within the same area, Greece is often sited as the first domino to topple.
Over the past decade Greece embarked on a large social spending program subsiding many key public services. Greece had large capital inflows that funded many of these programs and so long as any debt could be serviced through government revenue, capital inflows and economic growth, it would be possible to promote such policies.
However, the programs started to falter as the government could not raise enough revenue, tax evasion was rife and the subprime crisis meant that foreign investment capital was harder to come by. As the spending continued but revenues dropped the figures started to be ‘massaged’ and Greece had to expand its loan portfolio.
The world markets demanded a higher and higher yield for Greek debt as they looked increasingly unable to service it. Only after intimate scrutiny of the Greek economy did it become apparent that an earlier government had underplayed the debt level in order to gain access to the eurozone in the first place.
The Republic of Ireland looked the next casualty in the crisis albeit for different reasons. Ireland had become known as the Celtic Tiger due to its rapid growth after joining the euro. The problem was that the government, companies and individuals borrowed money on the world markets to help fuel this growth and channeled it into the property market. When the subprime crisis hit, Irish banks were overexposed to the toxic debt that was created and people started to withdraw capital. In infamous haste, the government bailed out all loans and became responsible for all liabilities.
Portugal is the last country in the eurozone, so far, to accept a bailout (with modest annual growth of around 2% since 1989 making it increasingly difficult to service debt). When capital was freely available, Portugal could resist key labour market reforms. Unfortunately, without these reforms, Portugal became less and less competitive. Given the current climate, it’s unsurprising that the markets were unsure whether the state could service its debt and the yield on government bonds soared.
The common theme is that whilst all eurozone members share a common monetary policy, they have sovereign fiscal policies that do not always align. For many critics of the euro this remains the fundamental irresolvable dichotomy and unless there is greater homogeneity among member-state fiscal policy a common currency will never be sustainable. Others don’t accept the premise that unified currency is even desirable let alone practical.
Furthermore, all three governments – Greece, Ireland and Portugal – needed an increasing number of loans to service the debt on the preceding loans. While in the short term running large budget deficits caused by an external shock are manageable, the loans accepted have to create economic growth to be worthwhile otherwise it simply adds to the level of debt.
Unfortunately the interest on these debts (7-11%) far outstripped any potential economic growth and ultimately a bailout was needed.
It’s possible that the contagion will spread. Portugal’s bailout could spell problems for Spain as their banks are heavily exposed to Portuguese debt. Moreover, Spain has debt issues of its own and a slow growing economy that was largely reliant on the property market. Building work has slowed markedly and those who bought property now face the problem of not being able to sell it. This makes people asset rich and cash poor and when you cannot sell assets personal defaults occur.
Belgium also has its problems. Without a government for close to a year, it has been unable to enforce its austerity measures. This has pushed yields up close to 4.5% around 1-1.5% higher than in Germany and the UK. Ratings agencies will not look favourably on an economy that cannot enforce austerity measures due to a lack of government. Meanwhile, Italy is currently servicing a public debt at 116% of GDP with poor growth forecast.
The initial hope was that a bailout by the ECB, largely funded by Germany and France, would sure up the individual economies of Greece, Portugal and Ireland, promote growth and send a signal to the markets that the economy is back on track. With these bailouts come conditions that aim to rein in public spending and control budgets.
However, the markets don’t seem to be buying it. Following the €85 billion to Ireland last November, yields rose not just for the Celtic Tiger but for Portugal, Spain, Italy and Belgium also. Credit rating agency Moody’s has again recently cut it’s rating for Greece by three notches from B1 to Caa1, just five notches short of default.
Furthermore, if public spending is cut too far it will have profound negative effects on labour force productivity. So long as the markets believe governments cannot service their debt, the yields required to buy this debt have to be extremely high to reflect the risk. The pandering to investors and financial markets may be unpalatable to domestic electorates but the consequences of higher borrowing costs would only exacerbate the situation.
It ‘s difficult to see how this scenario could continue given domestic political pressures. Germany does not want to continue to write blank cheques to economies in trouble while the tide of anti-sentiment bailout will only swell – Eurosceptic Finnish party True Finns won 19% of the vote in recent elections running an anti-bailout campaign and protests against strict loan conditions have sprung up in Greece and Portugal.
Any country that decides to leave unilaterally would face significant risks. While a currency devaluation would allow wages to correspond to productivity and the economy could grow as exports rise, it could spell economic suicide and countries would find themselves in a worse position than under the strict conditions of the bailout(s).
Logistically and technically the demands of reintroducing a national currency would be extremely onerous and very expensive, changing bank machines, reprogramming computers, minting coins and notes; preparations for the introduction of the euro took three years. Any acute ‘divorce’ from the euro is unlikely; instead we might expect to see an acrimonious and prolonged separation.
Would restoring independent monetary policy control to Greece help it better steer a course through this period of rough economic turbulence? In many ways it’s a moot question at this point because restoring those mechanisms would take several years. Membership of the European common currency was not the protagonist in Greece’s economic mismanagement but it has limited the levers they had at their disposal and probably expedited – both in scale and time – the package of austerity measures.
Austerity budgets are not the preserve of eurozone countries and it’s important to recognise the chronic and underlying factors of weak economies in Europe – lost competitiveness, unreformed labour markets, exorbitantly expensive public welfare programs – that left them vulnerable and incapable of better weathering the financial storm that blew in off the Atlantic.
When awarding the prestigious Charlemagne Prize last year Chancellor Angela Merkel was explicit as to the consequences of the euro collapsing – “Europe and the idea of the European union will fail” – and resolute in her determination to guarantee stability to citizens of the common currency. The silver lining of the crisis, remarked Merkel, was the possibility to pursue a common economic and political union to work alongside the common currency, thereby creating a “stronger Europe than ever before.”
If the euro is to survive then in the short term the debt in those countries which face severe problems will need to be restructured. At the most extreme this can mean defaulting on loans, causing large-scale problems both for cash flow and the financial sector.
A better method would be a ‘haircut’ on these loans meaning that the period of the loan would be extended thus decreasing the return on the investment over the period but also avoiding a default.
In either option, the ability to borrow on the world market will be more expensive in the short term but the shoring up of the finances will lead to greater stability and enhance the possibility for growth.
In the long term there clearly needs to be better co-coordinated economic governance and regulation. When France broke the 3% deficit rule (the Growth and Stability Pact was adopted in 1997 as a means to maintain fiscal discipline within the Economic and Monetary Union) but did not get punished, this sent the wrong signal to other countries; a classic case of moral hazard. There are two policy implications to note; either the fiscal rules and stipulations need to be more rigorously enforced or the eurozone moves closer towards fiscal union.
Some have asked whether Greece can survive without the euro but can the euro survive without Greece? While it’s likely that Greece would do its utmost not to leave, it does not hold the same clout as other nations. Its debt level is 115% of GDP but only represents 3% of the euro area. Would the credibility of the euro survive a member-state defaulting?
What is clear is that without France and Germany’s support – financially, rhetorically and practically – the euro will not survive. Breaking up the euro is not unthinkable, opined The Economist in December, just very costly. And because they “refuse to face up to the possibility that it might happen, Europe’s leaders are failing to take the necessary measures to avert it.”
A precipitous collapse of the common currency in the next 6 to 12 months is unlikely, if only largely for logistical reasons, but that doesn’t mean the idea is not already beginning to germinate amongst eurozone members that without fundamental reform, long-term prosperity and stability is better assured outside of the euro.
Peripheral countries may question whether the demands on their economic performance are too onerous to be sustainable and core countries such as Germany and France will tire of being the crutch to an anemic and mismanaged eurozone.
“As with the banking crisis,” wrote Sam Browman of the Adam Smith Institute, “the problem with the eurozone is not that it’s too big to fail, it’s that they are too interconnected to fail.” Nearly all things intertwined, however, can be unwoven.
It’s viable that countries countenance leaving but to do so imminently would ultimately be counter-productive and very costly. Being a member of the euro did not precipitate the global financial and economic crisis and leaving it will not resolve that – austerity budgets will still be implemented, deficits will still need to be reduced and debt will still need to be repaid.
Originally published on ‘The Vibe’