The Euro Ups and Downs

The Euro Ups and Downs Will it survive? Keith Pilbeam, City University, London

The Euro was not designed to be a weak currency The independent ECB was placed in Frankfurt with a target for inflation of 2% over the medium term The Maastricht Treaty set out explicit criteria for members to join the monetary Union. Unfortunately the 60% ceiling on the National Debt was ignored thus enabling Italy, Portugal and Greece to join in. There was also no stress testing of public finances to see how they would cope in an economic downturn. The “no bail out” clause was supposed to send a signal to markets that they took on Greek, Portuguese, Irish and Italian debt at their own risk.

The Euro was not designed to be a weak currency The Stability and Growth Pact was designed to ensure countries would control their fiscal finances after EMU. However, France and Germany to a large extent undermined the credibility of the SGP by resisting fines when they breached the 3% fiscal deficit limits.

Greek bond yields have risen predicting almost certain default

5 Year Credit Default Swaps show some hope for Italy and Spain

Annualised Probability of Default implied by CDS spreads assuming a 40% recovery rate

The Euro is both a political and economic project that will not be lightly discarded. Economics alone will not predict its survival chances. Germany accepted Italian and Greek membership for both economic and political reasons. It required their consent for the Eastern enlargement in 2004 and was not prepared to risk a European version of the Asian Financial crisis by excluding Italy, Portugal and Greece from the process. There was a genuine belief in the Economic gains to be had from the monetary union. In particular, a sound currency would benefit countries like Italy, Greece, Portugal and Spain over the long run which would ultimately benefit Germany. Germany would likely gain relative competitiveness if its wage growth was less than, and productivity higher than the PIIGS.

Why did the speculative attack only really begin in January 2010? The financial crisis by both mushrooming structural fiscal deficits and reducing the GDPs clearly exposed the unsustainabilityof the Greek national debt. Ireland was over reliant on a housing bubble as was Spain. The latter has still not owned up fully to problems in its Cajas and the exposure of its banking system. The heavy exposure of French and German banks to Greek and other PIIGS debt has become apparent. Meaning a default by Greece would have significant impacts on French and German banks. In addition, a Greek default would likely have severe contagion effects.

Is the European Financial Stability Fund (EFSF) enough to save the Euro? The current funds of the EFSF are €440 billion that is probably sufficient to rescue Greece, Portugal and Ireland combined but NOT enough to rescue either Spain or Italy To save both Spain and Italy would realistically require EFSF capital to be raised to €1.5 to € 2 trillion which is not politically feasible and would threaten the credit ratings of both France and Germany.

Possible solutions for resolving the crisis Euro bonds backed by all Eurozone member governments are one option. This would lower costs of finance for the PIIGS, while raising interest rates for countries like France and Germany. Eurobonds would require strict control on public finances, European level tax raising powers and strict country quotas. As has happened in previous rescue packages e.g. Latin American debt crisis, Asian financial crisis, debt will be restructured with much greater maturity and lenders agreeing to accept lower interest rates and/or some loss of principal.

Conclusion The Euro will survive with all its members! The powers of the ECB to monetize some of the debt could enhanced. The ECB has expanded its balance sheet lending to Greek banks and through its purchases of Greek and Spanish debt on the secondary markets (some €60 billion July/August) in a bid to lower long term bond yields. Alternatively, we could let the debtors default, bring their debts to manageable levels and leave the banks to suffer losses. A default by one of the Eurozone countries is not equivalent to the end of the Euro, either for that country or for the other Eurozone members.

Conclusion The Euro will survive with all its members! It is in the interests of Germany and France to keep all current members of the Eurozone in the zone. Their banks are heavily exposed to the PIIGS and their exports would be adversely affected by members leaving. There is no legal foundation for a country to leave the Euro and it would likely be impractical I don’t see too many Greeks wanting to give up their euros for a “new drachmas” the threat of a new drachma would lead to a major run on their banks, millions of contracts would need renogotiation and there would be massive switchover costs.

Conclusion The Euro will survive with all its members! The international monetary system requires and alternative to the US dollar, the Chinese, Japanese, OPEC and Russia have a clear stake in the Euro’s survival. It is not clear that Greece leaving the Euro would be in the interest of Greece. A partial default on its debt and remaining within the euro is a better outcome. Greece needs to undertake major structural reforms inside or outside of the Euro. The Euro membership at least provides it politicians with a scapegoat/rationale to undertake the reforms.

Conclusion: The Euro will survive with all its members and continue to expand. Its not all gloom and doom. It will probably be a mix of bank write-offs (partly subsidised by tax payers!), debt restructuring, Euro Bonds and some degree of monetization combined with heavy fiscal restraints and large structural reforms in the PIIGS that will emerge from the current crisis. The Eurozone area will actually be stronger for it. The crisis has delayed the timing of membership for some countries and made some of them think again about the benefits of joining e.g Poland. However, they still have long run commitments to join that cannot be avoided.

The Euro Ups and Downs