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October 23, 2011

Euro currency – RIP?

The bold experiment has failed
In a recent article in Financial Times, Wolfgang Muenchau wrote that he had never seen European leaders as scared as they looked at the World Bank – IMF meeting recently. At least, they got that one right. They now have an appropriate expression on their faces, it appears. Part of the problem is of their own making and partly due to the culture of financial sector appeasement that spread eastwards from the other side of the Atlantic. Both have conspired to bring Europe to the current state in which all alternatives appear unpalatable and with uncertain consequences. It is hard to objectively evaluate the costs and benefits of the various policy alternatives that are being breathlessly spouted by academics and journalists who have nothing at stake except a deadline to meet, to send in their bytes. There is no known historical precedence to the situation that the Europe and the world face today.

Image: Images of Money

Two fold problems – debt and growth
Takshashila fellow Narayan Ramachandran alerted me to a sincere proposal emanating from euro-nomics, a group of academics focused on coming up with workable and specific solutions to the problems that Europe faces. Europe faces two problems – one is the historical debt accumulated by borrowers and lenders and the other one is to re-discover structural drivers of economic growth. Most of the solutions in the public domain address the first problem – some carelessly and some sincerely. The second problem is barely touched. That is not a lacuna nor am I implying a criticism. Had it been easy to come up with a solution for the latter, many would have done so already.

Hence, the circumstances facing the debt-laden European nations – creditors or debtors – are formidable, to say the least. They cannot find new avenues of growth even if, miraculously, cure is found for their historical debt burden.

Moral hazard of fiscal union
Solutions on the table on the debt problem contain elements of securitisation, ring-fencing, collective guarantee with limits, a European debt agency and scope for market signals on debt not guaranteed or ring-fenced. They do not propose a fiscal union. See for example, this.

This idea is elegant in theory and plugs many of the limitations of other ideas in play. One is the fiscal union and a common Eurobond. The same moral hazard issues that plagued and still plague European monetary policy would afflict the idea of a fiscal union unless there is a European Ministry of Finance that has complete power over taxation and spending policies of the member-States and sovereign states are stripped of their authority over discretionary fiscal policy. That is not politically feasible at all. But, without that, a common Eurobond transfers the burden on to more prudent States and they lend their credit rating to nations that are lower down the pecking order of prudence.

The problem is not dissimilar to what European monetary policy faced. When the countries formed the economic and monetary union, all countries were able to borrow at the rate that Germany was able to borrow at. Thus they got Germany’s privileges without earning them over a long period of prudence and responsibility. The result was a debt binge in their countries. A similar situation could arise with a simple fiscal union which leaves residual powers with sovereign nations. The privilege could be abused.

Quality of growth and safe European debt
Hence, the proposal by the Euro-nomics academics is sensible to the extent that it sidesteps these moral hazard issues. However, any proposal will eventually run into both the quality and the magnitude of growth issues. Countries can achieve GDP growth by accumulating debt and while they are growing, markets might reward them with low interest rates. The proposed European debt office would then buy more of that country’s bonds in good times. Eventually, when the growth juggernaut grinds to a halt and the quality of growth is revealed, the safe bonds acquired by the European debt agency might not be all that safe. That is what happened in 2002-07.

While Spain, Greece, Ireland and Portugal were growing, they were able to borrow at low rates of interest in the market. When growth stopped and their accumulated debt burden was revealed, their borrowing rates skyrocketed. Had this happened under the proposed framework, they would find more of their bonds re-classified as unsafe bonds. To that extent, these countries would have to raise their market borrowing which would be available at rates of interest that would be too much for them to bear. In other words, what is happening now for the indebted nations would be happening even within this proposed framework.

Further, even within this approach that claims to deal with the burden of debt, there are issues of recapitalising banks and re-assessing sovereign risk.

So, it becomes clear that the debt issue cannot be addressed by separating from the economic growth issue. The latter is more difficult. The indebted nations need external sources of growth – an ultra-competitive exchange rate and/or steep decline in real wages.

Europe needs and the world cannot accept a super-competitive Euro
The former would set off confrontation with the United States, Japan, Switzerland, China and Brazil, just to name a few key players. Confrontation would occur both over loss of trade competitiveness and asset price impacts. Today, the world is united in seeking competitive currencies. Not all can succeed. Europe is poorly placed to succeed compared to others. Re-negotiating social contracts are, at best, time-consuming and, at worst, non-starters in the mollycoddled European labour markets.

No matter how many argue to the contrary, the world is becoming resource-starved. Global production of crude oil peaked some years ago. Yield on agricultural commodities is declining. Demand for these commodities is rising fast due to the entry of populous nations into the middle-income category. Therefore, economic growth has become difficult to maintain for all nations simultaneously. The failure to acknowledge this fact led many nations to gorge on debt under the belief that they had drunk the growth elixir and hence, taking on more debt or creating more debt would not be problems. The 2007 crisis debunked that notion. The lessons have not been fully absorbed yet.

Further, European nations face the problem of ageing. They had become uncompetitive due to their social contract with the labour class, agreed upon during prosperous times. Finally and more importantly, the stranglehold that the financial sector has exerted on policymakers, politicians and hence on taxpayers, bereft of any sense of fair play or morals or ethics is no less a problem in Europe than it is in the United States.

The bold experiment has failed
So, here we are with very few easy options. It is not that the problem started when Greek debt alarmed financial markets since May 2010. It is simply that a bold experiment to politically unite Europe and pose a formidable challenge to the reserve currency status of the US dollar has come unstuck. It is now clear that the hope that the Eurozone would eventually become an optimal currency area, even if it was not one, to start with, has been belied, due to a combination of factors.

This is in the nature of bold experiments. They can spectacularly succeed and, equally, fail spectacularly. Therefore, whatever is happening in Europe today does not invalidate the bold experiment that took shape over five decades starting from the end of the World War II, culminating in a single currency in 1999.

Humility about our strengths, intellectual capabilities and limitations and hence uncertainty over the end-result is one lesson for mankind that is enduring in all experiments. Alas, that is as conspicuously absent now, as it was before the union happened.

Now, it appears that a divorce appears inevitable. Consequences are hard to tell. The Euro currency – whether it remains or disintegrates – will impose significant costs on the world. Each of us has no choice but to gear up for it in our own ways.


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