Think of the unthinkable

Picture of four of the eurozone’s finance chiefs
EU Commissioner for Economic and Financial Affairs Pierre Moscovici (L), talks with (L-R) Olaf Scholz, Euclid Tsakalotos and Bruno Le Maire, the finance ministers of Germany, Greece and France, respectively, at EU headquarters in Brussels (source: dpa)

The January 1999 introduction of a common currency, the euro, for several European Union countries was a great, visionary concept. It proved extremely helpful in facilitating business and afforded Europe a stronger position in global currency markets. Today, the eurozone faces a crisis that can no longer be ignored or fixed painlessly.

The criteria for joining the euro club were set with great foresight and clarity nearly two decades ago. They included restrictions for governments on the use of the common currency, with its comparatively lower interest rates and availability, to increase public debt. Limiting eurozone countries’ budget deficits to 3 percent of their gross domestic product (GDP) and the total accumulated debt to 60 percent of GDP was supposed to avert such a threat.

If enforced, the limits would have led the weaker economies to gradually improve their productivity and become competitive. Before they joined the euro system, such countries could achieve competitiveness by devaluating their currency. To assure the maintenance of healthy regional competition in Europe, the eurozone’s rules excluded imposition of a common economic policy. Equally wisely, bailing out excessively indebted governments was ruled out.

Brazen irresponsibility

Everything was set for a good start. Optimism was also based on the belief that with the politically independent European Central Bank (ECB) in place, the legendary stability of the old German mark would be extended to the entire eurozone.

So much for good intentions. No later than two years after the common currency’s launch, the two largest eurozone members, Germany and France, violated the deficit criteria. Although Germany corrected its behavior later on, a terrible example had been set. The ECB, too, became politicized and the dam broke.

More and more members embarked on unsustainable growth strategies financed with low-cost debt while expanding oversized welfare programs. Political parties bought votes with debt-financed gifts. Next, to forestall inevitable bankruptcies, the ECB betrayed its mission and engaged in such rule-bending schemes as zero-to-negative interest rates and “quantitative easing” to shore up the troubled eurozone governments.

A country like Italy cannot leave the eurozone without going bankrupt

These travesties appeared helpful – but only on the surface and in the short term. Today, most EU leaders remain stuck in the mind-set in which the right remedies are excluded and the steps considered possible can merely delay the catastrophe. The idea of creating a common eurozone economic and fiscal policy, and common debt, might buy another few years. But it would in no way solve the problem. To the contrary, such measures would turn the eurozone into a transfer union.

Lately, concerns about the Italian debt have surfaced. Justifiably so, given the size of the Italian economy. In contrast to Greece, a bailout of Italy would be too huge to finance. And Italy’s problem is not the only one the EU faces.

Several European countries lament the competitive edge enjoyed by some countries in the north, especially by Germany’s export sectors. It is true that the euro has proven highly beneficial for Germany and the Netherlands, which steadily increased their productivity and kept a lid on public spending. The countries that took advantage of abundant “hard” currency are in a fix today that reveals the scope of the problem for all. The bill for the spenders’ profligacy shows in the target balances of the ECB, where the amount – unpaid and practically unpayable – due to Germany, approaches a trillion euros.

However, a country like Italy cannot leave the eurozone without going bankrupt. If Italy introduced its own currency to become more competitive, the value of that currency would inevitably and drastically weaken against the “hard” euro. Italy’s debt, though, would remain denominated in euros. As a result, the existing, already nonrepayable debt would balloon in the local currency, in which Italy’s income would be generated.

Skating on thin ice

The situation in the eurozone reminds me of a dancing party on dangerously thin ice with the beat of the music quickening and the number of dancers growing, while the temperature keeps rising.

At this point, all of the correct solutions appear unthinkable, as too painful to the interested parties. But as responsible and realistic individuals, we need to face the scenarios – bitter as they may be – and try to make the best choice.

One such solution would be to allow member countries to leave the euro and go bankrupt. This is the simplest way out, albeit with grave consequences to all debt holders who trusted the governments and rating agencies – even after the triple AAA ratings and mathematical models of these agencies proved worthless in the 2008 financial crisis. Under this scenario, the broke governments would need to sell quite a few of their assets to the private sector or pension funds and subject themselves to stricter spending discipline (increasing taxes is certainly not the right way to go).

The responsibility for fixing the eurozone’s problem rests with the politicians, as it has been caused by the states, not a market failure.

The states’ bankruptcies and leaving the eurozone are tough measures, difficult to entertain. In the long term, however, this is the best solution. It offers the only sure path to restoring vibrant economies, solving the liquidity problems and easing the social tensions. Such a cure also would be less damaging for Europe’s global position than any alternative.

Another possible way to go, also politically difficult and considered “unthinkable” for various reasons, would be to split today’s eurozone into two parts. Germany and other highly productive northern countries like the Netherlands could leave the euro and create a “hard” currency system of their own. The remaining eurozone members, including big countries such as France, Italy and Spain, soon would see their euro weaken, their competitiveness improve and the total sum of their debt decrease.

The approach has several drawbacks. The northern block countries would find themselves under even harsher pressure to ramp up their productivity (to remain competitive despite their very strong currency). On top of that, the “northerners” would still need to write down a big part of the receivables from foreign government debt and the ECB, due to the devaluation in the eurozone. Also, the split would send an ominous signal about the prospects of the EU’s internal market, not to mention the “political union” project. Worst of all, it again could create the wrong incentives for fiscally irresponsible governments.

Although this script may seem quite far-fetched, it has a chance of becoming a reality. At the moment, though, it looks like muddling through as usual, for as long as possible. This is irresponsible: if the eurozone countries fail to address their biggest problem, they may quickly get caught on the wrong foot by a sudden political crisis or global economic slowdown.

The responsibility for fixing the eurozone’s problem rests with the politicians, as it has been caused by the states, not a market failure. The governments and some in the media will, of course, try to scapegoat business, as they frequently have done in the past. Business and savers need to be extraordinarily cautious and hedge against the worst consequences of the inevitable crisis.

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