Monday, January 6, 2014

Euro Zone Paper

Chris Besserer
January, 2014


The Euro Zone Crisis
        The birth of the modern day Euro Zone can be traced all the way back to post-WWII Europe and the Treaty of Paris signed in 1950. Since then, European countries have been on a steady path of integration, financially, economically, militarily, as well as politically. When the Berlin Wall was toppled in 1991 and the German state was finally unified, the EU started to take a more solid form. The European Union formally came into being with the Maastricht Treaty two years later in 1993 and 10 years after that the Treaty of Accession permitted the EU to claim 27 member countries. The continual economic integration of Europe finally culminated in the establishment of the Euro as a continent wide currency, a monetary union that, at last count, boasts 18 participating countries. The Eurozone provided an economic boost and monetary stability to its member economies for over 10 years after inception. However, now the Eurozone finds itself in difficult waters. Greece, its government massively in debt, has been on the brink of a financial collapse for over two years now. Yet, Greece is only the tip of the debt laden iceberg, as financial integration has made all participating Eurozone members so intertwined that the contagion effects from Greece will spread economic hardship throughout the entire continent. The causes of this Eurozone crisis begins with the fact that member countries do not have control of their own monetary policy as well as the fact that the financial sectors of all European countries are now closely integrated. The enormity of this the problem leaves politicians in Brussels with tough decisions to make and only a few tough options to choose from, among them, massive bailouts coupled with austerity measures, new European Central Bank policy measures, a further integration of Europe both politically and 
economically, or lastly, a semi or complete breakup of the grand Eurozone experiment.

        In 2008, the global economy plunged headfirst into a financial crisis not seen since the Great Depression. In the United States the panic really came to fruition in mid September of 2008 when the large financial firm Lehman Brothers declared bankruptcy. The Dow Jones Industrial Average fell of a cliff over a subsequent six-month period, from a summer high of over 14,000 until it finally bottomed out in March at a low of around 6,500 points. In comparison Europe faced a similar situation to that of the USA, except Greece acted as Europe’s very own Lehman Brothers just a few years later. If Greece went bankrupt, the inevitable panic and economic downturn would be equally, if not worse, than Lehman’s impact on the global economy. Huge banking institutions throughout Europe would collapse as the investments they made in Greek bonds and other Greek assets lost all value. The entirety of the European financial system would be negatively affected by a Greek default and exit from the Eurozone. To create parallels, one must take a look at how the United States reacted to Lehman Brothwrs and the financial collapse back in ’08. Although, as noted by the CEO of Research Affiliates Rob Arnott in a 2011 article, “This is bigger than Lehman in terms of scale, you’re looking at most of the largest banks in Europe, which on a market-to-market basis, are insolvent”(Macke 2011). Nevertheless, European leaders will try to do everything they can to save Greece or stem the bleeding of the gash that a default would cause on the financial sector. This is why a combination of bailouts and austerity measures are continuously being put in place in Greece. A problem that arises with this option comes from the citizens of countries in the Eurozone. On one hand, the German voters are not too pleased at having to bailing out other European countries with German tax money. While on the other hand, the Greek people are rioting and striking all over the country about austerity cuts being implemented by the government to try to ring costs under control. A Greek public sector employee sums it up best by saying, “Yes, maybe we lived a life bigger than we could afford. And we wouldn't object to these sacrifices if we knew they would get us somewhere. But there is no way out, there is no end to this slide. If I could, I would leave the country now”(Georgiopoulos, 2011). The austerity measures being put in place are throwing the Greek economy further into recession that can even now be called a semi depression. The Greek people may only tolerate these measures for a period of time before they get too tired of bowing to pressures and demands from outside the country. Recently, a Neo-Nazi party gained 7% of the vote and entered parliament for the first time. This is a consequence of the economic depression and political upheaval that has been going on in Greece, and sets a dangerous precedent. This is also happening broadly throughout the Southern European economies, as countries buckle with large numbers of unemployed citizens and youth, large deficits and debt, and pressure to cut spending and raise taxes from the Eurozone leaders.

However, both the Greeks and Germans benefit from the Euro Zone as a whole. Germany’s export sector benefits from a devalued currency in the Euro that it otherwise would not have if the Deutschmark was in use; this makes German exports cheaper, thus boosting the domestic economy. Greece and others on the other hand, had benefited from lower borrowing rates than it would have without its membership in the Eurozone. Markets respected the Greek economy and the Greek government due to the fact that Greece had membership in the Eurozone. This could have been a factor that led to increased borrowing rates in Greece and ultimately the doubts over Greek’s ability to repay the debt it borrowed at those lower rates. Right now its seems that neither side will budge, with Germany forcing austerity cuts onto the Greek people which is throwing Greeks into the streets while simultaneously alienating the German people to the idea of more bailouts without concessions. That is why the patchwork of bailouts and austerity cuts is only a short term fix to this serious structural problem of the Eurozone and has really been a stop measure to allow a more meaningful policy to be enacted.

        Currently, the Euro Zone has a common monetary policy but 18 different fiscal policies. This is the main reason why there is the current problem with the Eurozone today. The participating countries all have different tax rates and various government spending levels. Social programs and welfare programs may be a primary goal of one government in the Eurozone but not another, and it costs money to keep these programs going. The reason for this is one of national sovereignty, countries view fiscal policy as a tool that an individual nation should have control over and no one wants to give up that right. This setup leads to Euro Zone participants to have uncoordinated fiscal policies, which summed up means, “The present system of uncoordinated policies gives us contagious austerity with a contagious downturn”(M√ľnchau, 2011). Essentially, the lack of fiscal unity limits the Eurozone’s capability to deal with certain countries using austerity measures and causing a downturn that can spread to other member economies. The CEO of Germany’s second largest bank, Commerzbank, is leaning towards a fiscal unity, saying, “I believe we have reached a crossroads. If Europe wanted to save its single currency, it must move toward a fiscal union. A monetary union without a fiscal union, this construct has failed”(Georgiopoulos, 2011). Obviously, something needs to give one way or the other with a side leaning towards further integration or leaning towards a disintegration of the Euro Zone, as we know it. The biggest step towards integration would be the issuance of a common Euro Bond, although currently, that option seems to be off the table due to a lack of enthusiasm from German leaders and other European politicians. Euro bonds would reduce the national sovereignty of all countries involved and this is a major no-no for European leaders at this point. Most citizens of Europe, as a whole, are opposed to a supranational union of Europe, preferring national sovereignty. A main reason to this is that the further incorporation of European countries will force political leaders to decide what type of policies are put in place throughout the continent. Will it be the tax rates and spending rates of Germany? Or will it be the taxing and spending rates of the Southern European countries, where spending levels and social programs differ than that of Germany or the BELUX countries. Clearly, there are many obstacles to a further integration of the Euro Zone moving forward.

        Lastly, the Euro Zone might end up in disaster with a break up. It is technically feasible that there could be a partial breakup, with Greece or another smaller country exiting. However, in the last year, the ECB and the Germans have made it clear that they will do whatever it takes to keep Greece and other countries in trouble within the Euro-zone. A complete breakup with each country going back to its own individual currency is more plausible if the situation worsens. Once one country leaves or is kicked out, there is nothing to stop markets from attacking the next country in financial trouble. Where would the European leaders draw the line, an arbitrary line that will be continually tested by markets if the credibility and resolve of the Euro-zone fails? If the bailouts and austerity plans fall through, and the Eurozone doesn’t start to have one fiscal policy then there is a strong possibility that Greece might exit the monetary union and go back to the Drachma. As stated by Nouriel Roubini, “Greece is now in a vicious cycle of insolvency, lack of competitiveness and ever-deepening depression, exacerbated by a draconian fiscal austerity… Default and exit will be painful and costly, but the alternative of a decade-long deflation and depression would be much worse, economically, financially, and socially”(Roubini 2011). If Greece were to go back to the Drachma, the value of that currency would plummet, thus bringing back some competitiveness to Greece because it would boost the country’s export sector. Greece might actually be better off defaulting and exiting the Eurozone for the long term. For example, Argentina went from a negative GDP of 20% to a growth rate of 8% in just over a year after the country defaulted (Roubini, 2011). The Greeks could recover, albeit after a period of depression. The problem is that if Greece were to exit, Pandora’s box would open up with regards to the rest of the Eurozone. Who would be next? Most likely it would be Portugal and then Ireland. In the end nobody would be safe as noted in another article, “The European debt crisis is classic contagion in the sense that everything’s linked. And as time goes on, we’re moving up the ladder from the weak to the strong” (Gold, 2011). Without proper steps to protect other member countries, or a deep policy change, no country would end up being safe from the market which would go after one country after the other. This makes the risk of contagion from the Greek’s leaving the Eurozone a very real and scary risk that threatens the very heart of the monetary union.

        In conclusion, the monetary union of Europe needs large policy changes moving forward in order to strengthen the monetary union. Political leaders face difficult decisions between bailouts, austerity, and/or a big policy shift either further towards integration or with a member country leaving and a split-up of the Eurozone. Looking into the future, it is difficult to predict which way the European leaders will look to head. However, thus far, the banking and political elites of Europe have been able to send a credible signal to the markets that they are there to protect the weakest link in the Euro Zone. Therefore, Greece remains in the Eurozone and contagion is ultimately being patched slowly. In the long term however, it remains to be seen whether the European Union can continue to increase fiscal and political solidarity, edging away at national sovereignty, while the people suffer under austerity measures.