In recent months, the
crisis in the euro zone has spread rapidly from peripheral members, such as
Greece, Portugal and Ireland to some of the biggest economies in the European
Union, namely Spain and Italy. This week the contagion continued, as interest
rates on Belgian and French 10-year government bonds increased,
and Germany only managed to sell €3.6 billion of the €6 billion-worth of
10-year Bunds available at an auction on Wednesday.
The
European Commission’s index of consumer confidence fell for the fifth month in
a row this November, signalling to a likely return to recession in the euro
zone. The growing financial pressure in this area is increasing the likelihood
of government defaults which may trigger the break-up of the euro zone.
In the not so distant
past, to question the stability and solvency of the European single currency
would have been thought sacrilegious. Upon the entry into circulation of euro coins and banknotes on 1 January 2002, the euro was widely regarded as a legitimate trading alternative
to the US dollar. Confidence in the success of the euro was so strong that no
provision for the exit of member states from the single currency was ever
written into EU legislation.
The once unthought-of
possibility of euro-zone disintegration is fast becoming a reality. Last week
Germany’s conservative Christian Democratic Union party passed a resolution
calling for changes to the Lisbon Treaty to allow euro-zone members to
voluntarily exit the monetary union without giving up membership to the broader
European Union.
Increasing unemployment
in the euro zone means lower tax receipts and increases in welfare payments, rendering
it more difficult for European governments to reduce their deficits. The foreseeable
failure of governments to reach deficit-reduction targets will cause markets to
question member states’ solvency to an even greater
degree than previously.
The unwillingness of
investors to fund sovereigns and banks is also undermining confidence in the
euro. During the credit boom, cheap foreign loans were purchased in Greece,
Spain, Portugal and Ireland to finance housing booms and trade deficits. Consequently,
these countries’ net foreign liabilities are close to 100 per cent of GDP. The
majority of this debt is financed in the form of bonds sold to investors in
creditor countries. While the latter tend to have low bond yields, debitor countries
with large international debts have a high cost of borrowing. This amounts to
an internal balance-of-payments crisis, which means the economic discrepancy
between euro-zone countries is only likely to widen as debitor countries pay
ever-increasing interest rates on their debt.
If a euro-zone member
is forced to default, it will likely have to reinvent its currency. This would
enable the country to write down the value of its debts, while also cutting its
wages to give the country a competitive edge over those still in the euro zone.
In addition, this would largely eliminate monetary shortages, because the
countries’ national central banks would be free to bail them out, something which
the ECB has thus far refused to do for ailing euro-zone members.
This currency
reinvention comes at a price. If a member state were to pull out of the euro,
it would have grave consequences for other weak economies. Governments would
have to limit bank withdrawals and introduce capital controls, as depositors rushed
to take out their savings to avoid losing money in a forced conversion to a
weaker currency. Furthermore, the lack of investment
security would disincentivise investment and lead to a credit shortage. Governments
would be forced to find other sources of funding to bridge the gap between tax
revenue and public spending.
While it is difficult
to pre-empt how a disintegration of the euro-zone
might come about, let us speculate. In advance of his resignation some two
weeks ago, Mr Papandreou, the former Greek prime minister, proposed a referendum on
Greece’s membership to the euro zone. Although the referendum was killed off by threats from the EU to withdraw the latest
instalment of bail out money, a similar future fall-out between Greece
and its creditors (the EU, the ECB and the IMF) may prompt Greek withdrawal
from the single currency. Or perhaps it will be a failed bond auction that tips
the applecart and leads to a euro-zone member leaving the monetary union.
Italian bonds worth €33 billion and €48 billion will reach maturity in January
and February respectively. Given Germany’s recent troubles shifting its sovereign
bonds, it is not unlikely that Italy will also struggle to sell its debt off to
investors.
If the euro zone does
disintegrate, the consequences would be disastrous. The region would be torn apart by government defaults, a drying
up of available capital, bank failures, and the imposition of capital controls.
More broadly, the demise of the euro zone would endanger the future of the
European Union itself.
Nevertheless, the euro
zone can still survive, but only with strong policies and swift action. The
ECB, hitherto unwavering in its refusal to act as a lender of last resort, should
launch a comprehensive programme of bond-buying to
avoid the euro zone plunging into a deep recession. However, to attract
investors back to government bonds, the euro zone also requires more than just ECB
support. Analysts stress the need for a solid debt instrument which would, in
some form, share liability for government debts. Germany’s Council of Economic
Experts has proposed mutualising all euro-zone debt above 60 per cent of each
country’s GDP, and allocating a percentage of tax revenue to paying it off over
a 25-year period. The German administration has nevertheless rejected this
idea, fearful that it would be their country bearing the burden of weaker
states’ economic strife.
One thing
is sure: the attitude in member states’ governments needs to change. And fast.
Otherwise the euro will certainly die a very painful death.
By Sonia Jordan
By Sonia Jordan