Thursday, 10 June 2010

Plan C for the Euro

The Malta Business Weekly  - 10 06 2010

Doubts about the sustainability of the euro monetary union are being expressed openly as never before. The foreign exchange value of the euro has fallen some 12 per cent against the US dollar over the last two months and, notwithstanding Greece’s bailout and a pledge for a trillion dollar stability fund as a defence against market assault on the next weakest links in the monetary union, instability remains.

Instability persists because the bailout of Greece, and the promise of bailout for other weak links, addresses only the liquidity problems of such sovereigns but does pretty little to address the underlying solvency problems. If Greece is over-indebted, switching its existing debts to banks and private investors to loans from fellow sovereign countries in the euro system and the IMF does little to solve the underlying problem. It just swaps one debt for another. This has kept international bond markets jittery about Greece’s long-term ability to service its debts, to whomever they are due, and about the ability of the next weakest links to enjoy unhindered access to bond markets for smooth operations of their debt management programmes.

International investors have good reasons to be concerned. The euro monetary union can only survive if Member States operate a harmonised fiscal policy alongside the common monetary and interest rate policy. Members of the monetary union are like runners in a three-legged race whose legs are tied together with a somewhat elastic rope. They have to move forward in harmony if not in perfect synchrony. The bailout packages augur the exact opposite. Given the conditions associated with such bailouts, the phenomenon of a two-speed Europe will be made even worse. Greece, Ireland, Spain and Portugal will be suffering deep recessions while Germany continues to rev its export engines without apologies, aided as it is by the fall in the euro’s external value.

The two-speed nature raises problems for setting a common ECB monetary and interest rate policy. These problems already existed but will become more accentuated. Spain, Portugal and Ireland are suffering the consequences of the ECB keeping low interest rates to accommodate the German economic recovery programme when domestic conditions in the periphery countries would have necessitated higher interest rates to avoid dangerous speculation and bank exposure to an artificially inflated real estate boom. The property bubble exploded with a vengeance in Ireland, Spain and Portugal, causing gummed up financial markets, a shaken banking sector, high unemployment, a deep recession and a sudden and huge increase in public budget deficit, mostly due to loss of revenue from subdued economic activity at a time when social triggers of unemployment and social payments were activated.

The gap in two-speed Europe grows wider. While Nordic EU members gain a competitive advantage from a devalued euro, which make their exports more competitive, some periphery members of the monetary union, forced as they are by bailout conditions to address their public finances, will see their economies move in reverse gear into a recession. Will Europe tolerate rising unemployment and austerity measures (including wage cuts, wage freezes and reduced entitlements) on the periphery while Germany continues its export driven economy?   Will the elastic rope binding together the euro members in a single monetary union be stretched to the point of rupture?   When pressure builds up beyond a certain level something will have to give.

In an effort to avoid such rupture, many distressed members are taking harsh austerity measures that were considered politically suicidal before the Greek near-death experience. Greece’s problems seem to have conditioned public opinion in Ireland, Spain, Portugal and Italy to accept austerity measures before it gets forced on them by bailout conditions.

 It is gravely doubtful whether austerity is the right medicine. Austerity is more likely to push periphery countries into a depression spiral making debts heavier in a shrinking economy and without any palliative from the inflation front. What these countries really need is an instant gain in their external competitiveness through a devaluation of their currency coupled with a freeze on internal costs. But the devaluation tool is no longer available within a monetary union. Leaving the monetary union is greatly unappetising as the burden of their euro-denominated “foreign” debt (the euro would become a foreign currency for whoever leaves the monetary union) will get much heavier leading to default with all the unpleasant consequences across the whole continent and the world economy, of which the EU economy is a most important component.

So what future is in store for the euro?  Plan A, built on hope rather than realistic expectations, sees austerity in errant countries bringing order for the euro to continue as it did during its first decade of existence. Plan B is just to muddle through somehow from crisis to crisis as the austerity measures cause instability and greater disharmony within the euro club. The ECB had better think of a plan C!

As Plan C it is much more practical for the stronger members of the euro area (Germany and other countries that have no structural negative imbalances) to exit the euro system and either go back to their national currencies or form a new Hard Euro currency union among the strong countries. The newly adopted currency or currencies will then inevitably float upwards against the existing euro (though not necessarily against other currencies) and this will lead to instant re-instatement of competitiveness for the euro distressed economies without having to default on their euro debt.

This would make growth rather than austerity the key solution for economic re-sanitisation of Greece and its companions in distress. It is the most practical way to address intra-EU payments imbalances. Eventually a plan will have to be worked out for the re-merging of the Hard Euro (or the newly re-created sovereign currencies) and the Soft Euro. The ECB can remain the central bank for the two distinct euro areas operating dual monetary policy as appropriate for each area until a plan for the re-merging can be worked out gradually.

The architects of such re-merger will have to get it right the second time round. If full economic and fiscal union remains politically unacceptable then sovereign borrowing, in all its forms including derivatives and debt of semi-government organisations, will have to be abolished. Euro members will have no direct access to capital markets. The capital markets will only be accessed by a supra-national EU institution which raises debt guaranteed by all euro member sovereigns (thus lowering borrowing costs for all members) and which then lends to individual sovereign members in the framework of pre-approved budgetary submissions. So, while fiscal revenues and expenditures will remain within the sovereign domain, fiscal borrowing, guaranteed as it is by all Member States, will be controlled by those who are effectively responsible for it.

 Strange as it may sound, Germany and other strong members of the euro can save it by leaving it, and work their way back into it under new conditions.

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