By: Steven M. Roge, CMFC
The future of the euro has consumed global investors over the past two years. While global markets have intensely focused on the potential insolvency of Economic Monetary Union (EMU) members, the current political and economic turmoil in Europe strikes at the very heart of the “European Union (EU) project.” Indeed, the original architects of the EU envisioned economic union as a mechanism to usher in gradual political convergence and greater economic prosperity between economies with starkly different structures and levels of competitiveness. As time progressed under the umbrella of economic union, however, countries showed greater divergence, particularly in key areas such as labor productivity and economic growth. As a result, when the global financial crisis struck in 2008, the stark differences between EMU member economies were laid bare. In the aftermath, a main question has emerged: How will the EMU ultimately survive? At one level, the question is an existential one calling into question the idea (and ultimate wisdom) of a unified Europe. On a more practical level, the question refers to what policy tools and scenarios will ultimately play out as the EU faces its stiffest challenge to date. While this article will not necessarily provide specific predictions to what will happen, it will provide a roadmap outlining potential scenarios along with weighing their likely benefits and costs.
Before assessing what scenarios may evolve over the long-term in the EU, a quick look will be given regarding what limitations EMU member countries face in promulgating economic policy. Typically, if a country with significant debt levels (reflecting excess credit) and unbalanced economic growth experiences an external shock, there are a number of macroeconomic tools to facilitate a rebalancing. First, a country could adjust monetary policy by lowering interest rates that would, in turn, also likely lead the currency to depreciate as capital flows exit the country: the net effect of currency depreciation is to make the country’s exports cheaper vis-à-vis competitors’ exports which could boost exports while also increasing the cost of imports. The recalibration of monetary policy helps narrow a country’s current account gap, rebalance the economy and promote economic growth.
Fiscal policy, in the form of spending cuts and tax increases, is the second major policy tool used by governments. A combination of balanced fiscal policies not only reduces the government’s overall fiscal burden, but also may renew investor confidence that the government is effectively dealing with the crisis. Tighter fiscal policy by itself, however, has limited efficacy depending on the overall level of debt: while government spending cuts may be adequate to restore equilibrium with moderate debt levels, there is no fiscal silver bullet to deal with excessive debt. This is primarily due to the existing tradeoff between balancing public and private investment in times of dampened demand. That is, government spending can only be cut to such an extent that private investment will fill the gap- otherwise, the result will be anemic economic growth over the long-term that is far more damaging to a country’s economic health. Domestic political constituencies also serve as a key limitation unwilling to accept excessive cuts to public services or onerous taxes.
The current crisis in the euro-zone has exposed the limited policy tools EMU member countries possess to deal with economic difficulties. Indeed, as part of the Maastricht Treaty signed in 1992, EMU member countries agreed not only to give up national currencies (for the euro), but also to cede national central bank monetary policy powers to the ECB. Thus, EMU countries that experience acute economic problems essentially find themselves caught in a “policy straightjacket” solely reliant on fiscal tools without remedy to traditional monetary policy tools to weather the economic storm. Although the details surrounding economic crisis in Ireland, Spain, Portugal and Greece are different, each country has unsuccessfully relied on fiscal policy as a stop-gap measure during a painful period of deleveraging.
Ireland, a country that faced unprecedented debt levels as the government backstopped insolvent national banks, implemented draconian fiscal cuts as a prerequisite to receive outside aid. Although the Irish government proposed $6bn in spending reduction for 2011, these cuts were only a fraction of the roughly $20bn in cuts needed to reduce Ireland’s deficit to the 3% threshold mandated by the Maastricht Treaty – a goal Ireland hopes to reach by 2014. The Greek government faces more severe difficulties relying on fiscal policy to restructure the economy as the main economic problems are more structural in nature; economic growth has plummeted with attendant cuts in spending calling into question the country’s economic viability.
The straitjacket of a common economic policy leaves European bureaucrats with limited choices to maintain the EMU. Indeed, the main policy measures available to save the union may ironically pose the greatest political and financial risks for member countries. The easiest solution, but also the most politically insoluble, would be a full bailout of affected countries by a “coalition” of the willing – likely involving a combination of EU members, the IMF and outside countries. A full bailout, however, is not likely due to existing opposition in main EMU economies (e.g. Germany), as well as the ECB’s reluctance to bail out countries without first extracting “a pound of flesh.” In lieu of this unlikely measure, other scenarios to keep troubled countries in the EMU center on the restructuring of existing debt obligations.
The first option is a “voluntary” restructuring. A voluntary restructuring would involve a change in existing investors’ terms of investment through a maturity extension on existing loans. The measure would be beneficial for indebted countries in that it may head off a complete default (depending on the terms of the restructuring); however, any voluntary restructuring would lead to significant market volatility. In addition, credit rating agencies have ruled that any attempt to voluntary restructure debt that resulted in a lesser return for investors would technically constitute a default. In order to cut off the possibility of being ruled in default, other bureaucrats have pushed for selective “debt rollovers” in which creditors would roll over existing debt into bonds with a longer maturity and equivalent borrowing conditions. This is the current policy preference of larger EMU members, such as France, that have significant exposure to Greek debt via domestic banks. Although debt rollovers may help to settle agitated market sentiment, it is not in itself a solution to the problem: That is, debt rollovers may provide additional breathing room via an elongated timeline for debt settlement but do not significantly change the amount of debt on the books.
Finally, some have proposed the issuance of “Brady Bonds” as a solution to the current crisis. The Brady Bond concept, initially implemented to help Latin American countries expunge debt in the 1980s, would involve a net reduction of debt on existing bonds in exchange for the issuance of new bonds and a promise to pay back all remaining debt. This proposal is the only one that could result in a lower net debt load for indebted countries in the short-term; however, there may be resistance to such a solution by some private creditors and it is not clear how credit rating agencies would ultimately view this solution.
In absence of an agreement to draw a line under existing debt, remaining solutions to the crisis focus on a potential breakup of the EMU. It must be stated at the outset that there is no robust legal framework or precedent to manage a country’s exit from either the EMU or the EU. Thus, the prevailing assumption will be a member country’s exit based on a negotiated settlement among all member countries rather than a unilateral withdrawal or mandated expulsion. The potential benefits of executing such a strategy would be clear: The ability to reestablish a circulating national currency (that could be devalued) and reinstated central bank powers. The new national currency would likely be pegged at a far lower rate to major currencies than the euro resulting in a substantial reduction of debt liabilities (unless negotiated otherwise) and the central bank could use its revived sovereignty to pursue a more accommodative monetary policy to ease the pain of fiscal cuts.
While exiting the EMU may provide some benefits to the exited party, it’s not immediately clear what benefits would accrue to other monetary union members. Regardless of whether the former EMU member defaulted or not, an exit would inevitably send shock waves through the global financial system potentially feeding existing contagion fears and effectively killing the European project. In addition, due to the excessive exposure of European banks to troubled economies, outstanding loans could be written down immediately triggering either substantial losses or a number of politically unpopular bailouts for banks. Thus, the negotiated exit of individual countries, either singly or in pairs, might still not be the silver bullet needed to end the crisis as most countries with existing debt problems also suffer from long-term structural problems.
In order to prevent the political and economic carnage that would accompany countries “exiting” the EMU, some have proposed an intellectual half-way house: the splitting of the euro-zone into two different blocks (north and south) based on differences in economic competitiveness and structural economic differences. Under this admittedly provisional arrangement, the existing EMU would be divided into two different blocks: 1) North Block (consisting of Germany, France, Holland, Austria, Benelux and Finland,); 2) South (Spain, Ireland, Greece, Italy). The prevailing logic underpinning this arrangement relies on the existing divergence among EU members: To some observers, the euro-zone has already de facto broken down into a northern and southern zone based on differing productivity levels, industry structure and competitiveness By dividing the existing euro-zone into two different areas, with two different currency zones, a natural rebalancing would occur, whereby the “Northern euro” would likely appreciate above the euro’s current depressed level dampening exports and strengthening domestic consumption in richer countries. The “Southern euro” would likely depreciate giving debt-laden countries additional room to export and rebalance while not being tied to a one-size fits all monetary policy. While this elegant solution would essentially save the EMU by creating putatively compatible sub-groups, there are numerous questions regarding its ultimate feasibility. In addition to potential strident criticisms from exporters such as Germany and France that would not want to be tied to a stronger currency, there is also a question whether there is truly a natural divergence between the two groups of countries. For example, while Ireland’s current debt load is at a similar level to Greece, their economies are fundamentally different: Ireland was a beacon for foreign investment and efficiency in numerous industries due to low tax rates; Greece still is in the initial throes of privatizing bloated state enterprises.
While the future of the euro is currently undecided, the stakes in the current crisis are inevitably high and would impact the global economy. Indeed, although it is often times assumed that European countries will play the definitive role in deciding the fate of laggard economies , the IMF, United States and China have already pledged key economic and fiscal support to affected countries that suggests a post of stability in the storm. Thus, while some are betting that the financial crisis will ultimately be the undoing of the EU, other observers see the important influence of inertia and political pride behind maintaining the “European project.”
Erik Tollefson contributed to this article
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