As EU leaders work to agree on a “comprehensive solution” to the eurozone’s debt problem, the question remains as to whether or not such a solution exists.
It is a critical time for the eurozone and everyone knows it. The structural problems and imbalances of the eurozone are well understood. Most polls indicate that investors expect the eurozone to lose a few member states in the years to come. As EU leaders work to agree on a “comprehensive solution” to the debt problems, trends within the eurozone will challenge EU policymakers to determine the shape of the eurozone and how the Euro debt crisis will end. The political will of EU leadership is likely not enough to keep the eurozone together.
Why isn’t political will enough to keep the eurozone together?
Diverging weaker and stronger economies. Fiscal austerity, the cornerstone to European Monetary Union and the key to eurozone fiscal unity, is now contributing to the problem of divergent economic growth rates within the eurozone. Austerity measures are resulting in negative growth rates for the peripheral countries. Divergent economic growth rates are solidifying a two-tiered European economy, roughly divided between the “core” and “periphery.” The two-tiered Euro economy is making monetary policy formulation all the more complicated for the European Central Bank to govern the eurozone equitably with one monetary policy, particularly now with signs of inflation influencing policy and higher interest rates.
Rising anti-Euro resentment and political backlash to pro-Euro policy. The “Competitiveness Pact,” having broadened and institutionalized “bail-out” mechanisms that require further austerity measures, is likely to result in continued political backlash from public opinion and political parties. While the ”periphery” tires of accepting austerity measures at home, the “core” tires of transferring wealth and financing subsidies to the weaker and less productive periphery. In one example, Finland, one of the single currency area’s six AAA-rated members, has seen anti-Euro sentiment swell as polls indicate taxpayers in the Nordic country are reluctant to subsidize governments that have “overspent. “
EU leadership is certain to face challenges garnering support for the “Competitiveness Pact” in their home countries as it touches on politically sensitive sovereign issues such as pensions, wages, and labor market reform. In a “worst case” scenario, if anti-Euro resentment continues to rise, new leadership will eventually be elected and will look to re-negotiate new solutions to the debt-crisis. The election in Ireland may be the first of many such anti-Euro election outcomes in the months and years to come. Regional German elections are in process now, and the outcomes are not likely to favor current EU policies. The abrupt resignation of the Prime Minister of Portugal over frustration with the Portuguese Parliament for not approving austerity measures is one indication of how quickly leadership can lose support for pro-Euro policies amidst rising anti-Euro resentment at home.
Eroding investor confidence and divergent market measures. While credit rating agencies have downgraded Spain, Greece, Portugal and Ireland, markets have reacted, as expected, with rising bond yields. However, yields have risen and credit spreads have widened beyond what the credit downgrades might imply, which likely means that investors are expecting the situation to deteriorate further for the weaker countries. Even in the case of Spain, the difference between Germany and Spain has narrowed to 200 basis points, considered to be a favorable investor view of Spain’s policies and credit risk. Even so, at the time of the formation of the eurozone in 1998, the difference was much narrower at 32 basis points. It is clear that the eurozone is diverging by many market measures of risk, bond yields, in particular. The question of debt sustainability remains; when uncertainty increases the bond yields that investors require to buy a government’s bonds, government borrowing costs increase to a point where investors can conclude that it is unsustainable for a government to pay that level of interest rate and debt. Investors flee, pushing bond yields higher still, which may continue to occur for some weaker eurozone countries.
What will happen to the Eurozone?
If the eurozone is diverging economically beyond repair, as some economic and market measures would currently indicate, the long-run survival of the single eurozone currency will be assured only if a mechanism were to exist that allows a country or group to leave. The original 1991 Maastricht Agreement purposefully left out such a mechanism, as it seemed inconceivable at the time that a country would or could leave. Economists today vary in their estimates of the cost to a country to leave the eurozone, but there is a common belief that a country exit would be extremely costly if not financially impossible to do.
As there is no way to leave the eurozone, all options proposed for a member state to exit the eurozone are theoretical. One idea is that weaker countries could be left to default, which would never be allowed in actuality given the financial shock that would result to the global financial system, and also because the loss in investor confidence would be so great that the eurozone could not continue to function, in any form. Another idea is that Germany, a globally competitive economy in its own right, could leave and form a new type of Deutsche Mark block, which is implausible in reality for political reasons as European Monetary Union has the French-German political alliance as its foundation. A third idea is that the eurozone stay intact and that there be an automatic method to shift financial resources from the relatively wealthier countries to the relatively poorer countries; an idea that could not be realistically institutionalized as it would not be acceptable to the stronger countries’ populace. A final idea is that the debt problem be resolved in part by bond re-structuring, forcing bond holders to absorb the cost by taking a write-down in price, a “haircut” solution which is almost certain to occur in some way. This would further weaken the banking sector which would, in turn, require injecting equity from some source, likely the ECB or another mechanism. Though this idea might work for a while, it does not solve the structural problems and long-standing imbalances that the Eurozone creates and maintains.
How will the Euro debt crisis end?
For the Euro currency to survive, the Eurozone as it is now cannot. Each of the “peripheral” countries is unique in that each has a different set of economic problems to solve. What they have in common is that each of these governments is hampered by the tools that they have to stimulate growth by the structural constraints of the eurozone and EU policy. Perhaps a few countries could be managed-out in a non-discriminatory manner for not meeting Maastricht criteria. Or they could choose to leave due to the harsh penalties the EU imposes on their sovereignty. The IMF’s involvement could eventually be seen as a means to assist countries to leave the eurozone, rather than a means to keep them in. It is even possible that two currencies and two economic areas could replace the current economic structure, roughly divided by the core and the periphery, between those that are willing and able to compete with the Euro and those that are either not willing or unable to do so.
Whatever the reshaping of the eurozone, for the debt crisis to end, at least one other currency will have to also exist for the weaker economies. The weaker countries will have to devalue the new currency relative to the Euro to become “more competitive” by cheapening wages and exports, while stimulating economic growth. Sovereign debt could then be issued in the new currency to pay for the currently unsustainable levels of debt. The costs related to this scenario are great, immeasurable, and include the loss of purchasing power of the new currency, the loss of value of savings and other assets, and also imported inflation.
The current system of the wealthier countries assuming the costs of indefinite bailouts to compensate for the chronic structural imbalances of the eurozone will not last indefinitely, as continued crises will be provoked either by market mechanisms or an electoral outcome. Although EU leaders and policy makers will continue to work to agree on a “comprehensive solution,” there isn’t one to be found within the constraints of the eurozone. The political will of EU leadership is not enough to keep the eurozone together, given its inherent structural problems, economic diversity, and the imbalances it creates, particularly now given the emerging trends within the eurozone.