Will the Euro collapse?
The old continent -- Europe -- is in serious financial trouble. The common currency, Euro, is threatened with collapse.
As part of the economic and monetary union in Europe the setting up of Euro was decided under the Maastricht Treaty in 1992. It came into actual operation in 1999 with 11 European members, and now has 17 members.
The European Central Bank (ECB) issues the Euro currency notes and coins and administers the monetary policy of the Eurozone countries. Individual member countries, however, have control over their respective fiscal policies. Fiscal policy of a member country has to conform to the "Broad Economic Policy Guidelines" (BEPG), which are not binding.
The Eurozone was doing fine until 2009, when some member countries -- because of over-borrowing -- suddenly realised they were unable to reschedule their debts or repay their creditors. Massive public borrowings by Greece, Ireland and Portugal to finance their annual budgets had created a desperate fiscal situation. Subsequently, the public debts of Spain and Italy added to the woes of Euro.
The credibility, strength and permanence of the Euro, which is the second strongest currency in the financial world after the US dollar, came to be seriously questioned.
By 2010 the "European sovereign debt crisis" was full blown, with European leaders scurrying to meet repeatedly to rescue the Euro.
There is a simple macro-economic explanation of how this happened.
Because of globalisation of finance and easy credit many Eurozone members resorted to massive public borrowing, expanding their economies during the first decade of the 21st century. It was considered stupid, at that time, not to use that easy money to expand.
The money (Euro) came from private fund managers, private banks and central banks from within Europe and outside.
Governments invested in infrastructures and industries. As income levels and standards of living rose people went into conspicuous consumption -- such as housing, vacations, expensive cars etc. At that time, the governments' borrowing policies confirmed that joining the Eurozone was a good step in the right direction. The welfare state concept pushed governments to raise salaries and expand social security benefits to citizens.
The countries posted 2 - 4%GDP growth, which was higher than the interest rate they would have to pay to the creditors. In short, the non-binding BEPG were thrown to the winds and governments went on spending spree. Everyone was happy as more money was poured in-- little realising that the celebratory period was drawing to an end.
The economic expansion had raised the costs of living and consequently raised the costs of production, making these economies uncompetitive in the world market. Exports began to dwindle and earnings from exports declined. Recession slowly set in with factories and industries closing. Unemployment began to rise. As the economies shrank, GDP growth rate became negative.
While government revenues declined as a result of rampant tax evasion and declining export earnings, public expenditure could not be restrained. Governments were spending more than they were earning. The result was predictable -- huge annual budget deficits, in some case over 10%. EU rules require that Eurozone countries do not have more than 3% annual deficit.
To cover these gaps (between revenue and expenditure) governments went on borrowing (by selling bonds) at increasingly higher rates of interest -- until the situation got so bad that governments faced "default" (unable to pay the creditor) situation on their debts.
During the past three months, EU leaders met repeatedly to fend-off any doubt about the stability of the Euro. But banks and corporate houses are extremely wary and have pulled out their funds from the Eurozone, thereby instilling a sense of panic in the European money market.
After several high-level summits and meetings EU leaders decided on a rescue package of over ˆ1 trillion to help the cash-strapped economies. The fund will be administered by the ECB through European Financial Stability Facility (EFSF). But investors continue to off-load sovereign Euro Bonds issued by the erring governments. They no longer trust these governments' ability to honour their bonds.
On December 8, EU leaders gathered in Brussels to hammer out a deal to save the Euro. The deal, widely caricatured as "Merkozy Deal" (Merkel of Germany and Sarkozy of France), calls for strict fiscal discipline on the part of every EU member. Britain, which never joined the Eurozone, stayed out of the Deal.
Britain is also a badly indebted country. By not joining the Eurozone, it has retained the flexibility to raise or lower the value of the pound sterling and interest rates to ease out of the recession. Britain still can borrow funds at lower rates than most Eurozone countries.
On the other hand, the Eurozone countries cannot devalue the Euro unilaterally. This is where Greece, Portugal and others have got stuck. In recessionary situations countries can alter their monetary policy by devaluing their money, making their export price cheaper. The process helps increase exports and reduces unemployment as industries reopen. But in the Eurozone that is not possible.
Last October, when the Greek bailout was being arranged under some very harsh conditions, Greek Prime Minister George Papandreou threatened to quit the Eurozone. Greece later gave up the idea because leaving the Eurozone would not unburden it from its enormous debt of ˆ365 billion.
In a recessionary situation when industrial production is sluggish, governments need to invest to boost demand by generating employment (Keynesian theory). But under the Merkozy Deal that may not be possible because governments have been strapped to reduce public expenditure and raise tax -- both difficult propositions.
Theoretically, if EU countries could get out of recession and can grow at a healthy rate of 3 - 4% per annum then this crisis will blow over and the Euro would gain permanence.
The Euro is under grave threat of collapse. The scenario that is likely to unfold is that the peripheral countries -- Greece, Portugal, Ireland and others -- may decide to quit the Eurozone.
The need of the hour is to restore confidence among investors that the Euro is still strong and credible. Collapse of the Euro will unleash a series of upheavals in the world financial structure as we know it.
There is an old saying -- greed is a vice and one should not live beyond ones means. The Europeans are paying for their greed.
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