The Eurozone Fights for Survival – Part II

SINGAPORE:  With the eurozone shaken by debt crisis, the question is being raised: how did it happen. In retrospect, it’s clear that the fault was not in the terms of the European Union Treaty, the Treaty of Maastricht, itself but lack of political courage to supervise the implementation and reform flawed measures. Focus was on fiscal policy with well-known guidelines for deficits and debts. What wasn’t foreseen was the anomaly of capital markets over the first 10 years. That weak countries could continue to borrow at interest rates determined by the strongest country – Germany – fueling an irresponsible monetary policy escaped notice.

The countries exploiting this opportunity cannot in any way be exonerated from guilt. But they were not the only ones missing the looming disaster. A large number of European banks, the rating agencies, and the cohort of primarily US and British economists and columnists now somewhat belatedly queuing to criticize the EU overlooked it.

The financial markets delivered a prime illustration of overshooting: Warnings went ignored and lending continued even if the highly paid experts should have seen the writing on the wall. When it went wrong, the markets abruptly stopped lending thereby aggravating a crisis partly of their own making.

The crisis is comparable to the 2007/2008 US financial crisis, highlighting an increasingly agonizing swing of corporate governance. Is it acceptable that financial institutions can pursue a course boosting profits from a purely egotistic policy, ignoring an implicit contractual obligation to incorporate societal repercussions in their policies? Is it so that governments can neglect the effects of such policies, referring to free enterprise and the market? The answer: Yes, that is so, but the results in the form of a global recession, the US economy heading full speed into a debt trap, and severe difficulties for the euro gives rise to second thoughts.

This leads to one of the main questions placed squarely on the European agenda: burden sharing. Weak countries like Greece have acted irresponsibly, without doubt, but what about the banks allowing them to do so in their own quest for profits? How to distribute the burden among countries, taxpayers in debtor versus creditor countries, and the private sector, including banks inside debtor countries and creditor countries?

The future of the euro depends upon policymakers’ abilities to find economically workable and politically acceptable solutions to this problem. Until a couple of weeks ago, the fumbling and hesitation did not inspire confidence, irrespective of the fact that the euro was doing well – it has risen vis-à-vis the US dollar over the last 12 months although that may say more about the dollar’s weakness than the euro’s strength.

The eurozone took a decisive step at the July 21-22 meeting, trying to move ahead the curve by putting in place a respectable package designed to revive Greece and establish a fence around Ireland, Portugal, possibly Spain and Italy, asking the banks to write off a bit more than 20 percent of their claims – low compared to other cases over the last 20 years – beefing up the European Financial Stability Fund plus other measures to ensure the euro’s survival.

The package looks reasonable, but is it good enough? That depends upon three points:

First, the rating agencies have become a bit erratic. They were far too lenient prior to the global financial crisis, and now they adopt the opposite attitude, crying wolf at the slightest movement in the forest. Granted, time is needed to allow rating agencies evaluate policy measures and find their own feet after having been so wide off the mark, but too many players in the market seek short-term profits for themselves in forcing one or several member states into default and possible breakup of the euro. A test of willpower between the eurozone governments and the financial markets is playing out. The eurozone will win this contest because it’s a question of survival while the markets can and will switch their search for profits to other victims, like the US and probably also the US states, many of which will be severely hit by spending cuts in the federal budget.

The second test is success or failure of the weak countries to appear more solid and competitive over the next few years. The jury will be out for some time, but the answer seems positive provided the markets give these countries a chance. All have adopted and implemented serious austerity measures. Compared to the inactivity of the United States, the measures look gigantic. According to Goldman Sachs, the eurozone budget balance in percent of gross domestic product was -6 in 2010, estimated to fall to -4.4 in 2011 and further to -3.6 in 2012. Greece will go from -9.2 in 2010 to -5.6 in 2012. Italy and Spain anticipate a similar trajectory. The public generally seems willing to go along despite some protests. Indeed, widespread predictions of street riots and governments tumbling have not materialized. The reward is that economic growth in the eurozone is neither falling nor flat. It is going up.

The third point is a revision of the terms in the 1993 Treaty of Maastricht. Not fundamental changes, but steps towards a stronger fiscal union not only in words, but in deeds to prevent a repeat of the challenges during the euro’s first decade. This will be accompanied by euro bonds, or bonds guaranteed by all eurozone member states. Reading between the lines, the message is emerging from the leading countries that they recognize the need for revisions and are prepared to act accordingly, but as so often seen with the European integration, time is required, not just a snag of a year or two, but more during which political will be tested.

The crisis will break or make the future of European integration. The overwhelming odds are that the current debt crisis will usher in a new phase of integration. The crisis has hammered home: No European country can survive alone. Without the euro, the global financial crisis would surely have led to a currency war among the European countries with disastrous results for the global economy.

Some people flirt with the idea of Germany leaving the euro, standing alone as a knight in shining armor with a strong currency, low inflation and fiscal responsibility. It was seen during the 1970s and 1980s that this cannot be done and was the prime motivation for the single currency. It would be odd if Germany left precisely when the eurozone slowly, steadily is coming round to adopt fiscal responsibility and low inflation, not because it is the German model, but because it’s been tested and viewed as best.

Nor is it realistic to see other member states leave the euro, choosing to face economic and social meltdown brought along by failure to control fiscal imbalances and manage the economy. The markets would avoid such players. Their voices in other EU matters would carry little or no weight.

There are no viable alternatives. If for no other reason then, the euro is here to stay.