The Calm Before the Next Eurozone Storm

Includes: ERO, EUO
by: Robert Sinn

This Friday, euro zone (EZ) honchos will gather in Brussels for the second time in as many months in an attempt to find common ground on repairing the EZ’s finances. News out of the EZ has been fairly quiet in recent weeks and EUR/USD has rallied impressively, even vaulting over the 1.40 level on Monday. I believe we are now in a period of calm before the next EZ sovereign debt storm arrives.

Since I wrote on this subject on Feb. 9, none of my concerns have been alleviated and, as far as I can tell, EZ leaders haven’t moved any closer to the necessary compromises. One concept which I find particularly difficult to grasp is the idea of "punishing" EZ members who don’t adhere to the mandated standards of fiscal discipline. How exactly would the EZ fiscal authority go about punishing a member state that doesn’t abide by the agreed-upon fiscal standards?

The EZ fiscal authority couldn’t fine the violating country, as it would be absurd to fine a country that is already having problems balancing its budget. Is there any other means of punishment that a EZ member state would fear enough that it would alter its behavior? I certainly can’t think of one.

Moreover, a major obstacle remains attempting to harmonize tax rates across the EZ and implementing tax code enforcement. Ireland has already pushed back hard against the Franco-German proposal to eliminate low corporate tax areas within the EZ, and they are unlikely to budge on this issue given their current economic challenges and the recent change in government.

A political defeat for German Chancellor Merkel’s party in Baden-Wuttemberg just two days after the March 24-25 meeting of euro-area finance ministers would complicate things within the EZ even further. Germans are particularly allergic to inflation, given their history (hyperinflation during the 1920s), while EZ periphery states have a long history of relatively high inflation and currency devaluation. A major political defeat for Merkel’s party would send a strong signal that the German people are losing patience with the euro burden that they have been saddled with.

The challenges facing the EZ leaders in order to agree upon something resembling the "Pact for Competitiveness" are difficult enough, but I believe an even greater challenge currently faces the European Central Bank (ECB). The ECB is tasked with implementing monetary policy with a single primary objective of maintaining price stability within the EZ. The concept of one central bank setting the same monetary policy for 17 different countries with widely varying growth rates, inflation levels, labor mobility, etc. has always been treacherous. However, we are about to see just how difficult such an experiment can be: Never before has the EZ experienced such wide disparities in the economic well being of its members.

While Ireland deals with deflation in the wake of its banking sector bust, Greek unemployment surges to 14.8% (39% among 15-24 year olds), and Spain wrestles with 20% unemployment (43% unemployment among 15-24 year olds), Germany has never had it better economically. Greece (-6.6% GDP in 2010), Ireland (-1.2% GDP in 2010), Portugal (1.2% GDP growth in 2010), and Spain (0 .1% GDP growth in 2010) are all dealing with severe economic turmoil due mainly to uncompetitive labor forces and the fallout from excessive financial leveraging before 2008. By contrast, Germany has an unemployment rate of just 7% and enjoyed 3.6% GDP growth in 2010.

The recent bout of food and energy price inflation has prompted ECB President Trichet to begin sounding a hawkish tone, and he has even gone so far as to discuss the possibility of a rate hike in the next couple of months, saying, "An increase in interest rates in the next meeting is possible.”

Trichet also repeatedly used one of his old favorites, “strong vigilance,” when discussing the ECB’s stance on inflation. Thus, while most of the EZ is sputtering along, trying to deal with major structural deficiencies within their respective economies, the ECB seems set on making the same mistake that it made in 2008. A "one size fits all" monetary policy for 17 countries of widely varying economic dynamics seems naïve at best and disastrous at worst. It is no wonder that Bundesbank President Axel Weber chose to remove his name from the top of the list for the next ECB presidency.

As I see it the Euro-zone is nearing the end of a period of calm before the next storm arrives.