Will the Euro's Survival Be at Risk?

“The euro will disappear within 20 years because of the inability of member states to stick to the rules underpinning the European Union's single currency.”
-- Jim Rogers, 2006.

"Prodi's euro has screwed everybody."
-- Silvio Berlusconi, Prime Minister of Italy, July 2005.

The dramatic developments in Europe in recent days have shown a fundamental lack of coordination between European governments which is likely to put great strain on the cohesiveness of the European Union. As this crisis unfolds and if it deepens further it will become a life or death test for the euro.

Ireland's unilateral decision to guarantee all deposits and (more concerning) the debts of her six largest banks for a period of two years (which represent two times the country's GDP), followed by similar assurances from Greece and Germany (only regarding deposits) is very concerning.

Ad-hoc responses in an uncoordinated fashion by different governments are much less effective than a well coordinated response and leave the remaining governments in an even more difficult situation (i.e. increases the risk of capital draining out of a country’s banks into safety of a nearby country’s bank benefiting from a higher degree of government guarantees). This could lead to a sub-optimal result for Europe as a whole, a situation akin to game theory's prisoner’s dilemma. Nouriel Roubini called it a "beggar thy neighbor policy" in a recent piece.

This is substantially more damaging than the Irish turning down the Lisbon Treaty in the recent referendum (which sought to provide a much needed overhaul to improve the governability of Europe’s institutions post-expansion to the East). That this was initiated by Ireland is particularly regrettable as it is coming from the country that possibly benefited the most from the adhesion to the European Union. On second thought, this is perhaps not that surprising, as the Irish had been allowed to get away with fiscal dumping for decades, attracting businesses to be based in Ireland through very low corporate tax rates - at the expense of neighboring countries who, because of their larger size, or temperament, could not afford to have such a buccaneering attitude and eschew their responsibilities to the European project.

Different countries are being affected differently by the crisis. Some countries have a domestic housing bubble (e.g. Ireland and Spain) while others do not (Germany); some countries' banking systems have more leverage or more exposure to structured finance or US sub-prime, the precise contours of this landscape are still foggy but should emerge in the coming months. These differences make it difficult for countries to coordinate responses and find a policy that fits everybody.

Ultimately the crisis and the different responses will likely result in a further divergence of macro economic indicators, with some countries incurring substantial budget deficits and seeing further ballooning of their public debts because of the bailouts. At some point, if after suffering a couple of years the economy does not turn around, some countries may feel they need to regain monetary sovereignty to gain further degrees of liberty in dealing with the fiscal and economic crisis, so the temptation to pull out of the euro will be great, although this would surely take several years to play out.

The designers of the Monetary Union understood that its success would require a certain degree of economic and macro-economic convergence. So they created the Stability and Growth Pact (SGP), an agreement by European Union member states related to their conduct of fiscal policy, to facilitate and maintain Economic and Monetary Union of the European Union, namely seeking to keep the budget deficit under 3% of GDP and public debt under 60% of GDP. These rules were never strictly enforced (particularly if the countries in breach were Germany or France) but the current crisis will finally shatter any remnants of it.

One of the first casualties of a deep crisis is also truth, so the euro may be a convenient scapegoat for populist political leaders seeking to capitalize on the crisis for political gain.

The euro was always a highly ambitious and very difficult project, many (particularly on this side of the pond) did not believe it would ever see the light of day. If the euro survives this crisis, then it will become a more mature currency. I certainly wish it does, for the sake of Europeans and the world. But, unfortunately, the way things are going I would think long and hard before betting on it, we may be witnessing, I fear, the beginning chapters of the end of the euro dream.

Comments

[CLH:]

Very good article.

2008 Oct 07 12:28 PM

[carey_jim:]

I wont go so far as to agree with Jim Rogers but I'm glad to see the other side of the argument.

I've always said that after two world wars, wars that Europe can only see as civil wars, it's not easy to believe that Europe can be united enough to accept a single currency and all it entails.

After all, it took a long time for the American states to accept a single federal currency. So what can we expect from a Europe that is divided by many languages and cultural AND economic traditions?

We must hope for the best but fear the worst.

2008 Oct 07 02:11 PM