How the Eurozone Could Survive

Includes: ERO, FXE
by: Larry MacDonald

Will the eurozone survive? If it does, investors and businesspersons with exposure to the region’s stocks, bonds and real assets will benefit considerably as depressed asset prices recover and the euro recoups its huge decline.

If the eurozone doesn’t survive, exposure would be a source of grief, especially in the extreme event the euro goes to zero. There could also be a shock to the global economy and financial system that could trigger economic crises in many parts of the world.

Presently, a great deal of uncertainty remains even though the European Union (E.U.) has cobbled together a €750-billion emergency-loan package and the European Central Bank (ECB) is buying bonds to hold down interest rates. Indeed, worries remain quite elevated.

The eurozone could survive if there are some changes. And the current crisis could be the tipping point for those changes. On the other hand, national differences in cultures and traditions pose a rather large obstacle to obtaining the necessary consensus.

The basic problem is that the eurozone is a monetary union without a fiscal union. Members of the E.U. have given up discretion over monetary policy and currency but there isn’t enough of a mechanism in place to help troubled jurisdictions adjust to imbalances.

If a deficit arises in the fiscal accounts of a member country and lenders begin to lose confidence, correction of the imbalance requires real changes in the economy — namely, significant drops in gross domestic product, employment and asset prices. There is no option of smoothing the way with easier monetary policy or currency depreciation.

It is by no means assured that the citizens of E.U. members will accept such painful sacrifices. Unions and social democratic values are very strong in Europe.

If there are not mass protests in the streets, the next elections will likely see parties voted into power on platforms of canceling commitments to austerity and paying down debt. Exits from the E.U. will ensue. Of course, signs of mounting rejection by citizens in Greece and elsewhere will play havoc with European financial and currency markets.

To survive, the E.U. needs to also become a fiscal union. That’s what other successful political unions, such as Canada, China and the U.S., have going for them, in addition to being a monetary union. Let’s take Canada as an illustration.

It uses the system of “equalization payments” to transfer income between regions so that none suffer substantial hardship when disparities arise. Now, this is a contentious issue even in Canada — but its contribution to maintaining political union (for good or bad) cannot be dismissed out of hand.

Would Germans and French citizens agree to income transfers to Greece and Spain? Perhaps it’s possible if the latter scale back their level of social democracy to be comparable to Germany and France so that citizens in the latter countries don’t feel they are supporting benefits greater than they are themselves enjoying.

Those reductions won’t be easy and national jealousies may prove insurmountable. Perhaps the political elites of Europe will prove adroit enough to pull it off, but there is substantial room for error.

And if they pull it off, it might have to be — at least on an interim basis — through a guise different than fiscal unions in Canada and other places. This variant would rely more on loan packages and central-bank purchases of the bonds of governments and business in troubled regions.

We could be seeing early signs of it with the recent decisions by the E.U. to put together an emergency loan package and to allow the ECB to buy the debt of teetering governments. Indeed, if the ECB were to ramp up its purchases of Greek and other countries’ securities beyond present levels, it could have an effect similar to direct transfers of income in smoothing the adjustment process.

Some will argue this “printing of money” creates a problem with inflation. It would if the eurozone was at full employment of resources. There currently is a great deal of slack and no basis for persistent escalation in prices. Mind you, if the eurozone doesn’t get its house in order before full employment, then this variant of fiscal union may not succeed.

What’s the upshot? It’s possible the E.U. may survive, but predicting survival at this stage is a bit of a coin toss because much depends on the skills of the E.U. political elite to bring in needed changes.

They certainly have their incentives. Dissolution of the E.U. could i) risk returning Europe to its 1,000-year history of strife, ii) reduce the economic and military status of the continent vis à vis the U.S., China and other powers, and iii) lead to lower living standards in Europe.

For investors and businesspersons, the situation bears watching. Over the next few weeks and months, it should become clearer whether or not European political leaders are up to the challenge. Perhaps one key positive signal would be if the longstanding European fear of inflation gives way to allowing the ECB to step up monetarization of debt.

[This post is an abridged version of an article on Canadian Business Online]