The Ticking Euro Time Bomb
Updated: Dec 2, 2018
Clearly the euro has failed, but how should the problem be resolved? Deeper integration or a complete break-up?
For almost ten years the euro worked well. From 1999, Europe saw a growth in trade and most countries experienced a boost in GDP. France, Germany and Italy also had in excess of 2% growth per year yet in 2008 they all plummeted by at least 4% and they are yet to recover. The shadow of the euro debt crisis still looms large over Europe. The fundamental problem of the euro is that monetary policy must be consistent across Europe, but the economic characteristics of each European country are not consistent. Monetary policy is primarily concerned with interest rate setting. If a common currency is used there can not be different interest rates for different countries because the euro is a fungible good. If you are borrowing at one rate there is no reason you would borrow an equal amount of euros for a higher cost. Therefore, the monetary policy of the euro has to be controlled by the European Central Bank which creates a single interest rate for the whole of the Eurozone. The current rate is 0%.
Greece is perhaps the most significant example of how the euro came a cropper. Everybody knows that Greece’s economy is in crisis but fewer people know the economic theory behind it. Firstly, the euro means there is a single interest rate so Greece’s government can borrow much more cheaply because it effectively borrows at the trustworthy German rate. Pre-Eurozone Greece had much higher borrowing rates. Interest rates are ultimately determined by the riskiness of the borrower and in this case Greece is much riskier than Germany. Low borrowing costs mean Greece could go on a spending spree so they consistently ran large budget deficits to fund generous pension plans. This created a fiscal divergence between countries like Greece and countries like Germany which organise their finances prudently. This was fine while confidence was high and there were many willing lenders. However, when the financial crisis struck the supply of credit dried up. Therefore, Greece had no way of paying for its budget deficits and it was left with a mountain of debt which lenders were suddenly demanding to be paid back. A Greek default would compromise the security of the whole euro system. The two options for Greece and the ECB were to receive emergency aid or to reduce spending. In the end a bit of both was used. The total bailout was €289bn. Austerity measures were also imposed on Greece, however this triggered a political crisis as there was serious public opposition and riots. Eventually, the Greek economy stabilised but only after the economy had shrunk by 25%.
The Greek crisis demonstrates the vulnerability of the euro especially since Greece is a relatively economically insignificant country. If a large economy such as Italy’s experiences a similar crisis surely the euro will collapse. To ensure this won't happen the ECB must act by either abandoning the euro or adopting a single fiscal policy. A system of separate monetary and fiscal policy will never provide economic stability in the long-term for Europe because countries like Greece will always free ride on the cheap credit creating an inherently unstable system. This suggests the spending of each countries needs to be controlled by a central authority to make it equitable and safe or the entire system needs to be abandoned.
The first problem with a break-up would be the fact that it represents a costly retreat from this ideological project. As the UK is finding with Brexit, it is complex and costly to leave an institution which has been developing and expanding for nearly two decades. However, the cost of allowing the euro to collapse through crisis would be even larger. It appears the monetary costs of abandoning the system exceed the monetary costs of abandoning the system through the chaos of a collapse in confidence.
Also, without the integration of a common currency countries are less likely to cooperate with each other because they are less mutually dependent. The EEC and later the EU were based on the idea of economic integration to reduce conflict. A break-up would be a reversal of that idea and endanger the stability of Europe. Meanwhile, a fiscal union represents a strengthening of this union.
A break-up would also represent a return to the old system of currency speculation and transaction costs. We would lose the benefit of a currency union.
This involves a single budget for the Eurozone similar to the Federal budget of the USA. Debt would also be combined and a common Eurobond would be issued. This would overcome the problem of certain nations accumulating large deficits and would ensure the area's borrowing is at sustainable levels. However, this would be unfair on wealthy states such as Germany who would effectively subsidise poorer states such as Greece just as New York subsidises states such as New Mexico in the US. This is because for a common monetary policy to be effective all states must have an equal level of creditworthiness which a fiscal union can ensure. It would be advantageous to those poorer countries and would promote greater regional equality in Europe.
This subsidising of poorer states identifies the main problem with the fiscal union, politics. Like most sensible economic policies they are often limited by a lack of political will. Unsurprisingly, Germany and France are reluctant to subsidise these states. There is also a lack of public support for giving up their country's sovereignty. With a fiscal union a country is effectively giving up all control of its economic policy.
A partial fiscal union has already been attempted by limits being set on a country's fiscal deficit (3% of GDP). Italy is currently breaking these rules so a conflict between their national government and the EU is expected. This dispute demonstrates the inability of a partial union system to replicate a full union. It is also inflexible because it does not allow for temporary budget deficits which may act as an emergency stimulus in times of trouble. A full fiscal union is the only system which can provide the maximum stability if the euro is to remain in use.
What is clear is that either way a fiscal union or a break-up are much better than the current unstable system. A fiscal union would be preferable for European unity because it would increase integration. It would also create a much stronger economic body to rival the likes of the USA and China in terms of economic might. This is an effective way of giving more power to smaller countries and it can be an effective way of improving the economies of some of the smaller European states, reducing regional inequality. On the other hand, that does seem politically unfeasible at the moment so instead European states should leave the Eurozone. Either way countries should not be satisfied with the current system and they should be working towards one of these two solutions.