Tuesday, January 27, 2009

Euro and the crisis

As the twin dangers of recession and deflation stalks the European economies, questions are inevitably being raised about the role of Euro in containing the crisis. It is being speculated that one or more of the 16 Euro currency area countries, especially the weaker ones (Greece, Ireland, Italy, Portugal and Spain), their creditworthiness now downgraded, may default and declare bankruptcy and/or be forced out of the Euro zone, or the European Monetary Union (EMU), thereby deeply damaging the confidence in Euro.

The Euro was introduced as a single currency from January 1, 1999, to foster greater monetary and economic co-ordination between the economies of the European Union and reduce transaction costs. In order to participate in the new currency, member states had to meet strict criteria such as a budget deficit of less than 3% of GDP, a debt ratio of less than 60% of GDP, low inflation, and interest rates close to the EU average. Since inception, despite early weakness and doomsday warnings, the Euro had fast emerged as a worthy challenger to dollar global supremacy, even becoming the largest single currency area, overtaking the US. Though it had grown in strength in recent years, critics had always argued that the acid test will come when the Euro area faces a recession, a reality that now beckons.

With the present economic crisis requiring dramatic monetary and fiscal loosening, the aforementioned strict Euro conditionalities are clearly coming in the way of the ability of the individual Euro nations to respond aggressively. Conventional responses out of such economic downtruns like currency devaluations, slashing interest rates, increasing government expenditures etc are all constrained by these restrictions. This has left them with ineffectual and crisis-exacerbating approaches like wage reductions and lay-offs to combat the downturn.

While the stronger ones have been enacting large fiscal stimuluses to shore up their economies and protect their banks, the weaker ones, with growing deficits and debts, are experiencing a skyrocketing of the yields on their debts, thereby steeply increasing the premiums they have to pay on their public borrowings. This has constrained their ability to indulge in expansionary fiscal pump priming and capital injections for recapitalizing their ailing banks. As the NYT writes, "the widening gap between the interest rate that Greece and larger economies like Germany have to pay to borrow reveals the first cracks in what so far has been a fairly solid fortress Europe".

However, any attempt at leaving the Euro will only make matters worse as experience, including recent ones, show that investors would flee en masse from the banks and markets of a country that contemplated abandoning the Euro thereby wrecking the bond and equity markets and the banking system in that country. The major Euro economies and the ECB have so far been reluctant to make aggressive monetary and fiscal interventions, especially to bailout failing banks and other financial and corporate institutions. But the closely knit and effectively irreversible natire of the Euro zone means that the stronger economies will have to share the burden of bailing out those faced with bankruptcy, like especially Greece.

Barry Eichengreen argues that though the financial shocks have been asymmetric, with the weaker economies facing problems arising from their mounting deficits and debts (like Greece and Italy) and bursting of big housing bubbles (like Ireland and Spain), the entire Euro area is slowly being engulfed by a symmetric economic shock. In all the mainland European economies, growth is collapsing in the face of declining economic activity, slumping exports, and growing unemployment. He therefore proposes a swift and "common monetary policy response by (the ECB, thereby abandoning its single minded fixation with inflation) way of cutting interest rates to zero, moving to quantitative easing, and allowing the euro exchange rate to weaken... complemented by fiscal stimulus". Those with limited fiscal space, will have to be assisted from the outside, especially from their stronger partners like Germany.

The crisis facing Euro also highlights attention to the fact that most of these weaker economies had not undertaken any of the important and painful structural reforms that are necessary to bring in domestic economic and financial discipline. Many of these economies were already suffering from large current account deficits and unsustainable public debts. The calmness provided by the entry into EMU, coupled with the availability of the easy credit, thanks ironically to the success of the ECB in maintaining inflation at just 2.1% annually for the past decade and Germany's stagnation, had helped gloss over the structural weaknesses and fed the housing and other asset bubbles in Euro land.

Therefore, as Zsolt Darvas argues, the need to expand the EMU to cover its EU non-members should not be used as an excuse to relax the strict entry rules, and thereby postpone the necessary structural reforms, the absence of which have been the primary contributor to the extent of the crisis in many of these economies, both from the euro zone and outside. Further, the success of the Czech Republic and Slovakia, in maintaining high growth, low inflation, and staving off the contagion of the crisis, is a testimony to the policy reforms initiated by both these.

Interestingly, despite all the problems being faced by the Euro, the troubles being experienced by those EU countries outside the Euro zone are even greater, and could have been mitigated if they were part of the Euro zone. Zsolt Darvas and Jean Pisani-Ferry have drawn attention to an "asymmetry between the countries who benefit from the shelter effect of the euro and those who do not". The asymmetry in the monetary policy responses and the access to euro liquidity between the EMU economies and the non-EMU members of EU, especially the emerging economies of Eastern Europe, have adversley affected the latter. The authors claim that "being inside a large currency area considerably helps small open economies in times of crisis", and therefore makes the case for a swifter expansion of the EMU to include the other non-euro EU memebers.

They also suggest a few interim measures, that would help the non-euro members tide over the crisis - swap agreements between ECB and non-euro member Central Banks; dilution of collateral standards by ECB for for its repurchase transactions with counterparties local currency denominated government bonds; avoidance of asymmetric credit constraints by euro area banks in the non-euro members; and monetary and fiscal loosening by the affected non-euro members.

Mostly Economics draws attention to a speech by the Governor of the Denmark Central Bank, Nils Bernstein, where he made a strong case for Denmark joining the EMU, especially in view of its stabilizing influence at times of economic crisis. He said, "The single currency and single monetary policy are stabilising factors that prevent the individual member states from seeking their own – often mutually competitive – monetary solutions to the crisis." It also draws attention to a pamphlet by William Buiter et al, who make a strong case for Britain joining the EMU.

No comments: