Is the future of the euro in question?

George Soros says so, but is he right?

Well, if you ask us, things have to get a lot worse before the European Monetary Union (EMU) will break up. But he’s certainly right about pointing out certain deficiencies.

The countries that are now in trouble (Greece, Spain, Portugal, Ireland, Italy) have tremendously benefited from joining the EMU, but funny enough, joining it has also contributed to their present problems. This is what happened:

  1. These Southern countries generally had less monetary (and budgetary) discipline compared to the ‘core’ Northern countries (Germany, France, Netherlands, etc.), resulting in higher inflation rates and expectations, and therefore considerably higher interest rates on their public (and private) debt as compensation for higher inflation and bigger devaluation risk
  2. By joining the EMU they abolished the devaluation risk and ‘imported’ much more credible monetary policy, leading to much lower interest rates (rates already started to converge when expectations were formed that they were going to join)
  3. These much lower interest rates led to a boom in lending and spending, both in the private sector (Spain’s and Ireland’s real estate boom) and in the public sector (the roots of Greece’s budgetary crisis), especially because the budgetary discipline necessary to join the EMU (the so called Maastricht criteria: having a public sector debt no bigger than 60% of GDP and a budget deficit of no more than 3% of GDP) was relaxed after joining. Electorates and politicians were tired of that discipline, and the much lower interest rates made financing deficits cheaper anyway.
  4. The spending boom not only led to larger debts and deficits, but to higher inflation. Since these countries could no longer devalue their currency, higher inflation, especially accumulated over years, let to an erosion of competitiveness, large trade deficits and hence imports of foreign capital to keep the party going.
  5. The financial crisis made all of this much worse, especially in those countries where economic growth relied rather heavily on real estate (Spain) and/or finance. Problems became especially acute in the country that relied on both (Ireland), but luckily enough, that country had done very well economically in the two decades previously, so it had more flesh on its bones (it has also embarked on some incredibly harsh measures to counter the crisis).
  6. In other countries (Greece, Italy, Portugal) it just exposed the underlying lack of competitiveness and budgetary discipline.

Now, people like Soros question whether the EMU is still a viable project.

Soros: Euro’s Future in Question Even if Greece Saved
Monday, 22 Feb 2010 07:18 AM

A makeshift assistance should be enough to rescue Greece but bigger problems facing Europe would leave the future of the euro currency in question, billionaire investor George Soros said.

Writing in the Financial Times, Soros said what the European Union needed was more intrusive monitoring and institutional arrangements for conditional assistance.

He said a well organized euro bond market was desirable.

“A makeshift assistance should be enough for Greece, but that leaves Spain, Italy, Portugal and Ireland. Together they constitute too large of a portion of euro land to he helped in this way,” Soros said.

“The survival of Greece would still leave the future of the euro in question.”

Greece’s deficit swelled to 12.7 percent of gross domestic product in 2009, way above the EU’s cap of 3 percent.

Greece has pledged to reduce its budget deficit to 8.7 percent in 2010.

On Saturday, a magazine reported Germany’s finance ministry has sketched out a plan in which countries using the euro currency will provide aid worth between 20 billion and 25 billion euros ($27 billion to $33.7 billion) for Greece.

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We think that things have to get worse, a lot worse for the EMU to break-up. Contrary to the previous situation, one immediate advantage of the weak countries would be that it enables them to devalue and restore their competitiveness. Under the EMU, they can’t devalue (as they have the same currency as the other countries, needless to say), so they’re facing a long period of deflation to get their price level anywhere near competitive levels again.

And deflation is a dangerous beast. Once entrenched, it’s very difficult to get rid of, especially in these times as central banks everywhere are already pulling out all the stops to defeat deflationary forces. As we’ve earlier argued, it would actually be a good thing if inflation elsewhere would be higher.

In that case, the weak countries could re-establish competitiveness without falling prices, their prices would just have to increase less than those of their trading partners. Without inflation though, this is not possible.

So how to proceed? Ireland (especially hard hit by the financial crisis as their economy relied much on real estate as well as finance) is showing the way with a really drastic economy drive in their public sector, cutting wages up to 20%. Of course, this is a bit of a catch 22 situation, as this will worsen the economic crisis (consumer spending declined by a whopping 7% last year), and a lower GDP automatically increases public sector deficits and debt relative to it.

If this medicine would be taken by all of the weaker, Southern European countries, this would have a noticeable effect on the European economy. It’s for a reason that the IMF and central bankers have warned against premature tightening of policy.

But what’s the alternative?

It is the lack of a real alternative that leads people to speculate about a break-up of the euro area, and in the process, they are actually providing at least a little relief. The euro is tanking, and this both stimulates the euro area economies, and increases inflation (as imported goods and services become more expensive). And that is good. So people should perhaps speculate a little more about a break-up of the euro…