Monday, 23 January 2012

The Fundamental Flaw of the Eurozone

Many people believe the Eurozone was untenable, impossible, and prone to failure, but this is not true. The Eurozone problem stems from members that cannot control their budget deficits. Most governments are also afflicted with this problem of deficit spending, when governments continually spend more than what they collect in taxes. Unfortunately, deficit spending during the Great Recession ruined the Eurozone and it will lead to its demise and break up.

The introduction of the Euro was efficient and beneficial to the Eurozone. When 17 countries use the same currency, money, resources, services, and goods can easily cross borders. (Britain still uses its Pounds and Hungary uses its Forints). In theory, regions in the Eurozone would specialize, causing production to expand and trade and commerce to flourish. With a unified currency, banks in one country could lend to citizens, businesses, and governments in other Eurozone countries. The exchange rate risk would be zero since everyone uses the same currency. Businesses could invest in other Eurozone countries with no worries of inflation or depreciating currency. Consequently, the Eurozone should unite Europe and help expand its economy.

Where is the origin of the European Debt Crisis? The problem lies with budget deficit spending, which the Maastricht Criteria explained explicitly. Before a country joined the Eurozone, a country's budget deficit could not exceed 3% of its Gross Domestic Product (GDP), and its government debt to GDP ratio could not exceed 60%. The 2011 statistics for some of the Eurozone countries are listed below in Table 1. Most Eurozone members have structural budget deficits and growing government debt far exceeding the membership criteria, specified in the Maastricht Criteria. Of course, the Maastricht Criteria impose many more conditions, but deficit and debt criteria will lead to the demise of the Eurozone and its break up.

Table 1:  2010 Budget Deficit and Debt for Select EU Countries

Country

Budget Deficit to GDP (%)

Government Debt to GDP (%)

France

7.0

81.7

Ireland

32.4

96.2

Italy

4.6

119.0

Greece

10.5

142.8

Portugal

9.1

93.0

Spain

9.2

60.1

Source:  Eurostats, http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-26042011-AP/EN/2-26042011-AP-EN.PDF

Where did the crisis originate? Europe was doing well until the 2007 Great Recession. Recessions always reveal weaknesses in an economy. As bankruptcies rise, employers lay off workers, and income begins falling; governments might see their tax revenue start falling. Furthermore, more people use governments’ social programs and file for unemployment claims. This becomes the heart of a financial crisis. A recession compounds a government's budget deficit. For example, let us say before the recession, the Greek government had a budget deficit to GDP ratio of 3%. We use these imaginary numbers for illustration purposes only. Then the recession strikes. Consequently, tax revenues fall by 3%, and government spending rises by 3% as more people utilize government's social programs and file for unemployment. Now, the Greek government becomes plagued with a 9% budget deficit that Greek leaders cannot eradicate.

Governments, unfortunately, have trouble reducing budget deficits. For instance, if the Greek government increases taxes, the citizens become angry and protest. If the Greek government reduces government benefits, then its citizens again become angry and protest again. Reducing budget deficits have another side effect. When a government boosts taxes or decreases its spending, the economy slows down. Consequently, the Greek government has only one option – to sell bonds to investors to cover these large deficits.

A government selling bonds to cover budget shortfalls is a temporary solution. Investors will only invest in government bonds if they believe the government will repay the bonds at full value plus interest. Every year, many Eurozone countries keep issuing bonds to cover their deficits, and their debt continually climbs and accumulates. Once a country’s total debt reaches a limit, then investors will have stop buying bonds, sparking a financial crisis.

A growing debt forces the government to increase the interest rate to attract investors. Then the interest portion of the government's budget begins to grow, causing the deficit to widen even more. If a credit rating agency downgrades a country's credit rating, such as the Standard and Poor downgrade of nine Eurozone countries in January 2012, a downgrade informs investors that a government's bonds became riskier. Thus, a government must increase interest on the bonds to attract investors. Then Greece had raised the stakes by informing investors it would pay only 50 cents on every euro to its bondholders, imposing a massive negative return of 50%. This is a huge loss! Who will buy Greek bonds now, once the Greek government had screwed the investors? Unfortunately, Greece faces a bleak future, and it will leave the Eurozone and resurrect its currency, the Drachma, again.

Many countries with perpetual budget deficits have another financing option. They can print money to cover budget deficits. If the government cannot find investors to buy its bonds, then government forces its central bank to buy its bonds, injecting money into the economy. Unfortunately, injecting massive amounts of money into the economy always lead to inflation. If a country has an inflation rate greater than 10% per year, then this inflation originates from the money supply growth. Many people believe the U.S. government's massive debt will lead to a bout of high inflation. Once investors stop buying U.S. government securities, then the Federal Reserve will buy these securities, preventing the shutdown of the U.S. federal government. Government could shut down if government cannot pay its bureaucrats and agents. (I could be wrong on this. During the breakup of the Soviet Union, people still returned to work when employers have not paid workers in months.) Unfortunately, high inflation could have a disastrous impact on an economy such as the case with Zimbabwe. In Europe’s case, a member country has no control over the money supply because European Union assigned this responsibility to the European Central Bank (ECB). The ECB has only one task - maintain an inflation rate of 2% or less.

Now we arrive at the crux of the problem. Many Eurozone members have structural budget deficits, and the politicians cannot tackle them. If the politicians increase taxes or decrease government spending, then government hampers economic growth, deepening the recession and potentially sparking violent protests in their countries. Unfortunately, these countries continue issuing bonds and covering budget shortfalls until December 2011. Then investors shied away from the bonds, triggering a crisis.

The European Central Bank (ECB) kept the government bond market afloat in Europe in 2012. The ECB either guarantees or outright purchases government bonds. Once the ECB stops buying bonds, these countries have one last option, leave the Eurozone and reintroduce their own currency. Then the countries can print as much money as they need to cover their budget deficits. Unfortunately, printing money leads to inflation and a depreciating currency, but the only choice left when the politicians cannot resolve their budget problems.

The Eurozone is not flawed. It was the perpetual government budget deficits during the booms and recessions that will force countries to leave the Eurozone. If the politicians used Keynesian economics as intended, then the Eurozone could weather the recession and financial crisis. Pure Keynesian theory suggests the government should increase taxes or decrease government spending to slow down the economy during economic booms when income grows; unemployment remains low, and the economy experiences strong job growth. A government finances would improve, and it might experience falling debt. Then government would have resources for deficit financing during a recession, when government would decrease taxes and boost government spending to stimulate the economy. However, most governments used deficit spending during good times and bad until the politicians have broken the system. Now leaders have rendered Keynesian economics useless and ineffective.

The crisis scares investors away from the Eurozone. As the world moves away from the Euro, the Euro could depreciate against other strong currencies. If the Euro collapsed, the Eurozone would enter a deep recession that it would export to the rest of the world. During a severe financial crisis, a country can impose capital controls to prevent an outflow of money (i.e. capital). A large outflow of money causes a country's currency to depreciate, which deepens the recession. Great Britain has developed plans to close its borders to the European refugees and impose capital controls if the Eurozone sinks into a deep depression.

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