Whither the Euro: Safe Harbor or Fractured Fate?Published: June 23, 2010 in Knowledge@Wharton
This spring, as American markets continued their somewhat shaky recovery from the global financial crisis, Europe, which had been a relatively steady force in the worst days of the U.S. downturn, began to shudder with its own concerns. The possibility of sovereign debt default and financial contagion across the Continent sent new waves of worry around the world. A massive stabilization package, valued at nearly $1 trillion, seems to have calmed markets for the moment, but the fate of Europe's unified currency, the euro, is not totally secure.
One camp of observers is betting that the euro is indeed safe. Though the currency is likely to remain volatile, the rescue package put forth by the European Central Bank (ECB) and the International Monetary Fund (IMF) has gone a long way toward easing fears about whether the European Union's monetary system will endure, according to this view. What's more, the euro still earns its keep -- in addition to helping create a larger, more efficient integrated market, it reduces transaction costs and the need for companies to hedge against currency fluctuations. The euro has also allowed Europe to develop a stronger financial sector. "Nobody has a crystal ball, but I think the euro will continue," says Saikat Chaudhuri, a Wharton management professor. "It is now too important a currency for the various member countries in the EU not to ensure its survival. They are not going to let it fail."
But another camp sees potential fractures ahead. It is possible, this group argues, that Germany and other nations will break away from the monetary union if political stress on the euro continues to build. The currency's future, they say, depends on how much money German taxpayers are asked to put up to bail out their neighbors. "If they keep trying to push the current political option, [the euro] will collapse," Wharton finance professor Franklin Allen says. "At some point, the German taxpayers will have to put out real money." When that happens, he adds, "the voters will force Germany out" of the euro.
Allen suggests that Europe could then split into two monetary blocs, a northern group centered in Germany and a southern one oriented toward France. Under this scenario, Germany and others who quit the euro would continue to remain in the European Union since the EU is much more than its currency. But the repercussions from a split over the euro, if it should happen, would be broad and deep since it would certainly raise new concerns about the sovereign debt situation and spark new market turmoil.
Under terms of the Maastricht Treaty, the euro was launched in 11 countries on January 4, 1999. Today, it is the currency of 16 of the 27 members of the EU. The United Kingdom and Denmark have negotiated exemptions from using the euro. Most of the other EU members not using the currency are in Eastern Europe and have pledged to adopt the euro as their economies grow stronger. The euro traded at $1.18 on the day it was introduced and has ranged in value from 84 cents in October 2000 to $1.59 in April 2008. This year, it has declined from $1.45 in January to $1.19 in early June before rebounding following the adoption of the stabilization package and a successful sale of Spanish bonds.
This week's decision by the Chinese government to allow its currency, the yuan, to appreciate should also help the euro, according to Allen. However, he cautions that the effect could be limited. In his view, the move by the Chinese appears to come as a gesture to appease finance officials of the G20 nations, which are scheduled to meet in Toronto this weekend. The United States and other developed nations have been pressuring China to allow its currency to gain in value, which would permit other countries to compete more easily against China in global markets. Allen predicts China will allow its currency to go from 6.8 yuan against one dollar to perhaps 6.5 yuan. "What will happen after that, we'll have to see," he adds.
The current concerns about the euro initially surfaced last winter as doubts emerged about the financial strength of some members of the euro zone, Wharton finance professor Richard Marston notes. Analysts began to use the acronym PIIGS to identify the countries most at risk from escalating debt loads -- Portugal, Ireland, Italy, Greece and Spain. The crisis escalated this spring when the new Socialist government in Greece came to power and discovered that the nation's deficit was not 3.5% of GDP, as stated by the prior regime, but 12.5%. The estimate has since increased to 13.6%. "That alerted the markets and started the concerns about fiscal risk in general with some EU countries," says Marston. As a result, financial markets and rating agencies downgraded debt in these countries, leading to a decline in the value of the euro and nervousness throughout global financial markets.
On May 11, EU finance ministers and the IMF announced a €750 billion (nearly $1 trillion) rescue aimed at stabilizing markets. Marston points out, however, that the new European Stabilization Mechanism (ESM) does not diminish or restructure the debt. It merely provides a mechanism to rollover the obligations. The package was structured that way because Germany and other Northern European countries would not have agreed to finance a bailout for EU members that are perceived to be living beyond their means. The ESM fix will not solve the underlying problems in the financially troubled countries, Marston says, but it does buy some time and will prevent the sort of contagion that could lead to another crisis in global markets. Another financial panic could be disastrous at a time when the world's economic systems remain weak following the 2008-2009 crisis. "The debt is still there, so Greece, Portugal and Spain are all going to have to cut back to get their fiscal house in order," Marston adds.
The Limits of Self-Restraint
That kind of belt-tightening, however, will be extremely difficult. In addition to their fiscal problems, these countries are also less competitive internationally. Monetary policy for all of the countries that use the euro is set by the ECB in Frankfurt. Without the ability to devalue their own currency and export their way out of financial problems, observers say the weakest European economies will be unable to stimulate trade and economic growth that could generate the tax base to pay down their debt.
Even before the euro was adopted, economists raised concerns about this disconnect between the single monetary authority and the continued ability of member nations to set their own fiscal policy. As a result, the European Monetary Union required countries to keep their deficits at 3% of GDP or lower and the EU has the right to impose a tax of 0.5% of GDP on countries that exceed the limit. According to Marston, this provision was added by the Northern European countries mostly to keep Italy in line; Greece "wasn't even in the picture." However, the first countries to violate the rules were France and Germany. "At that point, [France and Germany] fudged," Marston adds. "That left a lot of ambiguity because they hadn't followed their own rules."
He applauds the new government in Greece for standing up to the problem -- which led to street riots over new austerity measures to contain government spending. "It was courageous of the Socialist government to fess up to the truth," Marston asserts, noting, however, that the proposed solution is not without risk. The government has said it would reduce its fiscal deficit to 8.1% of GDP this year and below 3% in 2013. Marston considers those cuts to be "draconian." In fact, he argues, implementing overly harsh deficit reductions during a recession only makes an economy weaker, which in turn makes it all the more doubtful that the country will be able to pay off its obligations.
At the height of the European crisis, some analysts predicted that the single currency would break apart. Albert Edwards, a strategist at Paris-based Société Générale bank, said the euro's collapse was "inevitable." Meanwhile, the Centre for Economics and Business Research (CEBR) in London predicted that the euro would fall to parity with the dollar in 2011, "assuming the euro exists then." Despite those bleak forecasts, Marston reckons the euro will not fail. "In the most catastrophic, horrendous circumstance where all the PIIGS default, we will still end up with a ... euro area [comprised] of the strong countries," he suggests. "I don't think Holland, France, Germany, Belgium, Luxembourg and a few others are going back to national currencies. There will always be a euro." The most likely scenario, in his view, is that the "situation will quiet down" and that European officials will then negotiate at least a partial default by the Greek government. "I just don't see the Northern Europeans absorbing the debt and it will be difficult to cut too much," he says.
Wharton finance professor N. Bulent Gultekin agrees that the euro is here to stay, noting that the advantages of the current system still outweigh the weaknesses. And he asserts that the ECB has been successful in achieving its mission of providing price stability -- an achievement that can largely be attributed to Germany's longstanding fear of inflation, a legacy of the instability following World War I that led to World War II. Gultekin predicts, however, that the euro will continue to face sharp swings in value because the ECB and the Federal Reserve in the United States have been pumping liquidity into global markets that will result in added volatility. "My guess is we probably have passed the worst, but we will have these fluctuations for some time," says Gultekin, who adds that an aging population in Europe will continue to limit opportunities for growth on the Continent. Nonetheless, economists who are skeptical about the euro's long-term viability underestimate Europe's commitment to the currency, he notes. To go back to national currencies now, he says, is "unthinkable" in Europe.
By contrast, Allen and others say that while Germany benefits from the euro system, there is a limit to the benefit. Germans may be willing to foot the bill for a Greek default estimated at $50 billion, Allen allows, but would balk at paying the estimated $500 billion to $1 trillion to wipe out bad debt throughout the euro zone.
Wim Kösters, professor of economics at Ruhr University in Bochum, Germany, also sees problems ahead. The ECB's response to the crisis has been to create a "transfer union" in which the "stronger countries have to support the weaker ones," he says. "You can do that once, but that's not the right way to solve the problem and it is not a sustainable solution. The monetary union could break apart." According to Kösters, the ECB's recent actions reflect a shift in thinking from a systematic, rules-based German approach to a more French-flavored solution focused less on economic governance than on "dealing with the problem on an everyday basis."
Going forward, the markets will be more influenced by fundamentals, such as growth in GDP, corporate earnings and employment, than by the psychology of panic that has dogged the euro in recent weeks as markets reacted strongly to reports on the status of government debt or European bank obligations, Chaudhuri notes. "The general sentiment has been that if you can't tell how bad the problem is, assume the worst," he says. "Right now, given that [the United States is] starting to come out of our own crisis, anything that may potentially derail the recovery spooks the markets." Adam Cole, global head of foreign exchange strategy at RBC Capital Markets in London, agrees with Chaudhuri that the euro will survive, though it is likely to remain near its current low valuations or perhaps decline more. There is even a small chance that the euro will reach parity with the dollar, he says.
Will reforms emerge from all of the recent turmoil? Cole predicts that monetary officials and policy makers will consider new ways to centralize fiscal policy, but will not go as far as to create a formal authority to oversee national spending. "We'll get a much tighter look at the rules and regulations of what individual governments can and can't do," he says. Although some of the recent instability in the euro might have been avoided if national governments had complied with the European Monetary Union's original rules, he notes, the system must tailor new policies that take into account the possibility of externally driven crises and "it needs to be made clearer how you would accommodate extraordinary circumstances."
In a recent testimony before the EU Parliament, ECB President Jean-Claude Trichet said Europe needs a "fiscal federation," which would increase the power of the EU to intervene in members' budget and fiscal matters to protect the rest of the union from the kind of problems they are now struggling with. Trichet, however, did not suggest that the EU receive the full power to drive fiscal decision-making in member nations. Allen is "very skeptical about this notion of across-euro-zone mechanisms. I just don't think [the member countries] have the politics in place to do it yet." Further, he notes that the ECB's approach to solving the current crisis focuses heavily on deficit spending, while in Spain the problem lies in huge private-sector imbalances.
In the same vein, Charanjeev Chana, market economist at Stone & McCarthy Research Associates in London, points to numerous "u-turns" taken recently by the ECB on such policy issues as allowing the IMF to participate in the stabilization package and suspending rating requirements. The u-turns "dented" the ECB's credibility, he says, and may have been primarily responsible for the sharp depreciation in the euro. Chaudhuri recommends an increase in oversight for European authorities to help countries out of the current crisis and prevent similar ones in the future. Countries should face punishment for misleading monetary authorities, as happened in Greece. The punishment could include expulsion from the monetary union, but Chaudhuri acknowledges that is not likely to happen.
For his part, Allen suggests that the system needs a bankruptcy mechanism, similar to the Chapter 11 process in the United States. Such a system would allow European monetary officials to appoint a trustee to oversee a bankrupt nation and to issue debt, similar to debtor-in-possession financing, to keep the country operating.
Curtain Raiser for the U.S.?
According to Marston, the events in Europe may foreshadow developments in the United States. "We know that down the line the U.S. government is going to have a serious problem with its fiscal imbalances," he says, adding that the country's deficit is roughly the size of Greece's as a percentage of GDP. He notes that while the U.S. economy is recovering, government spending is likely to increase even further than it already has as the Baby Boom generation retires and begins to collect on government health and pension benefits. Last summer, Marston would have predicted that interest rates in the United States would be starting to increase by now. Instead, he asserts, the uncertainty about the euro has drawn increased investments in U.S. bonds, which, in his view, will delay rate hikes in the United States by nine to 12 months.
The recent financial panics in the United States and Europe reflect the growing level of integration of global markets, Chaudhuri points out. While economic unification, including the single currency, drives growth, it also makes national economies more vulnerable to contagion when problems surface. The U.S., Chaudhuri notes, was recovering steadily until markets were unnerved by the problems in Europe. He says the only way to halt this kind of contagion is cooperation on the global level to change the incentive structure for banks, increase oversight or change risk management practices. Although Chaudhuri does not envision a global equivalent of the ECB or the Fed, he calls for better coordination of finance at the G8 level and across all nations. "Even if there is no formal institution, I don't see why we won't have coordination at least on certain directions," he says. "Everybody will have their own interests so it would not be possible [to have] one entity, but we do have the World Bank, the IMF and the ECB and I would expect global banks to coordinate on major political initiatives."
In mid-June, as the G20 prepared for its meeting in Toronto, France, Germany and the United Kingdom announced jointly that they would each introduce bank levies to offset the cost of any future financial crisis and they urged other members of the G20 to follow their lead.
Even though some countries have taken steps to curb future meltdowns, comprehensive regulation has been stymied by a lack of agreement on the fundamental question of how much regulation is necessary, Chaudhuri contends. The United States has always favored less regulation and a more "pure" form of capitalism. Europe, he says, "comes from the opposite perspective."
"Until the U.S. on one end of the spectrum and Europe on the other can find the right balance," he asserts, "you won't find the right policies to build the system to that end."