Friday, February 12, 2010

Hanging In The Balance - The Future of The Eurozone

The future of the Eurozone seems to be decidedly hanging in the balance following the recent meeting of EU leaders in Brussels where it was stated that the EU stood ready to help Greece confront its financial crisis but failed to spell out exactly what form such help was going to take. As a result the common currency continued its downward path and investors fretted about the absence of any clear commitment to a bailout package, asking themselves whether the Greek government would be able to handle the very difficult process of change that is being demanded of them single-handed. It still isn't clear whether the EU decision is a strategy to force the Greek government to seek aid from the IMF, or whether Europe's leaders really believe a simple declaration of support will be sufficient.

This communicational deficit has now become a real handicap as all it does is pile ever more confusion on confusion. As Nobel Economist Paul Krugman continually points out, the problems being experience on Europe's periphery in countries like Greece and Spain are not simply fiscal ones, they are about structural imbalances and lack of competitiveness, and raise questions which go to the heart of the functioning of the common currency.

In Spain's case the position is even clearer than in the Greek one: before the housing bubble burst there simply was no evident fiscal problem - indeed the country was running a fiscal surplus. Spain's current fiscal problems have only arisen due to the attempt to solve a competitiveness problem using fiscal stimulus as a means.

The Eurozone's future seems to be hanging in the balance since economists, analysts and financial markets alike take the view that current wave of policy initiatives emmanating from the centre constitute a continuing process of too little, too late. Countries like Greece and Spain would seem to have little alternative to carrying out a substantial process of deflation (internal devaluation), and doubts about the effectiveness of the currently proposed remedial action are only further fuelled by the attempts of some of the parties involved to deny that this is necessary or desireable.

Evidently such outcomes were not anticipated when the monetary union was set up, but that is no reason to now deny their reality. Equally, it was hoped that monetary management could be carried out on the basis of a hybrid institutional structure (the ECB plus national fiscal policy, with "light" monitoring from the centre via the Stability and Growth Pact), and that no bailouts or closer political integration would be needed. Again, it is now evident that this methodology simply doesn't work, but there is no road back. The biggest challenge now facing the EU is thus one of its own making - Europe's leaders need to be bold and resolute enough to convince markets that they understand and will do what is needed. That is to say they will implement the evident institutional changes necessary to put the process of monetary union on a firmer and more sustainable institutional footing.

As custodian of the shared currency, the European Central Bank has operated more by stealth than by dictat in the present crisis, quietly opening lifelines to all the most seriously affected countries by effectively buying their government bonds through specially created credit windows. This softly-softly approach worked for a time, keeping much of Europe's periphery in a state of fragile equilibrium, where countries who found their economies folding in on themselves had no real incentive to takle their problems by the roots, but were able to survive from one day to the next via an intravenous feed of ECB credit. They were able to do so until a few weeks ago, that is, when it finally became apparent that ECB President Jean-Claude Trichet, and his German anchormen over at the Bundesbank had gotten tired of simply funding procrastination, and needed to see some signs of real progress. Ironically it might have been the rapid recovery in the French economy, and the growing pressure from France for an exit strategy from the emergency crisis measures, that finally set things off.

And now, no matter how many times Monsieur Trichet calls the idea of Eurozone break-up absurd, market participants remain unconvinced. So what steps does Europe really need to take to save the current version of the Eurozone 1.0 from collapse, or steady disintegration?

In our forthcoming report we will.

i) argue that, the EU leadership should recognize that, despite all the associated difficulties, the IMF has unique expertise in designing programs that can pull countries back from the brink of financial collapse. As such a partnership with the IMF in the transition to Eurozone 2.0 makes a lot of sense. The latest indications are that the IMF could well be brought in to offer "technical assistance plus" to monitor the conditionality of national level agreed programs with a brief of reporting back to the EU on the degree of progress made. This IMF-EU tandem makes a lot of sense under current circumstances. The way forward from here is not written in tablets of stone, and improvisation should be seen as a positive feature, and not a sign of weakness.

ii) outline in detail and evaluate the measures EU finance ministers will agree to in order to oversee the implementation of the "new generation" Stability Programmes.

iii) review the way that ECB funding has operated to avoid the development of classic balance of payments crises in the respective member states, drawing attention to both the strengths and weaknesses inherent in this approach, and argue the the Eurogroup now needs to create its own multilateral funding system to redistribute fiscal risk and ensure that adequate finance is available to each nation as it adheres to the jointly agreed conditional programs.

iv) examine what is involved in the processes of internal devaluation which are likely to be introduced in those member states with severe competitiveness problems, and explore the mechanisms though which these can operate.

v) finally, explore what might happen should the unthinkable - Eurozone disintegration - come to pass, and look at the implications for the global financial system of this worst case scenario.

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