Will the Euro Zone Contract?

Will the Euro Zone Contract?

August 24th, 2011 // 10:13 am @

Countries pulling out of the Euro has been described as “Unthinkable” by politicians. When politicians make such statements it is time to consider that possibility as being very real.

The economic reality is, a shrinking of the number of countries in the Euro zone is now a very real possibility. The major Euro zone countries have been trying to quell the sovereign debt issue (The debt of member courtiers and their ability to repay that debt) for months. They have done what politicians do, they come up with what is politically possible, which is often economically too little too late.

The underlying issues of the debt crisis have not really been tackled and are becoming more serious every day. With larger and larger countries coming under threat and needing fiscal protection. Worryingly both Italy and Spain have needed significant fiscal support over recent days.

Greece would likely be the first Euro zone member to leave, but if that happened, they would possibly not be the last. A few unpleasant facts may make their departure necessary:

  • The Euro zone simply does not have the cash to save Greece. The larger economies that were supplying the cash increasingly have their own fiscal issues, and in that situation pumping more cash into Greece is difficult.
  • There is a lack of political will. Germany and France both face elections shortly, and explaining why they would want to pump more and more cash into other economies is a hard sell to their electorate.
  • Further fiscal integration is not politically possible. One obvious way to solve the debt issue is to issue what has been called “Euro Bonds”. In effect, this would mean all borrowing by all Euro members would be guaranteed by all other members – this is economically and politically explosive. In essence it means the major countries of the Euro, primarily France and Germany guarantee every other country’s debt. Politicians have no mandate for such a move, and it would be unlikely to get one from their electorate.
  • Greece could want to pull out of the Euro. It would be long term economically suicidal, but it could be popular in Greece in the short term. It would avoid Greek politicians and the population from taking responsibility for solving the mess. It is so much easier to blame the Euro and the Euro zone.

So what happens if Greece wants to or is forced to pull out of the Euro zone? Well that depends on whether it is done in an orderly fashion or in a panic. Sadly the latter is much more likely.

This poses a significant legal issue. There is technically no legal way to leave the Euro zone without leaving the wider European Union. So the legal status of Greece and whatever new currency it introduces would be very dubious. That said the numerous legal issues would be nothing compared to the economic and political ramifications.

Pulling out of the Euro in itself does not in any way help Greece deal with its debt issue. It is only when that withdrawal is linked to a default on its debt that it makes any sense to Greece.

What would probably happen is Greece sets up a new currency which lets call the ‘new drachma’. Then, it either unilaterally puts debt repayments back, or pays the debt off in the new Drachma at some nominal value. What that means is the Greek government says, for example: it will pay off Greek debt by paying one new Drachma for every Euro it owes. The new Drachma value plummets to 4 Drachma to one Euro. The Greek government thereby effectively only has to pay back a quarter of its debt. This is obviously illegal but governments can do this if they choose.

The impacts for Greece of a withdraw from the Euro and a subsequent default include:

  • Things they export become easier to sell, as they are cheaper. This could drive a short-term upswing in economic growth, which could make politicians very popular in the short term.
  • The government does not have to repay much of their borrowing making it possible to avoid short-term fiscal austerity being forced on them. Again very politically popular.
  • Greece loses all the fiscal support it gets from the Euro zone and possibly the European Union. In the long term this is damaging but in the short term survivable.
  • Greece will struggle to borrow money from anyone. Who would lend to someone who just defaulted on a previous loan? Any gain in the longer term would be disastrous, but in the short term it’s survivable.
  • All the benefits of being part of the open Euro zone are lost.

Beyond all that Greece would lose the opportunity to transform itself into a properly functioning modern economic state. In essence they would be opting for short-term relief but losing out on long-term critical change that Greece so badly needs to ensure long-term success.

The wider European impacts of a Greek withdraw from the Euro and a subsequent default include:

  • Confidence in the Euro will crash. If Greece does default on its Euro loans then who would be next? This risk of further countries defaulting would drive the cost of borrowing even higher. This alone drives up government costs forcing them to cut back elsewhere.
  • Many European banks including the European Central Bank are owed money by Greece; if they default it will damage these banks. This could trigger these banks to fail or require government intervention to save them.
  • Greece owes money to many European Governments and if it fails to repay it, then it is a further fiscal issue for those countries.

Shrinking of the Euro zone, particularly one done in panic could therefore trigger a worldwide recession.

In view of this, one can understand why countries’ leaving the Euro is described as “Unthinkable”. However, what is unthinkable today so often is what in fact happens tomorrow. To save the Euro zone as it is requires massive funds from Germany and France, or willingness by them to guarantee a weaker country’s debt. Both of these options look unrealistic.

It is interesting to watch as politicians manage to persuade themselves that because they think it is unthinkable it will not happen.

There are massive economic forces acting to split off some countries from the Euro zone. It will take much more than political rhetoric to stop those forces.



Category : Blog &Other Thoughts &The Future

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