“The Balkan region produces more history than it can consume.” Even though one may find Winston Churchill’s famous observation unpalatable by today’s code of political correctness, one can only be struck by its witty perspicacity. Albeit not comparable to triggering a world war, the region—through Greece’s economic predicaments—could once more be about to undermine (economic) stability in Europe. Indeed, how the EU deals with Greece’s debt crisis may end up defining more than the mere near future of the Greek economy; the future of the European Monetary Union (EMU) could also be at stake.
In all fairness, Greece’s problems alone are very unlikely to be fatal to the union. Nevertheless, the unfolding of events and contagion could end up sapping the credibility of the euro. For if EU members are unable to efficiently respond in a coordinated fashion to the Greek problem, one could ask, how can they provide an efficient and coordinated response to a similar situation involving one of the big EU economies such as France, Italy or Spain?
Paraphrasing Deepak Lal from UCLA, this lack of credibility is inherently related to the way the euro was created: by putting the cart of monetary integration before the horse of political union. This deficit in political integration, however, would not be so critical were the EMU to fulfill the conditions of an “optimum currency area.”
Within a currency area, dealing with high unemployment caused by asymmetric external shocks—and the resulting political pressures—requires one of two things: flexible prices and wages, or easy migration within the union. Neither exists within the EMU: Wages are highly inflexible, and language and customs are mighty barriers to migratory flows (except, of course, in the top echelons of society). Furthermore, the stability-pact precludes dealing with unemployment via exchange rates or (expansionary) fiscal policies, and fiscal transfers—bailouts in plain speak—between member states in case of crisis.
These inadequate institutions lead to situations such as Greece’s. When faced with rapid capital outflows, stiff labor markets make price adjustments between the tradable and non-tradable sectors slow, if not impossible, leading thus to unemployment, recessionary pressures and political instability. This, in turn, has a negative impact on fiscal revenues, which undermines the ability or willingness of governments to service their debts.
Today in Europe, stressing these institutional shortcomings may readily earn one the tag of Euro-skeptic. Be that as it may, facts are facts. To quote Churchill again, “Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened.”
Take, for instance, the volatility of the euro during the Greek crisis and compare it to the stability and even appreciation of the dollar—at the epicenter of the global financial meltdown—during the worse of the global financial crisis. Much of this is explained by the much stronger credibility of the dollar face to the euro.
Many, however, argue—or hope—the euro is growing to become an alternative or even a substitute for the dollar as the main global currency. To support these views, their proponents stress the steady rise of the euro in sovereign foreign reserves and the future weakening of the dollar as a result of the spike in public expenditures during the crisis. The loose monetary policy, the liquidity measures, the asset purchase and bailouts used to avoid deflation are, truth be told, very likely to lead to inflationary pressures. As these pressures grow in the US, they argue, the dollar is bound to lose value, which in turn would end up eroding its status of safe heaven.
Conspicuously absent from their discourse remains the fact that although the euro has indeed grown to constitute more than one third of foreign reserves in the past decade, this has mainly been achieved at the expense of the yen and the pound sterling. During the same period, the dollar actually rose from half to nearly 60 percent of sovereign foreign reserves, the highest mark in over 30 years.
This trend might seem at odds with the dynamics of the American burgeoning public deficits and debt. As it happens, however, by considering a simple equation of costs and benefits one realizes that there are systemic incentives supporting the dollar that are absent in the case of the euro. In reality, the market seems to question the probability of a collapse in the value of the dollar by acting as if foreign governments would readily step up to support the dollar if private financing were to prove insufficient.
This market belief is not far-fetched. Take the instance where speculation would lead to a run on the dollar. In this case scenario, the American current account deficit would become untenable, leading to a depreciating dollar, rising interest rates and collapse of asset prices. The systemic reverberations of such events alone are scary enough.
The story, however, runs deeper than that. The American current account deficit is part, many believe, of what has been called the global “savings glut”—referring to the massive current account surpluses ran by Asia, the Middle East and, to a lesser extent, Western Europe. For reasons extraneous to our story, these regions save more than they invest domestically and therefore need a profitable and dynamic “investment fund” for their “extra capital.” This is exactly what the US is in the eyes of observers such as Martin Wolf—a massive, safe and dynamic hedge/investment fund, a “borrower of last resort” if you will. If this fund goes bankrupt—or is unable to sustain its current account deficit—a world recession would very likely ensue.
This is not to say that the euro is an unviable currency. The euroland has a priceless opportunity to reform its institutions in order to create the necessary conditions for a credible euro. In the absence of similar business cycles, fiscal transfers or bailouts are fundamental. The substance of the €110 billion agreed by European leaders and the International Monetary Fund is a positive step forward if Europe is serious about keeping the euro around in the medium and long run. This system needs still to be honed and institutionalized with a mechanism to minimize moral hazard. These costs are nothing more than payments for the failure to put such a system together at the inception of the EMU and for admitting countries with such a dismal history of public finances management as Greece in the eurozone.
As wagers are being raised on whom the next victim will be—mainly pointing at other Mediterranean countries such as Portugal and Spain—the dream of a strong euro superseding the dollar as a safe heaven for investors is ludicrous. Although the dollar is likely to fall in the short run, in the long run, when 30 year bonds mature no one believes the dollar will have disappeared. At this stage, no one can be sure the euro will even be around in 30 years. Although stronger, investing in the euro requires caution.
Daniel Capparelli
