Is A Catastrophe Awaiting Europe?

This is a guest post by Sundar Parasuraman

Introduction

The Euro Zone was formed in 1992 where in 17 different countries decided to adapt a single currency. It required these countries to maintain strict fiscal targets (below 3%) and debt GDP ratios to be a part of the Euro Zone. The idea of promoting trade without having to run the risk of currency fluctuations, and an alternate for the USD were seen as the main objectives behind this move. The European Central bank was formed to oversee monitory operations in the process. The biggest risk in the process was the surrendering of each country’s currency sovereignty. In effect a monitory union was formed without a Fiscal union.

To understand the same Fiscal policy are budget allocation that governments decide. The government runs deficits in their budgets year after year to enable the private sector increase spending. This in turn means governments actually create money by running these deficits. These deficits are funded by raising bonds. The ratio of the deficit is directionally proportional to both the growth as well as the risks. The debt repayment happens with various processes including tax collections, sale of licenses etc.  Times of crisis occur when the governments are unable to fulfill these obligations.

Monetary policy is meant to ensure orderly execution of the banking system, and is a function of the central bank. European Central bank is the body in charge of the monetary union. Each of these countries does have independent central banks too.

The advantage that countries with sovereign currency have is to devalue their currency in the hour of a crisis. Although the process would be painful and make imports more expensive it does provide a few options and makes the internally produced goods cheaper. If countries lack production capabilities and imports are inevitable the process gets complicated. The processes and policies become even more complicated when countries do not have the power over their currency.

The whole process above is applicable for a single currency and taking the case study of India, Mumbai invariably collects more taxes than the entire Utter Pradesh (UP). The central government spends more on UP then on Mumbai to maintain a balance for the currency. This process happens on an ongoing basis and despite the resentments expressed by a few, there is a central parliament deciding the fiscal policy. Being a single country, the process is neither witnessed nor evaluated by the common man and the political compulsions to change these remain low if any. Imbalances are bound to happen in trade and this is true for all countries / monetary unions.  If the trade deficit between import/export rises continuously the external debt is the real threat.  Despite many constraints the flexibility to devalue the currency does give some room for improvement.