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. The Crisis

As the Euro Zone clubs with a single currency, trade imbalances are bound to occur between countries (unless each country has the capacity to manage their deficits trading with the outside world which is no more than wishful thinking). Individual governments lack the sovereign ability to devalue the currency and it does cramp the power to expand fiscally. When coupled with the fact that the rules of Euro Zone do not allow more the 3% fiscal deficit, de-growth seems like the only available option unless the EU as a whole is willing to do a Fiscal expansion. With the aftermath of the 2008 debacle, nations across the world are still struggling to create internal employment. Under the circumstances investments are not easy to come by either, unless they are made extremely attractive. In case of Greece it means potentially selling their assets at rock bottom valuations and it still may not be enough to fund their deficits. Additionally it is also dangerous to let the external entities to have power in the economic development. Greece is now confronted with the difficulty to raise money as their deficits have grown extremely large and investors are unwilling to buy their bonds as the risk of defaulting remains high. The problem is not restricted to Greece. Portugal, Italy and Spain also have their deficits growing and unless some drastic measures to improve exports are introduced in these countries the process will only complicate in the coming years. The Proposed Solutions and Their Drawbacks

Bailing out countries with deficits each time is economically and politically impractical for any of the involved members. The European Union has been confronting the problem by asking the countries with deficits to take strong austerity measures.  For Greece this means cutting government employee wages year after year for the next few years, cutting pensions and cutting government spending for an unpredictable number of years. The other deficit nations will have to follow. Effectively these nations will be in a recession for years and the unemployment rate will keep growing. It also opens up the possibility of a public cry, may be an extreme outrage in the respective countries, the consequences of which will be difficult to predict.

The proposed austerity measures would ‘kick the can’ a little further if at all, but does not lay foundations for a viable long term solution. An orderly default of Greece by capitalizing the holding banks and other institutions are making rounds as a strong possibility. This takes us back to the Lehman Brother’s scenario. If implemented, the consequences will be catastrophic. Letting one investment bank on Wall Street fail (Lehman brothers) left the world in a terrible recession. Letting a country fail is a far more dire threat. A default from a country will cause a rapid capital flight from financial markets across the world, both sovereign and the countries of Euro.  Spain, Italy and Portugal would be put tremendous pressure and their bond yields could sky rocket to disproportionate levels. Despite the European Union’s  SPV to capitalize the banks holding these bonds, in case of a default, the rest of the financial world would be reluctant to do business with Europe without counter party guarantees which can create chaos in the banking system of the EU. The same scenario would be prevalent if Greece is removed from the Euro Zone. For now we can only hope sanity prevails and a better solution is worked out. Alternates

Bailing out Greece for now and capitalizing their banking system is a temporary solution.  The onus to do so largely lies on Germany as the biggest economy in the Euro Zone. Germany on its part is confronted with the question of how many countries could follow suite and how many times these packages have to roll out. It’s almost a foregone conclusion that Germany’s average taxpayer will bring the coalition government down if their money is used for the bail out. In such a scenario neither the establishment nor the people are in favor of it. On its part Greece has been guilty of forging accounts to enter the Euro Zone and therefore does not have too much credibility among the other members.

A fiscal expansion of the entire Euro Zone (as proposed by the Americans) is unlikely as of now .The German’s on their part believe, it would be an unsustainable bubble and their bitter historical experience of Fiscal expansion rules out the possibility of their making an effort in this direction.

An economically viable solution for the process is for the whole of Euro Zone to have a central government collecting taxes and making Fiscal policies, which means the EU, must merge into a single country or Fiscal Union.  Socially this would mean German’s embracing the Greek and French as countrymen and looks like a dream far from reality .The solution is politically and socially improbable and any effort in that direction might take decades to be a reality if at all. A few temporary solutions and part bail outs can postpone the problem for now.

Conclusion  

The Euro Zone has been confronted with the problem more rapidly than the others due to the currency binding. If the default of Greece does happen (whole or partial) the bond markets in the other weak nations will see a drastic sell off making the conditions for all the weak nations even more difficult. The flight to safety will prompt more investors /banks seeking German bonds or US treasury bonds. A world wide sell off is a very strong possibility; increasing yields would add to the pressure of countries trying to roll over or raise fresh capital. The dollar will continue rising against all other currencies of the world, which in turn would be detrimental for the cause of the US economy which is desperately trying to increase its exports and put its own house in order. Europe for now is starring in the face of disintegration and unless the political leaders develop the will to form a Fiscal union with financial powers of the Central parliament, the Euro Zone will be hard to save. The problem in itself is big enough to cause an economic earthquake measuring 11 on the Richter scale across Europe. The impact will be heavy on the United States too. The rest of the world will also tremble in different magnitudes. For now it’s time to live on some prayers.