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Tar Babies of the Euro Zone

This diary is a follow up to an earlier diary about the Irish financial crisis. It can be found here: Irish Financial Stew. That dairy attempted to explain how Ireland got itself into its present difficulties. To understand what is happening now requires some background on the EU and its broader ongoing financial problems.

The European Union was conceived in the aftermath of WWII. The idea was that binding the nations of Europe together with economic ties could be a means of ending the endless cycles of wars. The nations within the EU have not been at war with each other for 65 years. It seems reasonable to me for the EU to claim some credit for that. As an organization it is a very strange conglomeration that has expanded in fits and starts to take much of the continent. There really is nothing comparable to it anywhere else in the world.

Americans need to understand that the EU is not the United States of Europe. The member states are still mostly autonomous governments that are joined together in asymmetrical relationships. There is a European Parliament whose members are elected by popular vote in each country. However, this body has very little real power. The electoral turnout for EU elections generally reflects the low level of enthusiasm for the whole thing. The European Commission is the center of power. It is made up of single commissioners appointed by the government of each member state. This is not an integrated federal nation state. At this point there are essentially two tiers of membership. There are 27 states that are members of the EU, but only 16 of these are members of the EMU, the European Monetary Union. These are the countries that share the euro as their common currency. Ireland is one of those 16. We are primarily concerned with the EMU countries and their economies in trying to understand the present situation.  . . .

The EMU was created by the Maastrict Treaty in 1993. The euro was launched as an accounting currency in 1999 and notes and coins were issued in 2002. There were 11 countries that were initial members of the EMU. Who is in and who is out an why is complicated. The UK and Denmark have negotiated a permanent opt out. Other countries are not yet in because they have not yet met the necessary economic criteria. When the euro notes were issued the member states discontinued their national currencies such as the Deutschmark and Franc. The treaty created a European Central Bank, ECB that carries out central bank functions and monetary policy for the zone.

Germany and France were the original core of the EU and remain its economic center of power, with most of the economic clout coming from Germany. During the 1970s and 1980s the EU expanded to take in the poorer countries on the periphery of Western Europe. These included Ireland, Portugal, Spain and Greece. All of these countries experienced significant economic growth over a period of years following their entry into the EU. Inclusion in the free market and transfer payments from the established members have been credited for these developments.

The EMU links the states that are members by sharing a common currency and a common monetary policy of sorts administered by the ECB. Member governments are required to limit their annual deficits to no more than 3% national GDP. This is a requirement that has been honored far more in the breach than in the observance. The members are free to pursue individual fiscal policies. This includes the areas of government spending, taxation, social benefits etc. There are other monetary unions in the world, but most of them consist of very small countries using the currency of a much larger neighbor. Thus there is one party able to exercise predominant control. The EMU was intended to be a union of equals. There is a provision in the treaty establishing the union that the union will not assume liability for the debts of the member states.

The EU as a whole is a free trade area. There are no tariffs on trade between member states. Much of the activity of the EU bureaucracy is devoted to harmonizing commercial regulations and standards of the member countries is ways that will facilitate trade. The EMU takes this goal forward by a major step. The common currency eliminates the risk of exchange rate fluctuation in trade between its members. Negotiation of contracts between businesses in nations using different countries requires the parties to make bets about what the exchange rate will be at some future date and the set prices and rates accordingly. Betting wrong will cost money. The common currency removes this element of risk.

From its full implementation in 2002 to the global financial crash in 2008 the euro gave the general appearance of being a successful project. Because of the size of the underlying economies it moved to assume a place beside the US dollar as another world reserve currency. The economies of the EMU member states all appeared to be prosperous. The reality was that several of them were being pumped up by participation in local versions of the global real estate bubble.

The great crash has caused major economic difficulties for all European economies. It has exposed some major fault lines within the EMU. Back when carriages and wagons were pulled by teams of horses, it was desirable that the teams be matched in individual strength and endurance. It turns out that the EMU is a wagon being pulled by race horses, donkeys, and maybe an ox. It is not a union of equals. Germany continues to be one of the world’s strongest exporting industrial nations. France has a reasonably prosperous economy and an export base of agricultural products and luxury goods. The nations on the periphery have turned out to be less solid and have suffered varying degrees of catastrophic impact. They have been grouped together under the unflattering acronym of PIIGS, Portugal, Italy, Ireland, Greece and Spain.

Each of the little piggies has a different set of economic problems. The diary referenced at the beginning of this one attempts to explain the situation in Ireland. The common thread is that all of them continue to suffer serious recessions. None of them were conforming to the deficit target before the crash. The decline in tax revenues and the rise in unemployment resulting form the recession has pushed their deficits considerably higher. For totally independent countries in such straits, one policy option is a devaluation of the national currency to make them more competitive in international trade. Bring tied to the euro removes this option. They are all in the position of needing to raise money in the international bond market to finance their deficits. Because they are individually liable for their government debt, the bond markets rate their issues independently from the rest of the EMU. Over the past year there has been a significant rise in borrowing costs for these countries. Greece was the first country to be pushed to the point of being on the verge of defaulting on its debt. This was the beginning of an ongoing financial crisis for the EMU.

Last winter the various players in the EU scrambled to cobble together some form of bailout mechanism for Greece. The news media where breathlessly following the situation the way that they are now following Ireland. An arrangement that involved various levels of participation by the EU, EMU and IMF was arrived upon at the last minute and a loan was extended to Greece. That appeared to put the lid on the situation over the summer. Meanwhile there were regular rumblings about problems in Portugal and Spain. Just as Ireland is coming to a head, the lid is blowing off in Greece again. The continuing recession is pushing their deficit above the agreed targets and some EU countries are dragging their feet about paying their share of the next round of support.

We now have the situation of a delegation from the EU/ECB/IMF having arrived in Dublin in an effort to pressure the Irish government into asking for a bailout arrangement that they say they don’t need. As Alice said in Wonderland, “It gets curiouser and curiouser.” The Irish government per se is not in immediate crisis. They have funds for six months before they will need to face the bond markets. It is the Irish banks that are on the brink of collapse. There are also numerous large banks in the rest of Europe, particularly the UK, that are heavily exposed to the Irish real estate problems. The European ladies bountiful who have swooped down from the heavens are not all that concerned about the Irish. They are worried about the spreading contagion to other sovereign debt in the EMU, the exchange rate of the euro and protecting the European banking system.

The presently available information indicates that the Irish government would like to have the banking problem somehow taken off their hands. However, if they can be persuaded to accept a bailout with the ostensible purpose of shoring up their sovereign debt they will remain responsible for the banking problems and the EU will be able to set conditions that infringe on their national sovereignty. The principal issue is the low Irish corporate tax rate. France and Germany have long gritted their teeth over the tax revenues that are being drained off by the Irish.

That is a very condensed overview of a very complex situation. It’s intended as a diary, not a book. One could easily write several books without exhausting the subject. There seems to be wide agreement that the EMU as presently constituted is not a functional economic arrangement. It looked ok for a few years during prosperous times, but it clearly is not equipped to deal with major financial crises. A monetary union without a political union is probably not a viable option. There appears to be a real possibility that the EMU and the euro could come apart either partially or completely. There seems to be little enthusiasm for the prospect of moving the EU toward being a fully integrated nation state.

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Richard Lyon

Richard Lyon