Another look at the EU’s problems with Greece

The European Union vs. the Eurozone

Speaking in the most general terms, the EU is the post-WWII federation of European (including the UK) nations with three main objectives:

1.  promoting closer social, cultural and political integration, in order to deter future pan-European warfare;

2.  encouraging faster economic growth, and the development of large-scale European-owned enterprises that would have the size to compete in an increasingly global world (read: to counter developments in the US), and, at the same time

3. preserving national political institutions (because no politician wants to give up his job).

The Platinum Elite form of membership in the EU is to be part of the Eurozone, meaning adopting the € as a currency and becoming subject to the monetary policy determined by the European Central Bank.

qualifying for the Eurozone

Not every country can qualify to be in the Eurozone.  On the other hand, not everyone wants to.  Neither Switzerland nor Norway are in the EU at all.  The UK and Sweden are in the EU but have chosen, so far, not to be in the Eurozone.

The Maastricht Treaty of 1992 set out criteria for Eurozone membership.  They include limits on the size of a country’s budget deficit, the size of its outstanding government debt, and the inflation rate.

A number of countries have struggled to meet the criteria for entry into the Eurozone, notably Italy, which undertook a truly heroic restructuring of government finances to be able to qualify to be a charter member of the club.

The unspoken–and, as it turns out, incorrect–assumption of the creators of the Maastricht criteria was that any country that had gotten its economic house in good enough shape to qualify for the Eurozone would continue in fighting trim after entry.  After all, local politicians could deflect blame from themselves for any restrictive fiscal actions by pointing out that they were “forced” into them by the EU.

the dark side of Euro membership

1. An interest rate policy that’s best for the Eurozone overall may not be good for any country in particular. The German economy, for example, struggled for many years while dealing with the reintegration of the old DBR and DDR (see my post).  So it needed low rates.  Spain, on the other hand, became a go-to destination for companies seeking to flee the high-cost, rigid labor markets of Germany and France.  So it needed relatively high rates.  The same for Ireland.

EU money policy made German progress slower.  For Spain and Ireland, on the other hand, it was like being on steroids.  Low rates revved up economic expansion, but also distorted growth (in favor of interest-rate sensitive industries like residential construction) in ways these nations are now coming to regret.  They could have run more restrictive fiscal policies as a counterbalance.  but they didn’t.

2.  Each country borrows on the credit rating of the Eurozone as a whole, not their own.  That’s not strictly true, but has been a good practical rule.  If a country’s government debt is downgraded by the ratings agencies below a certain level, that nation loses the European Central Bank guarantee.  But look how well relying on the ratings firms worked at avoiding the sub-prime mortgage crisis in the US.

for some countries, this has been like giving the family credit card to a thirteen year-old.

Mention this fact up until recently and the response would probably have been that this is the Italy problem.  Under the regime of Italian prime minister Berlesconi, that country has quickly returned to its old flabby self.  Investors have been willing to finance this degeneration, in the belief that Rome no longer has the option of avoiding repaying the full amount of the debt through devaluation.

Today, the talk would be about Greece, which has been able to borrow much larger amounts, and at lower interest rates, than anyone would have lent in drachma.  The Athenian twist to the story is that the recently elected government has discovered, and revealed to the world, that the previous administration had falsified its reports of the country’s financial condition.

Where to from here?

Acronym-happy commentators have already begun to talk about the anti-BRICs–the PIGS (Portugal, Italy, Greece and Spain).  Some are also speculating that Greece will somehow default on its debt and that this will precipitate a run on the other PIGS, replicating the Asian debt crisis of 1997 inside the EU.  This sounds crazy.

So far, worries have made themselves manifest through a large fall in the € and substantial drops in the stock markets of the PIGS.  If these trends continue, the EU may be forced to act sooner than it would like (its preferred course of action I think, would be to hope the PIGS muddle through for a good long while).

It’s also not clear, to me at least, how well hedge funds have anticipated these developments.  How much will they have to reposition themselves, meaning further selling of the already bettered Eurozone while they are doing so.

Stay tuned.

2 responses

  1. In and of itself a Greek bankruptcy or bond default should -in theory- not affect the Euro as such very much, Greece being maybe 3% of the total. However, just as a Californian bankruptcy (probably inevitable, large US cities at least are already contemplating insolvency, ten idividual states may well follow) would reflect badly on the “state of the Union” as a whole so would the default of on EU country, coupled with the rising interest rates and thus further destabilisation of the remaining over-leveraged member states, make investors wonder when sovereign default across the board is likely. Thus they wouldn’t commit themseves to bonds of longer maturity and that’s the beginning of the end.

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