The European Union would normally have been cock-a-hoop about the arrival of Estonia as the 17th member of the euro yesterday. The inclusion of a small Baltic state that until two decades ago was part of the Soviet Union would have been hailed as a sign of monetary union’s growing strength.
It is a sign of how tough 2010 has been for Europe that the talk is not of the country joining the club but of those that might no longer be members by the end of 2011. A break-up of the single currency is still thought unlikely, but 12 months ago so too was the idea that both Greece and Ireland would need to call in the International Monetary Fund to help them through their sovereign debt crises.
The past two months have been marked by daily reports of rising bond yields, debt downgrades from the big ratings agencies, a falling euro and anger on the streets of Europe. Little wonder the financial markets believe 2011 will be a make or break year for the euro, with opinion divided on whether it will collapse, stagger from crisis to crisis, or emerge strengthened from reforms forced by this year’s events.
Clearly, the past 12 months have been the toughest for the euro since it was established at the end of the 1990s. When Greece was targeted by bond traders concerned about its attempts to cover up its burgeoning budget deficit, a €700bn joint IMF-EU fund was assumed to be sufficient to prevent the crisis spreading. That hope faded in the autumn, when the financial markets took fright at the state of Ireland’s banks following the collapse of the country’s housing bubble.
And no sooner had a package been cobbled together to sort out the problems of the Irish banks than the talk was of how Portugal would be next. And after Portugal, perhaps Spain, the fourth biggest economy in the single currency, accounting for 11.5% of the eurozone’s output and carrying over $1tn in intraeurozone bank-to-bank debt.
The assumption in the financial markets is that a bailout for Portugal is inevitable, and that the real test for European policymakers will be whether they can ringfence Spain. The portents are not good. Spain is suffering after the collapse of a colossal property bubble, with almost a million unsold homes and a 21% unemployment rate.
A report last month from IHS Global Insight noted that Spanish banks had “probably understated their exposure to the housing crash by using debt-for-asset ( property and land) and debt-equity swaps to suppress their nonperforming loans ratio, when Spain enjoyed a period of low/negative real interest rates in 2002-06”. It added that a Spanish bailout would be huge, “and tough for German voters to swallow”.
Derek Scott, once economic adviser to Tony Blair and now on Vestra Wealth’s investment advisory board, says the issue for the peripheral eurozone countries is how to regain the competitiveness they have lost since joining monetary union. Higher inflation in countries such as Spain, Italy and Portugal has meant their goods and services are becoming more and more expensive compared with those produced by Germany, the hub of the eurozone.
Unable to devalue as a result of sharing the same currency, the weaker countries have discovered the brutal truth of monetary union: competitiveness can be regained only by years of fiscal austerity and deflation. Hence the feeling that Greece, Portugal, Ireland and Spain may be forced out of the euro in the same way the UK was forced out of the exchange rate mechanism in 1992.
The only alternative, Scott says, is for Germany to recycle the current-account surpluses it has accumulated through its hyper-competitiveness to those countries that will continue to struggle: “If German politicians were mad enough to go along with that, it would wreck their own economy.”
There are, however, forces pulling in the other direction. First, a break-up of the eurozone would almost inevitably lead to the creation of a smaller single currency involving a cluster of northern European countries with Germany at the core. This would be stronger than the current euro, affecting the competitiveness of German exports. Germany has had a sizzling 2010, enjoying a burst of strong non-inflationary growth. Provided the bills do not become too great, Angela Merkel’s government will try to keep the show on the road.
Second , quitting the euro would create serious practical difficulties. Countries that left would have to invent a new currency and almost certainly find that borrowing from the markets became more expensive than it is today. Simon Hayley, of Cass Business School, says that an even bigger problem would be the fact that all government debt for individual countries became denominated in euros when they joined the single currency. “Bondholders would not accept repayment in a currency that had just been invented – they would regard this as default by another name. A country leaving EMU would find its fiscal problems made worse rather than better.”
Finally, the euro has always been as much a political as an economic project. The economic rationale for a two-speed Europe or a full break-up may eventually become compelling, but first Europe will try greater harmonisation of tax and spending policies, and a formal bailout mechanism to replace the current ad hoc arrangements in 2013.