End of the Euro Experiment?

The Euro Area (also referred to as the Eurozone) was created in 1999 when 11 countries out of the 27 in the European Union (EU), agreed to use the euro as their currency. The goal was to create a “super currency” to compete with the US dollar and to help boost the smaller economies by uniting them as a single, economic entity. Milton Friedman was particularly critical of the Euro Area at the time, predicting that the new entity would collapse when faced with an economic crisis pitting the interests of one group of countries, against those of another group. He based his hypothesis on the belief that when difficult decisions were necessary, officials would naturally support initiatives favoring the Euro Area’s larger economies, even if at the expense of the more junior members.

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Looking back at interest rate policies shortly after the creation of the Euro Area, it would seem that Friedman’s misgivings were justified. It was during this time that the region’s two largest economies – France and Germany – were struggling with serious economic slowdowns. In order to boost spending and to help make exports from both countries more competitive, the European Central Bank (ECB) lowered interest rates.

At the same time however, several smaller countries including Greece – which was admitted to the Euro Area in 2001 – were experiencing inflation and the sudden availability of cheap credit soon ushered in another wave of spending. The resulting inflation spiral saw a rapid increase in wages and prices, while at the same time, the elimination of trade barriers within the European Union, allowed for the inflow of cheaper goods and products from other regions into the country. This had a devastating effect on the domestic markets of several countries, but most especially in and Greece and Spain.

In the years since then, Greece has borrowed ever-increasing sums in order to meet its obligations, and last week, Fitch Ratings announced that it was placing Greece on a ratings watch due to Greece’s inability to deal with its escalating debt. The effect of this downgrade placed a chill over the market, resulting in weak bond sales last Thursday as investors forced the Greek government to increase yields in exchange for the added risk. Today, S&P lowered its credit evaluation, downgrading Greece’s status to BBB+ from A-, and this will add substantially to the government’s costs at a time when Greece can least afford the extra expense.

Greece is not alone in facing a credit crisis as rumors continue to make the rounds that Portugal is about to be downgraded, while Spain is expected to receive its second ratings reduction in the span of twelve months. Things also look bleak for Ireland with today’s unemployment report showing that Ireland’s unemployment is now 12.4 percent – this is an increase of 75.5 percent in the three-month period ending in September when compared to the same time frame just one year ago.

Is a Bailout from the European Union a Sure Thing?

All countries within the European Union (EU) – and by extension, the Euro Area itself – are required to meet specific debt regulations. Yearly budget deficits are not permitted to exceed 3 percent of a country’s Gross Domestic Product (GDP), while total public debt must not exceed 60 percent of GDP. Despite these regulations, all EU countries ran afoul of the budget limitations this past year as a combination of stimulus spending and a sharp reduction in consumer spending conspired to throw everyone offside. Greece however, has been a chronic deficit and debt offender, and some highly-placed officials have even suggested that Greece “fudged” its debt numbers in order to gain admittance into the EU in the first place.

Be that as it may, patience has clearly run out as the European Commission initiated action against Greece earlier this year. Greece has exceeded the 3 percent deficit-to-GDP ratio for three straight years now and is currently in the 13 percent range. Meanwhile, total debt is estimated to be more than 300 billion euros (US$443 billion) and talk of a potential bankruptcy grows louder each day.

Given these facts, one must ask how likely is it that Greece could fall into insolvency, and even more critically, it is conceivable that the EU would just stand by and watch Greece falter?

Reaction to Greece’s most recent budget problems from fellow EU members was – to be kind – “muted”. On Thursday of last week, Jean-Claude Juncker – Prime Minister of Luxembourg and the current Chair of the EU finance ministers, said “I totally exclude a state of bankruptcy in Greece” when asked about Greece’s immediate future.

“The Greek authorities will take effective action. I am fully convinced Greece will return to the consolidation path. This is dramatically necessary,” Juncker noted in a press conference.

Despite his “optimism”, I can’t help but note that there is nothing in Juncker’s statement by way of a commitment to provide a bail-out if necessary. German Chancellor Angela Merkel offered the closest thing to a guarantee – although it did take the better part of three days before she made a comment – when she said “What happens in a member country influences all the others, particularly when you have a common currency.”

And that my friends, is the 800-pound gorilla lurking in the corner; should Greece or any of the other Euro Area countries already identified as a credit risk actually default on their debt repayment, the euro would suffer a sudden and potentially dramatic devaluation.

What if the EU Simply Allows Greece to Fall into Bankruptcy?

By simply standing aside and allowing Greece to fall into insolvency, the EU could well be setting off a chain reaction of sorts that could threaten to take down other counties on the cusp including Ireland, Portugal, and even Italy. Without a guarantee from the EU, further credit downgrades would be inevitable and the entire Euro Area economy could find itself facing an out-of-control cycle of declining government bond values and increasing yields, thereby making it even more expensive to service national debts.

If – and that is a rather big “if” – the Euro Area opts to cast Greece adrift, Greece’s last resort will be to turn to the International Monetary Fund (IMF). In the past eighteen months, the IMF has come to the aid of several bankrupt nations including Iceland and Estonia, but I can’t imagine Greece having to turn to the IMF. The fallout – both political and economical – would be more than the EU could bear, as the markets would see this as a monumental sign of weakness resulting in a further devaluation of the euro.

Therefore, if a rescue of Greece becomes necessary, my guess is that the EU would – reluctantly perhaps – provide funding, but severe conditions would probably be attached limiting how Greece could use the money. The impact on Greece’s sovereignty would not be insignificant, and given the riots of last year when the government tried to make cuts, future civil unrest is not out of the question. In fact, Greece’s public service unions have already threatened mass strikes should the government make attempts to limit spending that would negatively impact the unions.

What if Greece Decides to Leave the EU?

In theory, Greece could exit the Euro Area on its own accord and return to using the drachma as its currency, but this is highly unlikely. Greece is already struggling to borrow money and that is as a member of the Euro Area – there is no chance Greece could make it on its own so don’t even waste time on this thought.

No, Greece will be eventually be rescued by the EU but the cost could be considerable as Greece will be forced to accept any conditions that the EU insists upon in exchange for emergency funding. Greece’s bloated civil service and heavily-subsidized social assistance programs will certainly be targeted as areas to find possible savings, and this has potential for violence and the civil disobedience witnessed last year could well be a mere warm-up for what is to come. The next few years will be difficult as Greece lurches from one economic crisis to another and EU “skeptics” will no doubt point this out as an example of a “failure” of the EU.

Ultimately, like any organization, the Euro Area’s overall strength is limited to that of its weakest link, and I think that this is exactly the point Milton Friedman was making way back in 1999. Inevitably, the value of the euro will certainly be impacted in the coming months; it remains only to be seen by how much.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.