How things change! On 1 January 2002, much of western Europe rejoiced at the sight of euro banknotes and coins in 11 countries and three principalities. At last, Europe’s unification drive had created a common currency which could conceivably end of the monopoly of the US dollar. Today, with some European countries toppling like ninepins and others swaying drunkenly at the post, many are wondering if it was a case of premature elation.

The euro is a story where meticulous planning and careful design of a common currency has been systematically debased by political grandstanding and poor governance of many member countries. Let me explain.

When countries relinquish their right to manage their own currencies, they lose a critical policy variable and therefore need to be very disciplined in their fiscal policy — particularly controlling deficits and public debt. The Maastricht Treaty of February 1992 underscored this through the ‘stability and growth pact’ (SGP). Adopted in 1997, the SGP had six conditions that all euro countries had to follow, of which two were non-negotiable, namely:

• No euro nation could have an annual budget deficit higher than 3 per cent of its GDP — which was the sum all public budgets, including municipalities and regions and off-balance sheet items.
• Each euro country needed to have its public debt at less than 60 per cent of GDP, or close enough and approaching that ratio.

It is one thing to sign off on these conditions. It is quite another to define what actions would come to bear if these were breached. That was the problem — and remains so till today.

The questions were simple enough: What would happen if a country deviated from the two core conditions? How soon would they be punished? How severe and credible would it be? Who would punish? Would the enforcer get the political freedom to inflict the punishment? Or would the political importance of a unified currency preclude any credible punishment?

The euro’s tragedy is that no country has been ever punished for deviating. Right from the beginning.

Here are some facts. Consider the 3 per cent fiscal deficit ceiling. In the last 10 years, Greece has breached it every year; Italy on seven occasions; France and Portugal, six times; and Germany, four times.

Now consider the 60 per cent public debt ceiling. Greece has broken it every year with much to spare; so too Italy, also by significant margins; France breached it seven times; parsimonious Germany, eight times; and Portugal, five times. In 2011, it is estimated that Italy will breach it again at 4 per cent of GDP, with suspect numbers; France at 5.8 per cent; Spain at 6.5 per cent; and Greece at 9.6 per cent.

No country has been punished. Not even with a gentle reminder. In such circumstances, why should be surprising to see major collapses? The first Greek crisis led to a May 2010 bailout that cost €110 billion. Then, Ireland tanked in November 2010 leading to a €85 billion bailout. This was followed by a €78 billion bailout for Portugal in May 2011. Then, on 21 July 2011, there was the second Greek rescue of €109 billion.

The second Greek bailout is farcical. Private bondholders are expected to show support by rolling over or swapping their sovereign Greek debts for new bonds that mature in 30 years, thus taking a haircut of an extra €37 billion. Moreover, the European Commission has committed to support Greece until it becomes financially healthy — an act of political grandstanding that can haunt European taxpayers for years.

The private sector ‘haircut’ was forced by Angela Merkel to reduce Germany’s tax-transfer burden and so assuage her irate taxpayers, who had just about had enough of supporting ‘the feckless Greeks’. Since the haircut is a decapitation, amounting to 21 per cent of the value of Greek bonds, it is unlikely that private bondholders will agree to such harakiri. If that occurs, we will see the first default on euro zone bonds since the creation of the euro. No wonder this bailout was resisted by Jean-Claude Trichet, the President of the European Central Bank.

Investors don’t believe in the euro zone. Italy is trembling, with the spread on 10-year government bonds having risen to 311 basis points (bps) over the German bund. Spanish bond spreads are 333 bps higher; and Greek bonds are junk — at a spread of 11.76 per cent above the bund.

Europe’s leaders can do one of three things. Option 1: Pray that things pass with the Almighty’s help. Option 2: Realise that it won’t and prepare for yet another bailout. Option 3: Say to Greece, “Remain in the European Union. But return to the drachma.” You know what will happen. So, why you shouldn’t you be bearish on the euro?
 
 

Published: Business World, August 2011