Tuesday, February 17, 2009

Will the Euro exist in 3 years? - Ari Paul

Before scoffing at the question, consider these facts:

Italy and Greece have quickly growing public debt of about 100% of GDP and shrinking tax revenues. Without independent currencies, Italy and Greece can’t devalue and inflate away their debt. Investors are still willing to finance such high levels of borrowing at single digit interest rates under the assumption that as members of the EU, Italy and Greece are safe from both inflation and default. What happens when investors start questioning the long-term solvency of these governments? What happens if they face a sovereign “bank run” as investors flee to safer sovereign debt?



As this graph (courtesy of John Mauldin) shows, the process has begun. The sovereign debt spreads are widening in a self-fulfilling process that threatens to turn exponential. If credit spreads continue to widen, at some point the costs of remaining in the EU will outweigh the benefits. The source of the problems for Italy, Greece, and the other weaker EU members like Spain, Portugal, and Ireland is primarily that their labor costs are much higher than the stronger EU members. This is causing rising unemployment, already double digit in Spain. Politicians may soon find the pressure from labor to be overwhelming. Their constituencies are demanding jobs and the only way to provide them is to boost export competitiveness by leaving the EU so they can devalue their currencies.

There are some alternatives. While the IMF’s remaining reserves would just be a drop in the bucket, they could issue special drawing rights or insure loans to temporarily sweep the problem under the rug. Germany could start buying the sovereign debt of weaker EU members and establish a symbiotic balance of payments relationship like that between the US and China. None of these are particularly attractive options though as they just put off the adjustment that will eventually have to occur. History has shown that currency imbalances can persist for decades, but they must eventually reverse; the longer they’re put off, the more spectacular the fireworks.

So will the EU exist in its present form in 3 years? Probably. But there is a serious risk that investors will pull capital out of the weaker EU members and create a self-fulfilling crisis in the near future.

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