Posted on June 5th, 2012


Those of us who nearly 14 years ago foresaw that the euro would eventually have to be taken apart have had to endure several years of cynical comments. Even now, however, we cannot breathe a sigh of relief, because the economic well-being of the world depends on it being done immediately and in an organized manner. And the chances of that are slim.
The inherent flaw in the construction of the euro is now plainly visible to most observers: it is not possible to construct a uniform monetary policy for all members each with a separate and diverse fiscal policy. A uniform fiscal policy is not only those items Germany was pushing for in the “fiscal compact” but also a re-distribution of wealth from the strong economies of the north (Germany and may be France and Holland) to the periphery states, a measure that of course cannot be agreed politically.  What is surprising is how long it lasted while all the time the relevant data were so blatantly obvious.
The problem is evident even with the simplest and least controversial data. It is enough to take a look at wage increases since Greece joined the euro in 2001. Clearly, Greece and Spain were bound to get into trouble due to loss of competitiveness. Also, while short-term interest rates were uniform across the eurozone, real — inflation adjusted — rates were much lower in Greece, Ireland, Spain and Portugal than in Germany. In fact, for some of these countries, they were probably negative for much of this period, helping create the bubbles in housing in Spain and Ireland, and more generally, “bubble economies” in Europe’s periphery.
The conclusions from Chart 1 are generally valid except for Italy and for the comparison with the U.S.  During the period shown, all countries discussed had an increase in productivity, except for Italy. Therefore the Italian economy could not afford even the relatively slow increase in wages it experienced. In contrast, the U.S. had a strong increase in productivity and therefore remained competitive with most of the eurozone other than Germany.
Chart 1

The data are therefore rather clear: the so-called “sovereign debt crisis” and “banking crisis” only name the symptoms of the structural deficiency in the euro. Of course, the cracks appeared first when and where the structure was most vulnerable. First to fail were those eurozone members that were weakest, most indebted, least competitive and so on. It is conceivable that at the early stages of the crisis it was still possible to delay its progression if the U.S., China, Japan, Germany and the IMF were to have banded together to build a “firewall” massive enough to recapitalize the European banking system, the ECB, the EFSF the ESM and any other institution the Europeans designed to stabilize the “European monetary project” i.e. the euro. Had that been done, there would have been some meaning to the “fiscal union” the Europeans plan to discuss at their June 28 -29 summit meeting. The time gained could also allow the German policy, begun in 2011 and continued in the more recent union agreements of accelerating labor wage increases, to work. This policy makes Germany less competitive and therefore the rest of Europe gets a relative gain. Finally, the “new” idea of the new European leaders (and of the UK) that Europe cannot make do with only austerity and that it needs some growth enhancement, could have been implemented.
But, that was then. Now, time is up. The euro experiment is over. The patient is barely breathing and cannot hold his breath for long. People with money in Europe are not thinking about where to invest for growth but where to shift their deposits. Money is flowing fastest out of Spanish banks into Germany that itself will be insolvent once the euro falls apart. Some funds are also flowing to Swiss banks (will they survive when the eurozone collapses?)  and to the most highly indebted economic power: Japan. Consumers are afraid to spend. As a result, the European economies are shrinking fast, as the latest PMI indices show. And in the age of information, US consumer and investor confidence is shaken too, with China not far behind. Finally, in reaction, the global stock markets are plunging too, guaranteeing that the confidence will ebb some more.

In their enlightening paper, Simon Johnson and Peter Boone describe the mayhem in the European markets and conclude that the euro is doomed and will have to be taken apart in a few months or even years. In his piece, Jim O’Neill at Goldman wrote several weeks ago that since the Europeans cannot agree on fiscal unification that will solve the euro’s problem, or on dismantling the euro, they will just keep kicking the can down the road.
That, however, is not how markets work. To see how they do behave, just look at one relevant example: when the true magnitude of the Greek fiscal problem surfaced, it took four months until the eurozone had to come to help and the amount necessary to temporarily  calm the market was relatively small (30 billion euro loan). Recently, when private investors wrote off more than 100 billion euro of Greek debt and made Greece eligible for additional help of similar magnitude from the eurozone it didn’t take the market more than a few minutes to reprice the new debt to reflect highly likely default levels. In other words, the markets are forgiving at first but their reaction time grows shorter and more violent as the problem persists. The Europeans are now trying to kick the can up the hill.


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