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Thursday, April 26, 2012

The Eurozone Crisis: Differences between the U.S. and the Euro Area

In the previous post, we’ve talked about the problems of a diverse group of countries sharing the same exchange rate. However, this leads to a question. If a currency union is such a bad idea, why does it work well in the United States? 

The American Currency Union 

You may not have thought about it, but in fact the United States can be viewed as a currency union as well. After the American Revolution in the late 18th century, the former British colonies, coming together to establish the federal government, chose to use a common currency. 

The reason is the United States is a fiscal union with a centralized tax collection system, as well as a political union where the citizens share the same national identity. When a state government (such as California) lacks money, the federal government will help by transferring money from states with healthier public finances (such as New York). The New Yorkers are okay with helping out the Californians because of a sense of national belonging. Besides, since states are required by constitutions to balance annual operating budgets, fiscal discipline can be ensured. 
As Kenneth Rogoff points out, a currency union is unlikely to be successful without political integration and potential fiscal transfers. Since there are many different national identities and many sovereign nations in the eurozone, it’s hard for a common currency arrangement to work.

(Comment: This echoes an article about cultural ties on the Economist in January. In today’s globalized world, differences in nationalities, cultures and languages still play an important role in all aspects of life, including business and finance.)

The Lack of Political Union in Europe

It’s understandable why the Greeks and the Irish are angry. They don’t understand why countries like Germany and France have the right to dictate the terms of Greece’s and Ireland’s domestic policies when they themselves are autonomous sovereign states. On the other hand, since the rescue efforts will cost German taxpayers lots of money, they have little desire to lend to Greece. Plus, Germany is worried about the moral hazard created by bailing out the PIIGS countries, which may lead to even more fiscal indiscipline in the future.

(Comment: Though German politicians want to save the euro to avoid a financial meltdown, they need to be responsible for the German voters. The result is ineffective and indecisive political leadership, which is often criticized by commentators. 

To save the eurozone, imposing fiscal union may be the only option. In the current situation, wealthy countries are only willing to lend to the distressed economies under the condition of fiscal austerity. Understandably, some may view this as a threat to sovereign autonomy. These nation states have already given up control over money supply, interest rate and exchange rate in order to join the currency union, and it’ll be scary if they’re now forced to forgo fiscal power as well. However, maybe this is precisely the level of political integration needed to sustain a currency union.)

Austerity that Crushes the Economy

(Comment: What is more worrying is some European politicians fail to grasp that fiscal discipline is a long-term practice. Austerity at difficult economic times is likely to further contract the economy and reduce tax revenue, which won’t help improve fiscal health either. Even if public debt is controlled, a contraction of economic activity wont help reduce the government debt to GDP ratio, which is a benchmark indicator for the sustainability of a countrys public finances. While European leaders hope to restore confidence and motivate consumers and businesses to spend more by reducing public debt, it seems this plan is unlikely to work.

What is needed in bad economic times is fiscal stimulus, especially when monetary policy isn’t an available tool. For example, in the early 2000s, Germany exceeded the deficit limits to weather the economic downturn. The fiscal expansion helped the German economy to get back on track back then, and it’s also what the PIIGS need right now.

Sadly, this is easier in theory than in practice. The real question is where these debt-laden states can find money to finance public spending, given that they’re struggling just to meet their debt obligations. To have a feel of the severity of the crisis, consider the debt problems of Greece. Without austerity measures, the Greek government may face bankruptcy immediately.)  

Is the Worst Over yet for Europe? 

The European financial industry is vulnerable to collapse. To understand this, let’s look at Figure 1 (which is from this website) and compare the European financial industry with the American financial industry. As we can see, the assets of American banks are just a small portion of the American economy. Therefore, when necessary, the U.S. government or government agencies can insure or even purchase the troubled assets from American banks.

On the other hand, the assets owned by European banks constitute a much higher proportion of the economic size of the host countries. Worse, these assets include the sovereign bonds of the PIIGS, which may turn out to be worthless. This makes it hard for a European country to rescue its banks when things go wrong.

(Comment: If the eurozone or the European Union can rescue the banks collectively, this may not be such a serious problem. However, the national identity problem kicks in again, and any proposal to prop up the banks of another country will face stiff opposition at the home country.)

This poses a serious systemic threat to the European economy. In the United States, the trigger is the burst of the housing bubbles, and the dynamite is the fall of Lehman Brothers. In Europe, if Greece exits the eurozone, it’ll only be a trigger. The collapse of any major European bank will be the dynamite.

(Comment: In the meantime, many analysts believe that what we’re seeing is only the calm before the storm. More concrete steps needs to be taken to solve the deep-rooted problems. Whether Europe can defuse the bomb remains to be seen, but there is reason not to be too optimistic.)
(Entry 6 of 6 in The Global Economic Landscape in 2012 series)

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