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Friday, June 15, 2012

The Future of the Euro Area: Growing Closer or Falling Apart?

Last time, we argued that monetary expansion is necessary to pull the PIIGS out of recession and the debt crisis. In the final post of this series, I’ll discuss the outlook for the European Monetary Union. While this crisis is an opportunity to address the deep-rooted problems in the eurozone, European leaders must decide at what cost they’re willing to preserve the currency union.

An Opportunity to Achieve Closer Integration

After two world wars, Europe came to realize that prosperity can only come with continental peace and stability. Since then, closer cooperation and integration have been Europe’s goals. The eurozone was set up in the late 1990s as part of the efforts to promote peace and integration.

However, the eurozone has always had structural problems, since it comprises vastly diverse economies which without fiscal union shouldn’t be allowed to use the same currency. The problems, which were obscured in good economic times, have been exposed in the financial crisis. It’s now clear that the absence of two institutions threatens the stability and sustainability of the eurozone.

First, to improve financial stability and market confidence, Europe needs a unified banking authority that monitors the industry and recapitalizes troubled banks when necessary. Second, a central authority with power over taxation, which ensures fiscal responsibility and provides a framework of fiscal transfers, is necessary to any sustainable monetary union.

Their absence has long been an obstacle to European integration, but only in a crisis can these structural problems be addressed. The current challenges have made it clear that the continued existence of the euro depends on the success of reforms. This sense of urgency and the high stakes involved have presented Europe with a perfect opportunity for closer integration.

Conflicting Interests among Euro Members

However, integration incurs painful sacrifices and is easier said than done. On one hand, the peripheral countries have to endure the pain of austerity measures and labor market reforms, which include cutting welfare spending to improve labor market efficiency and reduce economic distortions. Germany, on the other hand, is burdened with costly bailouts.

On top of the sacrifices, euro members have found it extremely hard to reach an agreement due to conflicting interests. Basically, Germany wants to spend the least possible to prop up the eurozone, while other euro members (with the exception of the Netherlands) are trying to get the most from Germany. Given the difficulty of cooperation, few concrete steps have been taken to solve the crisis.

Indeed, European leaders are still deeply divided on how to save the euro. Though deposit insurance may be the only way to save the currency union, Germany’s reluctance to insure over 2 trillion euros worth of deposits in Italy and Spain is perfectly reasonable.

Germany opposes the idea of euro bonds as well. The objection is justified though. The issuance of euro bonds will take the pressure off politicians and slow down structural reforms. More importantly, countries like France and Italy propose debt mutualization because they want Germany to share the cost of future spending. No wonder Germany rejects the deal.

Meanwhile, Germany is taking measures to minimize losses in the event of a breakup. Some argue Germany is bailing out Greece for its self-interest too. By propping up Greece’s banks, Germany can spread out the debt burden of Greece across all euro members.

Ironically, what was intended to create peace and prosperity has turned into a dysfunctional partnership that threatens the world economy. But it’s hardly surprising that every euro member is protecting and fighting for its self-interest. After all, the eurozone is composed of independent sovereigns with people of different national identities.

Breakup not the End of the World

If euro members lack the commitment to closer integration, then the exit of some countries, or even a breakup of the euro, is the only feasible option in the long term. Both a German exit (which some believe to make more economic sense than a Greek exit) and the exit of the “Club Med” countries could work.

In the case of a German exit, politicians can sell the idea abroad as a noble sacrifice to correct the imbalances within the eurozone. Internally, they can persuade voters that an exit means they no longer have to waste money on rescue packages.

The bottom line is the same rule applies in love and in politics: If different parties can’t settle their differences, then a breakup is all for the best. And a breakup of the euro doesn’t have to be the end of European cooperation. Members can remain good friends even after breakup, just like what couples do.

P.S. Sorry for the delay of this post. I was busy preparing for the CFA exam, and I just had a trip to Phuket last week. Now I’m ready to blog again. Please stay tuned for a series of new posts on personal development next week!

(Entry 4 of 4 in the Update on the Euro Debt Crisis series)


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