Europe and the Euro: Attacking the Problem or Dealing with the Symptoms?

The recent political events in Europe, especially the situation in Greece and in Italy, brought new concerns about the situation in Europe and the future of the Euro. If countries do not honor their debts, how hard will their economy be hit? What happens if any country decides to leave the Euro; will it be followed by others? In the meantime, the regime uncertainty around the European situation plays against economic recovery. The fact that the countries are dealing more with the symptoms than the real problems does not contribute to make the problem go away. On the contrary, it contributes to make it worst as time goes by.

Even though the subprime crisis and the European crisis occurred one after the other, and even though they are related, they are not exactly based on the same problems. The subprime crisis was a financial crisis triggered when the mortgage bubble burst, affecting the financial markets and financial institutions. The present European situation is due to the fiscal situation of the European countries. When countries issue debts, usually in the form of Treasury bonds, these assets are bought by banks and financial institutions.  Similarly, banks and financial institutions buy bonds from firms as part of their investment portfolio. If a firm goes into bankruptcy, then the investment the banks made on the firm’s bonds become a loss. But governments seldom go into bankruptcy; they usually default through a “renegotiation.” This process typically means that the bondholders (mainly banks and financial institutions) will receive either: (1) less re-payment, (2) delayed repayment, or (3) both.

It is not the same thing for the financial markets when some firms cannot perform their debts as it is when all the countries in the Euro area are facing that same situation. Countries like France and Germany, for instance, have a debt over GDP ratio between 75% and 100%. Greece, Italy, Portugal and Ireland are above 100%. This is a major source of distress in the European crisis. Governments that have accumulated deficits beyond a sustainable limit are now facing difficulties repaying their debts.

The problem in the financial markets, namely, the problem of the banks holding government debts, is a symptom of the underlying problem of fiscal deficit. In other words, to bail the banks out does not solve the problem; it merely relives the symptoms for a while. This in itself also brings moral hazard problems to the table. Why should a careless bank that was overexposed to treasury bonds from a country with unbalanced budgets be rewarded with special treatment?

This moral hazard problem is, in turn, replicated between countries. If Greece is saved by other Euro countries, why should not Italy and Spain receive the same favor from their Euro colleagues? Italy and Spain, for instance, face an incentive to encourage the Euro area to help Greece if this can become a card to play when their turn comes. The big economies are not exempt from contributing to this situation. If the big players, like Germany and France, did not have equilibrated budgets, why should the smaller economies? There is a big difference between having a unique fiat money for the Euro area and relying on the gold standard for several countries. Under a fiat monetary regime, the central bank can simply print more money when needed. It is easy to increase money supply. Under gold standard, however, central banks cannot print gold. The crisis of the Euro is not a failure of an international money, but failure of governments and the European Central Bank to call attention to the danger of fiscal deficits.

No doubt, the financial distress is in itself important. Nonetheless, to not deal with the underlying problem can only postpone resolution of the hard issues. It is in this respect that policy makers do not seem to be sending the strong required signal. How, when, and to what extent do each of these countries plan to balance their budgets? How strong is their mutual commitment to achieve this goal? What are their plans to escape to this problem in the future? With an unclear future, the level of uncertainty discourages investment and economic recovery. Will the old Italian and Greek governments be replaced by new ones with the will to face budget adjustment and strongly signal that their debt will be paid? Or will the new governments be tempted to try to free-ride on bailouts from the rest of the Euro countries?

If the Euro countries do not help e.g. Greece, will Greece choose to adjust its fiscal situation or will it decide to leave the Euro area? Leaving the Euro and adopting a new depreciated currency could be troublesome for domestic banks and firms who will find themselves unable to repay their debts denominated in now appreciated Euros. If the future of the Euro in countries like Greece is uncertain, hardly any firms will be willing to move forward with new investment. On the contrary, they may want to cut spending and increase their liquidity and cash holdings to hedge against a potential change in the monetary regime. Understandably, until all of this regime uncertainty fades away, the recovery of the Euro area will have to wait.

But this entire problem is far from new. No monetary regime has survived the burden of sustained fiscal deficit. The Argentinean crisis in 2001 is offered as a parallel of the situation in Greece. There are some similarities. Argentina had a currency board during the ‘90s, but a large fiscal deficit that was covered by issuing foreign debt. When the debt became too high, Argentina found itself in need of choosing between adjusting the fiscal budget to pay its debt, or defaulting on its debt, leaving the currency board and depreciating its currency. As is well known, it chose the latter with expensive results.

The abandonment of other currency regimes, like the gold standard, or the gold exchange standard, ultimately had to do with unbalanced budgets that governments are unwilling to, or unable to, equilibrate. The Euro is no exception. No monetary regime can be sound if it is not accompanied with budget stability. The role of central banks as guardians of the value of money should rely more on monitoring the treasury situation than trying to mange the price level. To deal with the symptoms will not save the Euro unless clear and strong measures are taken to solve the underlying problems.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

mage: Ambro/ FreeDigitalPhotos.net

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