The Euro came into being in 2002, replacing many national European currencies with a common currency. There are 16 members, with the largest economies being the Germans, French, Netherlands, Italy and Spain. The launch of the Euro was done successfully and it brought down transaction costs and financing costs across the Euro area, and was part of a broader movement of labor and services across the region (not as simple as the currency conversion, however).
The Euro was originally at around 80 cents to the dollar; it has gone as high as $1.50 to 1 USD and currently ranges around $1.30 – $1.40. This appreciation has been significant, caused both by policies that weakened the USD and strengthened the Euro.
While the Euro has been a successful currency and has brought benefits to the region’s economies, particularly the weakest economies (like Greece, Spain, Italy, Ireland, and Portugal, the “PIIGS”), recently the region has had difficulty with high budget deficits and the specter of outright default in these weaker countries.
While all parties benefit from having the Euro, some parties benefit more than others, and are “free riders” – particularly the weak Mediterranean countries that would never have such low financing costs and ability to easily raise funds in the bond markets without the implicit backstop of the German, French and Dutch treasuries.
There have been various crises that the Euro has faced, and the countries have responded to claim fealty to the Euro and pledge support to the flimsiest members. Notably there is the crisis in Greece with monstrous budget deficits, almost no tax compliance and a completely uncompetitive economy; and the crisis in Ireland, whose country and banks have been knocked flat by a giant bubble in the property sector.
Now, however, the core problem is rising again, which is the fact that at some point the rich countries will have to officially “backstop” the weaker countries or they will not be able to refinance their mounds of debt at favorable rates, which in turn will topple their finances like a Jenga tower with the bottom block yanked out.
This happened in the United States; when the crisis hit in 2008-9, the US Government effectively nationalized Fannie Mae and Freddie Mac and took over the US housing market, probably picking up $400 billion or so in losses, as well as backstopping US banks, GM, and even many states and local government entities through various stimulus measures and “Build America” bonds. While painful, at least the US government was bailing out US entities; while we can gnash our teeth and call for punishment (including criminal punishment) for those responsible, at least we are trying to clean up our own mess.
But it seems incomprehensible that Germany and other strong Euro-zone countries will just indefinitely prop up the spendthrift and uncompetitive countries; it isn’t that this is a liquidity crisis (short term cash flow) – this is a solvency crisis, meaning that they can’t pay their bills now (at incredibly favorable interest rates that they received today with Euro financing and the implicit backing of the strong countries like Germany, which will soon evaporate) or later; the debt burden is just too high. And Germany isn’t linked to say, Portugal, the same way that the United States is bonded together. Would the US risk our currency, solvency, and standard of living to backstop another country; maybe if the impact was small, but not forever and not if the impact was large to our net financial position, especially if it wasn’t linked to an imminent military conflict.
Assuming at some point the rich Euro countries give up the ghost, then the smaller countries won’t be able to finance their debt in the markets at reasonable rates, and some sort of restructuring will occur. Perhaps they will get some help, and each may have unique fates, but the current plan of implicitly relying on the stronger countries will evaporate.
This doesn’t necessarily mean that the Euro is dead; we will just move into a new era where countries will have to deal with the consequences of huge deficits each in their own way and take their own steps to be competitive and get their finances in order. It isn’t clear what happens next.
The lesson for us in the United States isn’t to be smug; it is to be terrified. While the US has many advantages over these other countries, we need to realize that confidence in the markets exists, and then it is GONE. There may be signals in advance, such as the earlier crises that hit the Euro, and today’s TARP and ultra-low interest rates may be our same markers towards insolvency.
It works until it doesn’t.
Cross posted at LITGM