Christopher Pang
Will the Euro finally disintegrate?
The Euro was introduced to facilitate trading within the EU, reduce currency risk, reduce inflation risk and integrate the financial system within Europe. The European Central Bank (ECB) is supposed to conduct monetary policy for the euro areas for the 17 members. It is a very difficult task to conduct monetary policy for a single country, not to mention 17 countries with different governmental and fiscal policies. This was the reason why Maastricht rules were set up to fine euro member countries heavily which budget deficit exceeds three percent of GDP, total government debt exceeding sixty percent of GDP. This set of rules applies to any new euro members before admission.
Greece was admitted as a Eurozone member only because Goldman Sachs “assisted” Greece in a cross currency swap deal that allowed Greece to mask the true extent of its deficit. This fact was reported in 2004 in a series of BBC news report here, here, here and here. The surprising thing is that no action was taken to rein in the spending in 2004 by the Greek government to keep up to the Maastricht rules nor was there any form of supervision by the ECB on the Greek government for their reckless fiscal spending. When the debt finally escalated to a point where investors were dumping and requiring higher interest rates for junk ratings, ECB rushed in with a rescue package to “save the EURO”.
If Greece was still using Greek drachma, what would most likely have happened during 2002 to 2011?
1. Would the markets have lend as much to Greece?
2. Would the markets have lend to Greece at the same interest rate?
3. Would lenders to Greece request for the loans to be denominated in drachma or their local currencies, e.g. Germany lending in Euros and England lending in GBP?
4. Would the riots and protests have taken place earlier? Would the government be forced to take austerity plans earlier?
It is likely the situation will be forced upon Greece earlier if the Greeks were still using drachma. Krugman suggested that devaluation of its currency could be used to adjust costs more swiftly. This suggests an indirect form of default by stealing purchasing power from the creditors (French and German banks) to the debtors (Greek government). The top 5 import partners of Greece are Germany 13.73%, Italy 12.71%, China 7.08%, France 6.1%, Netherlands 6.02% and the likelihood of the European trading partners using Euros as a contractual currency is high especially with Greece’s poor financial reputation. In this situation, Greece would be unable to print Euros to repay the debt. In the event they do print and sell their drachma in the foreign exchange markets to repay the debt, it would lead to massive devaluation of their currency or hyperinflation within Greece. Supposed the debt is denominated in drachma, the same drachma which they printed to repay the debt will then be sold in the foreign exchange markets by their creditors leading to an increase in the supply of drachmas in the Greek economy. The chaotic situation in Greece today is therefore inevitable not because they could not control their currency but a result of excessive fiscal spending.
By letting Lehman fail and bailing the other banks out, the government and Fed officials blame the downward spiral on the failure of Lehman. Confidence in a broken system does not give it strong fundamentals. Goldman, Citi, Bank of America, Merrill, Morgan Stanley were just one weekend away from bankruptcy and today they emerged profitable, paying off their employees billions in bonuses. This is not because they had strong fundamentals but because the markets had priced in a “too big to fail” negative risk premium. People were willing to lend to these entities because they had government backing. The smaller financial institutions without such backing were disadvantaged despite being prudent with their lending practices. By rewarding failure with bailouts, it encourages reckless behaviour with capital that could have been put to better use by the competent, it deprives the free markets of the needed capital for investments and production, thereby reducing job creation and creating more reckless speculation.
Greece is a broken system and should fail, together with the banks that bought the Greek debt. That is capitalism and giving due rewards and punishment to where it belongs. That being said, a Greek default is definitely better than a Greek bailout. It sends the right message to the rest of the Euro members that excessive spending will not be supported with financial assistance. Supposed France also went on a massive spending spree in order to buy voters’ support and Germany does not, the German government gets booted out and French government stays in power and gets bailout thereafter, without any claim of responsibility of their excessive spending. What message does the ECB send out with the bailout of France? “It is okay for you to be fiscally irresponsible, we will be there when you need us.”
After the bailout of Greece, similar financial fragility were spotted among Ireland, Italy, Portugal and Spain, forming the PIIGS. After the bailout of Greece and Ireland, Portugal’s finances have fallen into a slump with credit downgrades and hike in borrowing costs. In order to get the finances back in order, Portugal’s Prime Minister José Sócrates came up with a series of austerity plans so as to refinance the expiring debt. He had to resign last month end because the parliament rejected his austerity plans. The only person that was willing to take the right action found himself without any support from the parliament because no one else would support plans to cut pension payouts which would affect their own retirement plans.
After bailing out Ireland, Greece, and potentially Portugal in the next few weeks, the European Banking Authority (EBA) now wants to conduct a stress test on the exposures of the banking books of banks in the EU region. The stress test includes a 0.5% economic contraction, 15% decline in equity markets and a 75 basis point hike in interest rates. This is all but similar to the stress test conducted by the Federal Reserve more than a year ago to boost confidence in the financial system. The stress test is simply not stressful enough. With food and commodity prices soaring worldwide, 75 basis points hike in interest rates is hardly a test. As we could see in recently markets, it only takes a catastrophic event to have a 15% decline(referring to the Nikkei 1 day fall of more than 15%). This system is already broken. With the amount of social welfare and future unfunded liabilities, EBA is merely putting scotch tape to hold up a collapsing house of cards as the day of reckoning approaches.
