Labour Euro-Safeguards Campaign - Bulletin January 2011


QUESTIONS AND ANSWERS ON THE FUTURE OF THE EURO

  1. What has happened to the eurozone over the last twelve months?

    During 2010/11 the prospects for the future of the eurozone have dramatically worsened. The crisis in Greece which was looming at the beginning of last year came to a head in May 2010, leading to a massive bail out costing a total of about €100m, to shore up both Greek banks and the country's sovereign debt. During the last quarter of 2010, a similar fate overcame the Republic of Ireland, costing roughly the same amount again. In both the Greek and Irish cases, draconian reductions in government expenditure were made a condition of funds being provided, causing widespread unrest as unemployment rose sharply and benefits were cut. Nor did rescue packages for Greece and Ireland calm the markets. On the contrary, the fact that two eurozone countries were in grave difficulties made it appear ever more likely that others, with similar if not identical problems would follow. Portugal looks like being the next in line, but with much larger Spain not far behind, followed possibly by Italy and perhaps Belgium too. Although all euros are supposed to be the same, the tell tale signal was the borrowing rates in different eurozone countries. While three or four years ago, there was very little difference between the borrowing rates for euro bonds in Germany and what are now clearly the weaker economies in the eurozone, the spreads have now dramatically widened. Greece is now paying nearly 10% p.a. more than Germany, Ireland more than 6%, with Portugal at over 4% and with Spain not far behind.

  2. What is the fundamental problem with the eurozone?

    The root problem within the eurozone is that some countries have much higher cost bases - the cost of everything which goes into exports - than others. As a result, the countries where costs are higher are uncompetitive with those who have been better at controlling inflation. The country with the best control on its costs has been Germany, which therefore has highly competitive exports and a big surplus on its trade with the rest of the world, much of which consists of countries within the eurozone. The now less competitive economies, on the other hand, allowed their costs to rise sharply in recent years, partly because their eurozone membership allowed them to borrow very cheaply on the back of German creditworthiness, generating highly inflationary property booms. The result is that average export costs in Greece have risen about 25% more than those in Germany since 1999, 27% in Ireland, and 28% in Spain. Portugal has been so uncompetitive for so long that its balance of payments deficit reached over 10% of GDP in 2010. As a result, all these economies run large balance of payments deficits, which have been reflected both in similar sized deficits in their government accounts and, until recently, money washing round the economy leading to highly inflationary asset speculation. As boom has turned to bust, their banks have been left with huge loans, especially those related to property, which are now not fully secured and which it is increasingly unlikely that the borrowers concerned are ever going to be able to repay. Insolvent banks, however, are not just a problem for countries like Greece and Ireland. There is a huge amount of cross indebtedness between banks in all EU countries, so that any bank defaults in the weaker economies could easily generate massive losses and insolvency problems for banks right across the EU.

  3. What needs to be done to resolve the eurozone's problems?

    It is clear that the eurozone needs restructuring. This means that the cost base needs to be lowered to a competitive level in all the countries where it is now completely out of line with German cost levels. There is no way in which it is otherwise going to be possible for these weaker economies ever to be able to recover, resuming sufficient growth to reduce unemployment and to get their government expenditures on to an even keel again. This restructuring needs to be done by an internal euro devaluation in each of the weaker economies, accompanied by strict exchange and capital controls on all external transactions until new currencies have been established. However necessary such policies are, they will come with a high disruptive cost, not least because the very heavy cross border lending which has taken place over the last decade will leave banks right across the EU carrying massive losses. The key requirement in these circumstances is to stop banks defaulting on their depositors. This may well require widespread public ownership and support of banks while the European Central Bank (ECB) concentrates all its borrowing power on securing bank liabilities. This is crucially important to avoid the EU economy spiralling down as a result of bank failures, dragging down the performance of the rest of the world with it.

  4. What is the EU political leadership doing?

    Unfortunately, the EU leadership is desperate not to allow the eurozone to disintegrate, not least because - as they see it - this would be a huge set back to the whole EU project of ever closer union between all the countries making up the EU. Their reaction has therefore been to canvass a variety of different ways of exercising more budgetary control from Brussels over all the economies in the eurozone, in an attempt to force sufficient deflation on the weaker ones to enable them to avoid devaluation. At the same time, however, it has been impossible to avoid the ECB providing large scale loan support to countries such as Greece, Ireland, Portugal and Spain, to keep the markets at bay. Reassuring the markets is crucial because of the need to ensure that there are sufficient lenders to provide the huge sums required both to refinance existing debt and to finance new loans. This has put heavy strains on the relationship between those countries - particularly Germany - which are in a strong enough position, at least at the moment, to underwrite the ECB's loans, and other eurozone states which are in a much weaker financial position. Germany, understandably, wants much tighter controls, which - equally understandably - other countries want to avoid, over budgets, fiscal and financial policies right across the eurozone. The result is that there is no clear EU wide strategy to contain the contagion as the markets get more and more nervous about the long terms capacity of the weaker eurozone members to meet their debt obligations.

  5. Is the policy on shoring up the eurozone likely to be successful?

    While the policy currently being pursued by the EU leadership may delay the eurozone breaking up, at least for the time being, it does nothing to resolve the fundamental competitiveness problems which are at the root of the eurozone's instability. Indeed, the likelihood is that, far from converging, the performance of the stronger and weaker economies will diverge still further, not least because the deflation forced upon them will have a heavy negative effect on investment and their longer term export performance. This is why it is increasingly likely that the Single Currency will break up sooner or later. The policy of propping up the eurozone with more and more loans, however, is fraught with danger. This is because the larger the loans outstanding if and when the crash eventually comes, the more damaging the eventual outcome will then be. The more loans there are denominated in German backed euros to the economies which sooner or later have to devalue, the bigger their liabilities will be at risk of being inflated by devaluation. If both the state and the banks in a devaluing country owe, say, 100 billion euros before the currency depreciates by, for example, 50%, the liabilities in the devalued currency then double to twice their original size, measured in the new currency. This is why the risks are so high and the banks are so vulnerable.

  6. What is likely to happen if EU policies to preserve the eurozone fail?

    There is little doubt that the best course of action for everyone would be for the EU authorities to engineer a carefully managed restructuring of the eurozone as soon as possible, while there is still the borrowing power available to enable this to be done in an orderly way, underpinning the banks to avoid defaults on depositors. This is not however, what the EU is planning to do. Instead it is aiming to hold the Single Currency together at all costs. While the fundamental reason why the eurozone is so unstable and vulnerable is the divergence in competitiveness between the countries such as Germany and Holland on the one hand and Greece, Ireland, Portugal, Spain and Italy on the other, it is not just divergence in competitiveness which is the major current problem. It is also that, as a matter of deliberate policy, once the Single Currency was in being, the EU authorities strongly encouraged inter-country lending, because they thought it would produce economic convergence. In fact it had the opposite effect, creating unsustainable and inflationary property based booms in the countries with balance of payments deficits, as cash - as an accounting identity - poured in to finance the deficits. It is the huge scale of inter-country bank lending on top of unbalanced sovereign debt liabilities which makes the EU authorities desperate to avoid both the economic consequences of the eurozone breaking up and the political opprobrium involved in seeing this happening. The problem, however, is that the longer the EU goes on extending more and more loans to preserve the status quo, the bigger the divergence between the strong and the weak eurozone economies in competitiveness terms will become. As a result, the sums of money owed abroad by banks and the state in the vulnerable economies can only get larger, and the worse the eventual crash will be. The danger then is that there will simply not be the financial resources - and the co-ordinated political will to use it - left on a sufficient scale to avoid bank defaults. If this position is reached, there will be dark days indeed for the EU as unemployment soars, businesses fail and the whole eurozone economy spirals down.

  7. Where does this leave Britain?

    Britain very clearly made the right decision in not joining the euro, particularly at the kind of exchange rate there was between the euro and the pound only a couple of years ago. If we were in the eurozone now with one pound equalling 1.45 euros, our position would be as dire as that of Ireland or maybe even Greece. Like them, within the Single Currency, we would have been confronted with no choice other than drastic deflation, much higher public expenditure cuts than we are facing at the moment, economic contraction and mounting unemployment. Outside the eurozone, at least a major part of the adjustment the UK economy requires can be taken on the exchange rate, and it is this which has saved us from the worst. It is, however, a major illusion to think that, if the eurozone implodes, we will not be very seriously adversely affected. About half our exports go to the Single Currency area and if the economy there declines, ours will too. In addition, our banks are very heavily exposed, particularly in Ireland and Spain, to borrowings which are going to have to be massively written down if these countries devalue. Nor are we free from obligations to underwrite eurozone sovereign debt even though we are outside the Single Currency. The travails of the eurozone are therefore all too real for us, as indeed are the catastrophic misjudgements by the EU political class in setting up the Single Currency in the first place. The eurozone never made any sense economically. Its establishment was always driven by politics, and the huge gamble that a shared currency would generate political unity. Instead, it looks all too likely to achieve the opposite as economic divergence and all its consequences undermine massively both the credibility and the feasibility of political integration towards a single European state.

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