Test time for the euro

The euro seems to be having a pretty rocky time during the opening months of 2009. And not just because all of the world’s major currencies are suffering from the unsettling effects of persistent turmoil in financial markets. No. The problems here could conceivably run much deeper since, for the first time since the single currency’s creation 10 years ago, senior government officials in member states are quietly muttering the forbidden B word. Break-up.

One of the key indicators suggesting all might not be well has been the widening of spreads on sovereign bonds between countries in North Europe and those clinging on to the Mediterranean: namely Portugal, Italy, Greece and Spain (whoever thought up the acronym – PIGS – has obviously spent far too long working in finance and / or government and needs to get a new job). Spreads have come down recenty, but to give an example, at the start of the year credit defaults on Greek sovereign debt was trading at around 250 basis points and Italy at around the 180 mark. By contrast, Germany and the US were trading at around 50.

In layman terms, what this means, is it is much more expensive for countries like Italy and Greece to borrow money. Part of this is to do with their high deficit. Another part if probably to do with financial mismanagement. Basically, the high spread rate means that investors view Italian bonds as riskier than German ones, and demands a higher premium for taking them on.

This is a potentially dire state of affairs – should Greece or Italy be allowed to fail, they could bring down the whole European economy.

In a well-functioning fiscal system (i.e., one with a central nucleus that has all the powers needed to properly control the economy, which the EU does not have), money could (with relatively little political difficulty) be shifted from one part of the economy to another. This has happened in the US, for example, when states have mismanaged their funds – and may soon happen again, as the glorious sunshine State of California has just been declared bankrupt. Naughty, naughty, Mr Schwatzernigga. But it doesn’t happen easily in the EU because of so much national protectionism.

All of this points to one of my fundamental arguments against bringing in the euro: and that was that it needed a proper political mechanism in place for it to work. The EU needs to have the same fiscal stimuli aparatus in place as, for example, the US does. Fine if that is what everyone wants – but shouldn’t we have had a discussion about this beforehand?

Pulling out of the euro will be painful. If one country leaves, confidence in the currency will take a pounding, with all the economic ugliness that entails. And people are starting to worry about things taking a turn for the worse, on the back of all the current financial woes. This is one of the reasons that Angela Merkel, German Chancellor, has recently launched a debate on sending large parcels of taxpayer’s money southwards – to help prop up those heavily indebted countries like Greece and Italy. Now that is going to please all those thousands of workers that have just lost their jobs.

But one thing is for certain. Now is the test time for the euro. It’s own D-day, if you like. If it wins this battle, it has won the war. If one country decides that it cannot take the heat over the next 12 months – and Ireland, from what I am reading, could be the nation that jumps first – then the euro will take such a pounding it may not recover. Other countries could then follow suit, and revert back to their old currency.

But, if all countries grit their teeth and bare the pain, then the EU will have scored a vital victory: it will have proved, beyond a doubt, that the euro can work even in the darkest of days. Eurosceptics may be tempted to split hairs, and argue about whether the euro or old sterling faired better in the crisis (and who emerged from recession first), but such arguments will largely be academic. For the euro will have held tight. And, what’s more, Brussels may suddenly find itself with the opportunity and good will to push through crucial changes for the euro to work properly: additional fiscal stimulus measures and tax-raising powers.

Britain, a tradditional opponent to such meddling, is not going to like that. It will be interesting to see how long the country can stay outside the euro-club.

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2 Responses to “Test time for the euro”

  1. Mike Says:

    Just passing by.Btw, your website have great content!

  2. The public purse « Blake Evans-Pritchard’s Weblog Says:

    […] Blake Evans-Pritchard’s Weblog Blake Evans-Pritchard’s Sudan blog « Test time for the euro […]

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