Thursday, April 1, 2010

Problems Facing Eurozone Economy

At the start of the global recession, the Euro appeared to be faring relatively well. Germany and France were two of the first major OECD economies to emerge from recession. The collapse of Iceland had many people suggesting the Euro as the solution to global instability. However, in the past few months, the growing problems of Greece and other peripheral Eurozone countries have highlighted some of the problems with the bold Single Currency experiment.

The first problem facing the Eurozone is the prospect of a deep and persistent recession in the southern Eurozone economies. Greece, Spain and Italy already have falling GDP, but, current economic policies make it hard to see how they will recover.

Debt and Default

The Maastricht Criteria was supposed to limit government borrowing to 3% of GDP. However, this has been ignored. Greece is borrowing 12% of GDP. Italy and Spain are not far behind. Eurozone economies facing crippling national debt burdens. The irony is that the strength of the Euro enabled Greece and Italy to borrow for a long time at low interest rates. If they had not the strength of the Euro, markets may have charged higher rates earlier - there may have been market pressure to contain borrowing at an earlier stage.

However, the level of debt has raised the prospect of a sovereign debt default. This has worried markets causing the recent sell off of Greek gilts. The problem is not just confined to Greece, but, also the much larger economies of Italy and Spain. Prospects of debt default or just higher interest rates will undermine the strength of the Euro.

The problem is that the EU doesn't like the idea of bailing out profligate countries. There is not just the political problem of using German tax revenues to pay for a bloated Greek civil service. There is the real problem of Moral Hazard - where is the discipline to contain borrowing if the pain can be shared by your neighbours?

The other problem is that very stringent policies to reduce borrowing (tax rises, spending cuts, wage cuts) will damage the economies GDP. Yet, there are no other policies to fall back on to boost Aggregate Demand. They have to pursue tight fiscal policy, but, cannot loosen monetary policy or depreciate the exchange rate.

Unequal Labour Costs

One of the underlying problems in the Eurozone is the increased divergence of wage costs and competitiveness. Rising wage costs in Greece, Italy and Spain have made them uncompetitive, leading to large current account deficits, falling exports and higher unemployment. In the past, this would have caused a depreciation in their exchange rate and their competitiveness would have been regained. But, of course, this can't happen in the Eurozone.

Non Optimal Currency Area

Why does a single currency work in the US but not Eurozone? An unemployed person in California can relatively easy move to Texas to get a new job. But, the unemployed Spanish worker faces much more geographical immobilities to moving north (to say Germany or France). The lack of Geographical mobility and the geographical divisions means the Common Monetary policy can't meet the varying needs of different Eurozone Economies. see: Is Eurozone optimal currency area?

One Monetary Policy Doesn't Fit.

If Germany is growing strongly, due to rising productivity and exports, the ECB will wish to pursue a tight monetary policy - higher interest rates (certainly no quantitative easing). However, an economy like Greece is facing deflationary pressures - wage cuts, falling prices, rising unemployment. However, the south of the Eurozone needs the expansionary monetary policy the UK implemented - quantitative easing, prolonged zero interest rates. But, in the Eurozone, you can't have different monetary policies.

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