Options for the Eurozone and Euro

The EU gives the impression of stumbling through the crisis. There is an attempt to deal with issues as they come up, without tackling the fundamental issues underlying the crisis.

In particular, in response to rising bond yields, there is a rush to try to reduce budget deficits and reassure markets. But, this approach is not working. It is not working because:

1. It doesn't address the underlying lack of competitiveness and misaligned exchange rates in southern Europe.
2. It doesn't tackle the need to promote growth in GDP, which will help reduce Debt to GDP ratios.
3. It doesn't reassure markets there will be no liquidity crisis - because there is still no lender of last resort.

See more detail on: Euro Debt Crisis Explained

Options for the Eurozone

1. Internal Devalution, Austerity, Weak bailouts

The current option pursued by the European Union is to

• Reduce spending as much as possible to reduce budget deficits.
• Rely on internal devaluation (lower labour costs to restore competitiveness for the Southern economies)
• Implement structural reforms to restore competitiveness, although these tend to be vague.
  
• Offer a grudging and weak kind of bailout (i.e. the EFSF is guaranteed by countries like, er Italy)
  

The problem of this is that:

1. This is causing lower growth and falling tax revenues. Therefore, markets don't see how the likes of Italy are going to reduce their debt to GDP ratios.
2. Despite austerity measures markets still don't confidence in buying Italian debt because of the fears of recession, and also there is no lender of last resort.
3. The process of restoring competitiveness through this internal devaluation is very slow.
   

If the EU stick to this, we will get prolonged economic stagnation and a serious recession in the south of Europe. There will be a perpetual need to cut spending and try and reduce budget deficits. Internal devaluation may eventually restore some kind of competitiveness (Ireland has been more successful than other) and help promote some kind of economic recovery, but it will take a long time and cause very high levels of unemployment and instability. There will also be persistent pressure from the bond markets. Whether the Euro can surviving bailing out stagnant economies the size of Italy during a decade of economic stagnation is highly debatable.

2. Change the Role of the ECB

At the moment, the ECB seems only interested in preventing the non-existing inflationary threat. The ECB could be reformed to:

• Act as lender of last resort. Buy government bonds without hesitation and give markets confidence.
• Target a higher inflation rate (perhaps as likely as Berlusconi being made an honorary member of the Women's Institute) But, the ECB at least have to see the need to target growth, even at the risk of some higher inflation.
  

3. Break up of the Euro

Concentrate the Euro on only a small group of northern economies who have actually shown a degree of economic harmonisation (Germany, France, Belgium, Netherlands e.t.c). Countries who leave the Euro should honour current contracts in Euros, but new contracts should be based on their own currency (new Lira, New Drachma) These new currencies will significantly devalue. This has both costs and benefits.

• The rapid devaluation will restore competitiveness enabling an increase in export demand
• The devaluation would probably cause capital flight as investors seek safe havens in the 'strong Euro' and away from the south.
• The fragmentation of the Euro could cause great turmoil in the EU. However, it may still be a better alternative than the prolonged recession likely with current policies.

4. Fiscal Union

The other option is to go for broke and have a complete fiscal union. i.e. there would be no Italian bonds, no German bonds, only Euro bonds. This would prevent contagion for weak countries. It would reduce interest rates enabling a more ordered austerity program. It should give better chances for growth.

However, it opens a range of other issues.

• Can the EU impose a degree of fiscal discipline on countries with poor track records.
• Will German taxpayers be willing to bite paying for Italian profligacy.
• Is fiscal union enough? It still doesn't promote competitiveness and economic growth.
  

Related

• Potential impact of debt crisis on UK
• Solutions to EU crisis