Sunday, May 15, 2011

The eurozone crisis and why you should care

The eurozone is on fire. I don't know if anyone of you have noticed this, because in the US, no-one really cares about what happens across the pond.

This is problematic, because if the eurozone collapses, the party is over for the US too.

Before I explain more on that, let's just go through the basics:

The eurozone is a union of 15 countries, all with the same currency (the euro) and central bank interest rate. The idea behind the project is to further trade between the countries. The shifting exchange rates and transaction costs associated with different currencies used to be a barrier to trade between the european countries. The euro is meant to solve that problem and furthering European integration.

A reason behind the "integration" that is seldom mentioned, but that still exists, is that the EU is trying to overtake the US as the leading superpower of the world. A common currency is therefore necessary, a currency that can compete with the dollar for the position as world reserve currency.

So what is the problem then, with this currency collapsing? Doesn't that just make the US stronger, since it removes an otherwise serious competitor for the position as the world super power?

First, the euro is collapsing because a number of countries in the eurozone - most notably Ireland, Greece, Portugal and Spain have taken on way too much debt (sounds familiar?). If one of them falls, that's it for the euro. That's the thing with currency unions; if one member falls, then everyone is dragged down. All these countries, and many others, had huge property bubbles, but contrary to the US, they couldn't as easily bail out their banks (they didn't have virtually unlimited credit since they are much smaller). The interest rates on the bonds of these countries went through the roof, and three of them have already been bailed out by the EU/IMF (Ireland, Portugal and Greece) - that is to say, the EU/IMF gave them a loan to a lower interest rate than the market would provide. The interest rates they got were still way above what any of these countries can handle. And to make matters worst, no-one can afford to bail out Spain.

If you have an excessive amount of debt, you can always inflate it away - by printing money to pay back the debt, you avoid default. Of course, inflation goes up, but you can relieve the pressure from the economy for a while and deal with inflation later.

If you're in the eurozone, this isn't possible, since countries cannot decide themselves how much money to print. There is only one central bank for the whole area, and only one interest rate. As long as all the economies are in a boom, or all economies in a bust, that doesn't have to be a big problem. The problem is when some economies are recovering and wants to raise the interest rate (to combat inflation), while others (like Ireland) want interest rates to fall lower so that inflation can eat up some of their debt and ease the pressure. Right now, interest rates are increasing and will continue to do so, which will only lead to more pressure on the four countries struggling with their debt.

Virtually every economist in Ireland appears to agree the country will default. What year, exactly, is hard to say - 1 year, 3 years, 5 years? But default they will. And if they don't, Greece, Spain or Portugal certainly will - remember all four has to survive for the euro to survive. Those odds simply aren't good.

Now, why is this such a bad thing for the US? Two reasons

1) If the Euro collapses, or stabilises at a much lower value, that means imports will increase. It will be cheaper to buy European goods. Many countries are likely to leave the euro, and when it finally dissolves, these countries will have currencies much cheaper than the euro (one problem now is that the euro is simply too strong for a lot of countries). So, the trade deficit will increase.

2) Most serious is the problem that many American financial institutions got huge investments in Europe (investment banks in particular are very international). These countries defaulting means big trouble for these banks, and several may actually go bankrupt. Bonds will become worthless, investments in the euro currency will drop heavily in value, loans with fixed interest rates denominated in euros will mean big losses. And these banks have pretty much no margins; remember they were recently bailed out by the US in 2008 and have just barely recovered.

What is the US to do? Another bailout? That's hardly credible, the first bailout obviously didn't solve anything. And where would the money come from?

I think the US should offer the EU to assist with a controlled demolition of the eurozone, as opposed to a panic that brings down both of them. I believe many of the countries in the eurozone have already started to plan for what they are going to do when the euro is gone; for how they can bring their old currencies back. That is an area where the US may be able to help out and should if possible do so. It's in everyone's interest, even if intervening might not be free. It is certainly cheaper than repeating September 2008 all over.

Which 2012 candidate will be the first to adress this issue?



Anonymous said...

LOL, stimulus packages for Europe now too? It's not enough to bail out GM and Chrysler, let's bail out Fiat and BMW too.

Anonymous said...

John, I actually read your post, but I didn't make a comment. Don't assume that because people don't comment, they don't care. These are significant issues; just as Japan's earthquake/tsunami affects us all, Europe's ability to keep itself out of trouble also affects us all.

Many voters in the US don't pay much attention to what is happening with the national debt in our own country, so I don't see them paying much attention to what happens in other countries. Our current President is now in campaign mode--what he does best--and probably has as many ideas to cope with these money problems as the man in the moon.

I support a man for POTUS who actually does have firsthand experience with global markets and fixing businesses that are broken--Mitt Romney. Governments may not be the same as businesses, but at least he has some experience in these matters. He won't underestimate the importance of the European alliance or of the Japanese earthquake. That's a start.


John said...

Stimulus packages for europe? not exactly. but if the US can do anything to construct a controlled demolition instead of a meltdown in the eurozone, it should do so.