In 1999, eighteen nations in the European Union (EU) established a monetary union, known as the ‘Eurozone’. Nations in the Eurozone can formulate their individual fiscal policies (the ability to set taxes and adopt spending policies), but an European Central Bank (ECB) decides the common monetary policy (supply of money, interest rates and economic growth) for all member nations.
The idea worked well during times of economic prosperity, however, the ECB’s one-size fits all policy is suspect in the face of a global financial crisis.
The problem: Handling of public finances by member governments.
There is no formal structure to bridge the ECB’s monetary policy with the fiscal policy of individual nations. This has led to a chary Germany and a profligate Greece on the same side of the table, both bound by the same monetary policy.
A few riders do exist to protect member nations from their wastrel neighbours. EU Treaties have a ‘no bail out’ clause for member nations with financial difficulty. But, it is easier said than done. In an economy as intertwined as the EU, there is little choice but to bailout nations. The EU, lead by Germany and France have repeatedly bailed out Greece albeit on the condition that Greece slashes its public spending and reduces its national debt. The aftermath of these cuts could adversely effect an already recessionary Greek economy.
When there is a reduction in public spending, there is lesser money in the economy and in the hands of the people. This shrinks investments and reduces demand; thereby stifling growth. Without growth, Greece cannot earn revenue and it cannot repay its loans. If the Greek government increases taxes to reduce the debt deficit, it may lead to a civil unrest and political instability.
In such a scenario, the Greeks have little choice but to throw in the towel and default.
There are two outcomes. The $400 billion Greek debt default could push the world’s financial markets into a double-dip recession. Banks exposed to toxic Greek debt will close down, à la American subprime crisis all over again. Investors will panic and short bonds for other EU nations, especially Italy and Spain as they are heading the Greek way. All this could collapse of the entire euro zone and possibly, the European Union.
Or, investors are anticipating the imminent Greek default and are already hedging their losses.
While no one denies this would drive the global financial markets into turmoil, but unlike in the case of Lehman Brothers the financial markets are ready for the default.
Moreover, EU’s repeated bailouts seem to have little effect on the actual problem, Greece’s national debts. It is as if the EU is trying to buy its way out of trouble and wasting huge sums of good money. The EU should rather use the money to shore up European banks that are most exposed to the toxic debt. They could also use the money to bailout Italy and Spain, both bigger and more powerful economies than Greece and on the periphery of a Greece style downward spiral.
Greece, must use the crisis to cobble together political will to restructure its public finances and rewrite policies. If necessary, it should not refrain from leaving the euro zone, giving up the euro, and returning to the Greek drachm. I can then control its monetary policy, devalue its currency and kick start its exports. In time, these measure may lead to economic growth.
For Greece and the European Union, the only choices are these; the two must work out an integrated and orchestrated default wherein everyone takes a hit or deal with a complete collapse of the Union and with it kiss goodbye to idea of an integrated Europe.