In the 1990s Europe was debating which countries should join the eurozone and what the qualifications should be. Initially Germany, France, Belgium, the Netherlands, Luxembourg, Austria and others were considered favourably, but that was the easy bit. The real debate started shortly after; will Italy be ready to join with the first tranche? What about Spain & Portugal? Then Greece. What? Greece to join the eurozone? Impossible – that will never happen! Today, as we all know very well, these countries all form part of the eurozone.
When any economic zone (such as Europe and the US) is considering a single currency, a couple of very important qualities for a common currency need to be present; a) labour mobility between the common currency zone and b) fiscal transfers with a strong central government able to transfer monies between areas of varying economic strength. Arguably, Europe does not have enough of both. Furthermore, the criteria that were originally established to maintain stability and discipline within the eurozone and hence achieve economic and monetary union, through the Maastricht Treaty, have also been ignored by most eurozone members (including Germany and France) to various extents.
Today, shortly after the euro’s 10th anniversary of its virtual birth, we are starting to see major cracks in the system. The problem however is that no easy and cheap solution exists, primarily because of the structural problems behind these cracks and secondly because of the intelligent idea of having a common currency. The root of the European problem is competitiveness in costs accompanied by the fact that devaluation of a country’s own currency is no longer an option. Greece today cannot devalue the drachma and restore its competitive advantage.
The reality is that governments of southern European countries will fail to deliver on their long term promises – specifically healthcare and pensions. Ten years ago, these same governments would have very easily addressed their problem by devaluing their home currency and restoring competitiveness. That would have balanced the books in a very short period of time – but fortunately that is no longer possible.
I intentionally say fortunately because maybe, as a result of the financial mess some European Union members are in, these governments are going to have to apply real long term measures to restore competitiveness. Measures that restore efficiency and promote savings, measures that require entire nations to start from scratch with the use of simple financial models which go back to basics in terms of personal and national finances. It is imperative to understand one very simple concept – leverage of a balance sheet (be it of an individual, institution or nation) comes at a cost, an ongoing annual cost which needs to be serviced and honoured otherwise the long term future of that entity is jeopardised.
In all probability, these measures will not achieve the desired GDP growth in the quickest way possible, but they are definitely the measures that stand the best chance of addressing the structural problems of the southern European members. Greece, Italy, Ireland, Portugal and Spain all need to go back to their drawing boards and start thinking of how to achieve an increase in productivity in order to restore competitiveness. It is normally easier to lower real wages by generating inflation than by keeping inflation low and telling your work force that they have to take a pay cut. But since devaluation is not an option, that is exactly what Europe needs to do to become competitive again – get costs back in line. This is what Ireland is doing.
Europe needs to start focusing on growth and in order to achieve this, the problematic European members need to embrace and swiftly adopt austerity measures in order for them to exit such financial distress in the shortest time possible. I strongly suspect that such measures would not be considered at all if currency devaluation were a choice.
On the other hand, one must not ignore the interim risk the eurozone is currently facing – the risk that the irresponsible eurozone members will negatively impact the healthier and more financially responsible nations, an impact great enough to bring down the entire system. Imagine being a hard working, financially responsible German citizen, extremely mindful of what is affordable and what is out of reach, being asked to pay more taxes (and therefore having to work harder to maintain your current life style) to bail Greece out. This statement arguably oversimplifies today’s scenario by leaving out the economic histories and political relationships between the two nations, however, it is a fact that the German workforce is not at all pleased with this Robin Hood approach being applied in Euroland.
A possible outcome could be one where, rather than seeing the weaker economies exiting the eurozone, the financially stronger nations will exit instead. In conclusion, Europe is definitely making financial history which could either break it up yet again, or see it emerge stronger (financially) than ever before.
This article has been prepared by Karl Micallef, an investment executive at Curmi and Partners Ltd, and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
www.curmiandpartners.com
Mr Micallef is an investment executive with Curmi & Partners.