The Future of the Euro - an Economic Perspective on the Eurozone Crisis - Essay Example

The Future of the Euro: An Economic Perspective on the Eurozone Name Institution The Future of the Euro: An Economic Perspective on the Eurozone Crisis Benefits of Single Currency From the economic and political view, U.K has been for many years reluctant on submerging itself into a European identity. With its prescription of the shape and size, the EU remained an easy target for the tabloids and satirists of the U.K. The idea of giving up the currency used for the nondescript EURO is unlikely to make a populist political agenda. Nonetheless, with no focus on the political aspect, there is increasingly little support for the EURO even from the economic perspective. The benefits of joining the EURO are, to some extent, becoming increasingly marginal. The major benefit associated with using a single currency is stabilization in exchange rates. Joining EURO reduces the exchange rates volatility, especially with the EU trading partners (Germany, 2012). Although, since 2003, the £ showed very little exchange volatility rates. The Chief Economist HSBC, Stephen King, claims that in essence, U.K has already joined the EURO. Besides, it is relatively an easy process of insuring against the exchange rate movements through purchasing currencies on the open markets. Hence, currently, there is little risks associated with the exchange rate fluctuations. Just like some banks pay negative interests and charge the depositors to keep their money in the account, so does some central banks in Europe, which have cut the interest rates below, zero. For some countries, the strategy aims at reinvigorating the economy after exhausting other options while some employ the method to push foreigners to move their money in other countries. Either way, these strategies are unorthodox choices that have been able to distort financial markets. Although some of the commercial banks began passing the negative rates to the customers, it is crucial to note that such strategies might backfire. The major factor that has been able to contribute to low-interest rates in the eurozones is low expectation of inflation. A portion of the long-term interest rates often reflects an inflation premium that aims at reimbursing the investors for their potential losses in the purchasing power of the money over the period of security. Recently, the premiums gradually came down to very low levels reflecting reduction in expectation of inflation attributed to the commitment of the central banks. In addition, the real interest rates also came down to low levels indicating a downgrading longer-term growth prospects. According to secular stagnation theory, the global economy is suffering from deficient demand, which pushes the equilibrium real interest rate. Besides, scarcity of safe assets is another factor contributing to unusually low interest rates. In most cases, such incidents often result large purchase of the government bonds by the central government most referred to as quantitative easing (QE) (Germany, 2012). To reinvigorate economic growth in the wake of global financial crises, the major central banks in Europe have focused on lowering the short-term rates to virtually zero within the eurozones. In addition, these banks ensured exertion of direct downward pressure on the long-term rates through QE. However, elevated risk aversion could also contribute to the scarcity of the bond making the investors shift towards the government bonds, which they perceive to be more valuable against the risks than other assets. The new regulations used in the European countries to enhance financial stability also constrain banks, insurance companies, and pension funds to hold more debts of the government. If the European countries face declining net issuance, the investors will shift to the government bonds making the yields of the banks fall to zero. Upon hitting zero, there are fewer options available to remedy the situation. Another importance of having a single currency is the inward investment, which has continued to soar even outside the EURO. Initially, most economists and financial institutions thought that joining EURO was significant in attracting sufficient inward investments. Nevertheless, as it currently stands, the separate currencies have not been able to deter further inward investment. When U.K was facing financial crises, the traders had to find solutions to some of the challenges they were experiencing. With the rising level of competition, most business investors are seeking alternative market gaps that would ensure they acquire loans at low interest. As a result, most traders practiced carry trade which is a strategy used by the investors in borrowing money at low rates to invest in an asset that would provide higher returns. However, the strategy is prevalent in foreign exchange market. For example, below 2007, most investors borrowed Japanese yen and Swiss francs to take advantage of low-interest rates in Japan and Switzerland respectively. Furthermore, the investors used the money in countries whose currencies are backed by higher interest rates like New Zealand and Australian dollars and South African rand. Even though most investors prefer such strategies, concerns have been on the rise due to the negative effects of carry trade on macroeconomic and financial stability. Consequently, it contributes to extended periods in which the currency appreciates and finally declines. Single currency assists in reducing the inflation rates. In U.K history, there was a moment it was identified as “sick man of Europe” owing to the deteriorating economic state at that moment. The major factors that characterized its economy were booms and bust cycles associated with the ever-rising inflation rates. The economists thought that joining the EURO might assist the country in developing a strong anti-inflation framework. In some countries, the inflation rates remained close to the target of the governments (2%). Moreover, such inflation rates could be consistent with the enviably high growth rates, which make it crucial to note that when a country is outperforming within the Eurozones, there is little reason for joining. Joining the EURO gave U.K a small gain with regard to reduced costs of transactions and greater stability in the exchange rates. However, it is important to emphasize those most investments, either domestic or foreign; these costs are smaller percentages of the total costs. Although to some extent, some economists think that joining EURO might as well contribute to important economic problems. EURO contributed to competitiveness among the investors especially in the Northern Europe where businesses were able to redesign the strategies to focus on the value chains while investing in the eurozone economies. The reduced interest rates supported such strategies allowing the companies to reap the benefits from the economies of scale and operational scope. The Euro’s Fundamental Flaws The current problems experienced by Greece and other eurozone countries have been able to highlight some of the flows in the euro. The problems experienced by the countries consider euro an ill-prepared approach of dealing with the asymmetric shocks considering the fact that its balancing mechanisms are inadequate. However, from the case experienced by Greece, it is clear, serious fiscal irresponsibility integrated with the creative accounting concepts generated from the Wall Street severely aggravated such predicament. Currently, focusing on the strategies that would assist in preventing the Greek meltdown is of great significance. In the worst-case scenario, the crisis is spreading across the eurozone, which is seriously destabilizing the financial systems. As a result, the problems trigger greater social tension within the countries not to mention the associated political implications for the integration of euro and Europe. If the problems experienced by Greek continue to escalate, then Britain is also likely to be hit which makes it important to take effective measures. Any direct assistance from another European country such as Germany for the troubled Greece might be difficult considering the existing tight legal and constitutional regulations. Furthermore, such assistance is also likely to outrage opinion in both countries. In Germany, the citizens would not understand the reason for the endurance of wage reductions, social security cuts, and paying for the country that failed to adjust to the competitive pressures. To some extent, the Greeks would also be outraged on the sovereignty grounds citing that their fiscal policy might be run from Berlin if they received direct assistance. Therefore, to solve some of these problems, it is significant to have realistic measures at the European level. For effectiveness, the countries need to ensure the existence of two mechanisms currently lacking including an emergency system that aims to prevent crisis from spreading across the eurozone and better mechanism for maintaining and policing the fiscal responsibilities. Initially, the Maastricht criterion was identified as inadequate even before the struck of the financial crisis. Although there were insignificant changes, the rules and regulations were too flexible to account for special conditions, which needed flexibility such as handling the cost of unification experienced in Germany. Besides, fiscal straitjacket than the assistance mechanisms in maintaining the financial stability is significant. It is possible to circumvent through creative derivative deals. In addition, if the global magnitude hits, then it means very little since the deficit would have to increase beyond the Maastricht limits. The inadequacies experienced by the European countries pointed out to inadequate institutional mechanisms of dealing with such shortcomings. However, the stability of the criteria needs to remain the norm. The countries seriously need the economic governance system for the eurozone that offers greater oversight over the fiscal discipline and coordination of fiscal planning with an aim of preventing eurozone members from drifting further apart. Additionally, the Maastricht criteria, which are policed by the European Commission, are obviously inadequate. There is also need for a safety net to assist the member states of the EU in trouble. The idea behind the European Monetary Fund (EMF) is considered currently floated and crucial in remedying the prevailing conditions. The newly established EMF needs to cover the eurozone but the entire EU and funded through the contributions from all the EU member states (Germany, 2012). Additionally, the funds should also come from other sorts of the European tax on the financial sector. Such integrations would allow EU to function as an insurance financial institution funded by the industry itself. The countries that do not fall within the eurozone such as Britain might as well have additional security mechanisms. Precisely, having an EMF might not prevent Greece and other states from implementing the cuts that allow them to realign themselves with the rest of other eurozones. However, these activities would assist in providing a tool of supplying short-term liquidity attached to some specific situations, providing security for the available financial systems from the European Policy Studies argue. Concisely, what the eurozone currently experiences is a theoretical design flaw that is growing into a painful reality. However, it is not too late to address these issues, which makes the European governments to be at the central place in making decisive decisions. Currently, the British diplomats are concerned over the fact that the 17 governments using the euro might strike an agreement on the new rules between themselves and excluding the non-euro countries like Britain. Some economists suggest that there is need for fundamental economic reforms to respond to the euro crisis never required treaty change. Despite the much worries about the treaty changes process, some economists are pessimistic in their analysis that the financial markets are increasingly becoming optimistic that the leaders from the EU are edging towards dealing to support the eurozone. The euro group recently held a summit, but the outcome has failed to move Greece closer to ending reliance on the official tenders since its economic condition remained dire. However, the summit illuminated the design flaws within the eurozone that resulted into Greek’s crisis in 2010 and reminded the economists that the design flaws had not been fixed. Besides, it also created new risks for the heavily indebted members of the eurozone. If a country loses access to its sovereign debt markets, it can neither manage its budget deficits nor replace the historic borrowings since they fall due. With the unavailability of the non-market support, the country might be forced into immediate and possible some destructive fiscal corrections. The major aim of the lending program as provide by the IMF is to return the countries as quickly as possible to a credit worthiness state, thus the market access without experiencing severe contraction. The “rescue” of Greece in 2010 aimed to return the country to the markets without the need for further support after 2013 (Germany, 2012). The “no bailout” clause within the eurozone means that when the member states are in financial troubles, they can only turn to IMF, which often insists on the default especially to states that financed the initial excess. The factor that motivated the abandonment of the bailout clause in Greek when it experienced the crises in the late 2009 and early 2010 was the contagion fear. Additionally, the default might have severely affected countries such as Germany, French, and financial institutions that were fragile due to large Greek exposure. If IMF deemed Greece insolvent and permitted its default, then there would have been costs especially for French and Germany treasuries while rescuing the financial institutions in danger. Instead, both the Europe and the IMF lent the money allowing the payments to creditors but the debts transferred to Greek. The economists at the IMF made several reservations on Greek’s debt sustainability in 2010. However, they failed to persuade the political leadership to trim those holding the greek’s sovereign debt. The Four Possible Scenarios Currently, the eurozone is at its crossroads and facing the greatest challenge in the history. Additionally, both the systemic crisis and political attempts in overcoming the challenges have far-reached the effect for the future of the Economic and Monetary Union (EMU) and European integration. Through identification of the major drivers influencing the future development of the EMU, several scenarios were developed to offer insight on how the future eurozone will look like by 2020. Scenario 1: Monetary Bridging The defining feature of the scenario is the ineffectual implementation of the major existing agreements and management crisis considered reactive in addressing the ad hoc liquidity issues and deficits from the budgets. However, the scenario does not centre on the long-term fiscal stability or on the restoration of competitiveness and growth. Instead, the governments need to introduce reforms over short durations that only aim to address the most acute issues since the current fiscal pact might not only be limited to the extent but also ratification, slow growth rates, and high debt economies. The interventions from the EFSF and ESM might as well be insufficient of reassuring the market participants, which could contribute to increment intervention strategies in stabilizing the market position by ECB. Besides, the ECB might as well create a position that is difficult to align with the statutory regulations for the central banks. The scenario majorly focuses on the role played by ECB with regard to inflation and currency effects. From the analysis, the interest rate volatility is likely to remain high which could make market accessibility fragile. Such concepts might compromise the confidence of consumers and industries thus constraining the future economic growth. It is clear that the eurozone might experience high volatility, and low confidence among the consumers and industries like in 2008 and 2009 Lehman Brothers experienced bankruptcy causing the sub-prime mortgage bubbles to unravel. There is projection that between 2011 and 2016, the GDP of the eurozone might grow weak with an annual growth of 0.6%. Besides, the level of debts would increase to averagely 89% of the GDP. However, factors such as employments rates might increase with eurozone in 2016. The financial markets remain unsure of whether the eurozone governments can do enough despite the numerous monetary measures in place. The uncertainty level is high and the investors are critical. Therefore, the scenario only buys time but with continued diminishing level of effectiveness while the politicians might as well fail to agree on the logical path that is consistent and economically sustainable. Scenario 2: Fiscal Pact Plus The aim of the scenario is to build on the current policy proposals while focusing on the fiscal pact established during December 9 summit. The summit highlighted the strict limits on the budget limits and proposals for enforcing strict regulations for the eurozones. Additionally, the member states are expected to observe such limits cyclically through adjusting the deficits by 0.5% of the GDP and introduction of the constitutional debt brakes. However, every country needs to be responsible for its budget though many details still require hammering out. The scenario complements the status quo with regard to the various aspects of guaranteeing the attainment of sustainable and holistic solutions. The complements include promoting the policy coordination, providing liquidity, and long-term growth objectives based on the structural reforms in regaining the level of competitiveness (Germany, 2012). There is need for effective and interdependence EMU governance among the member states, which require high level of degree coordination. The fiscal pact plus requires the adjustment mechanisms to compensate for the different regional development through ensuring cross-border mobility and sufficient flexibility of the actual wages. Through the integrated financial markets and institutions, the EMU requires pan-European tool for supervising and reconstructing the banking sector. However, the arrangement might still fall short of the policy integration level, which has underpinned the other monetary unions. Another mechanism is through monetary stabilization while addressing the liquidity and public finance issues. These mechanisms also ensure that the countries can plausibly respect their inter-temporal constraints associated with budgeting. Scenario 3: Closer Fiscal Union The fiscal unions often complement the monetary unions; however, as a monetary union, EMU continues to maintain control over its national budget and taxation policies. Outside the eurozone, fiscal unions relate to a single budget. From the scenario, when there is a shift of powers over the budgets to the supranational state, then such instances become non-starter for the European political reasons. With regard to the “no taxation without representation,” the electorates within the eurozones might oppose such shifts, which could envisage that any move towards closer fiscal union could involve a gradual process for political reasons (Germany, 2012). Even with the fiscal unions taking different forms, the scenario describes a fully-fledged fiscal union type that differs from other fiscal arrangements. The proposal from the EU summit often requires the states in violation of the debt and the deficit limits to concede some of their fiscal sovereignty and other elements that could strengthen the eurozone. Some of the elements include joint and severe liabilities of the EMU members, EMU level of taxation, fiscal feudalism, and euro bond issues. With the temporary transfer scheme, it is clear that eurozone could evolve towards a permanent redistribution system. The fiscal pact plus scenario views that the path towards a closer fiscal union is through maintaining individual liability except under the conditions set by the EMF within the liquidity constraints. As a result implies a collective liability for some sovereign debt. Scenario 4: Northern euro/euro break-up The scenario views the EMU as struggling economies, closed from accessing the funds, and thus forced to leave leaving some in the Northern Euro. There is possibility of different constellation though it is assumed that the new eurozone include France, Germany, Slovakia, Estonia, Netherlands, Belgium, Luxembourg, Finland, and Slovenia. In addition, it is assumption that the Northern euro might strengthen the provisions associated with stability and growth pact. Such scenarios might as well limit the debts on the share of the GDP and codified within the Constitution of the members and violation identified through an independent authority (Germany, 2012). Irrespective of the chosen independent body, the sanctions would have to be implemented and legally enforceable with the European Court of Justice. Other codified factors within the constitution include the no bailout rule. Even if there were the homogeneity of EMU, the currency zone would still require a workable mechanism for ensuring economic adjustments whenever there is an asymmetric economic shock. Nonetheless, the scenario would have to meet the prohibitive costs due to the pronounced interdependence of both the assets and liabilities of the financial institutions in Europe. In the long term, the break-up might mean irreversible loss of opportunities majorly at the microeconomic level, reducing the effective of the market size in which the shared currency accelerated more trade, and contributing towards economic integration. As a result, there would be reduced economies of scale and increased cost of managing the integrated supply chains. References Germany, M. (2012). The future of the euro: An economic perspective on the eurozone crisis. Retrieved from https://www.mckinsey.de/sites/mck_files/files/The%20future%20of%20the%20euro_Mc Kinsey%20report.pdf Read More