* Patrick Dixon advises senior teams in many of the Europe’s largest corporations on a wide range of global trends including macro-economic issues.
I am often asked about the future of the Euro and Eurozone nations. Will the Euro collapse? Will one or more nations leave the Eurozone? Will nations like Greece default on their national debt? Will EU nations like the UK who are outside the Eurozone be damaged in the possible chaos?
Since the late 1990s I have warned of the risks and challenges facing Euro nations, as they seek to manage their own economies with common exchange rates and interest rates, but without the proper financial disciplines that would be expected if Euroland were a single nation of separate States like America.
Things can muddle along when the global economy is stable, but in economic crises, agility is always vital, with speed of response, rapid big decisions, firm and courageous action. These things are essential to restore market confidence.
We have seen such clear leadership in nations like the US, Australia and the UK, but in the Eurozone we have seen dithering, bickering, posturing, point scoring, blaming, blocking, delays, denial, muddle, confusion, complacency and toxic paralysis. We have also seen protests, riots and significant further loss of government control.
So here is my answer about the future of Euroland – written for non-economists, in non-technical language. Simple facts which cannot be avoided, and will drive the future survival of Europe for the next two decades.
More Euroland crises are inevitable
Euro nations will be at risk of crisis after crisis, for reasons I set out below, until the Eurozone is radically restructured – as it must be. At the same time, they will also continue to benefit from the ability to buy and sell goods between them without exchange rate worries or costs – but it remains to be seen whether these benefits will be worth their risk. The answer will vary from nation to nation.
Those outside common currency areas will remain vulnerable to speculative attacks on their own individual currencies – as we saw in the UK on Black Wednesday, an event which threw the UK out of the entry process for the Euro. It is much harder for global market traders to push a regional currency like the Euro up or down in a major way against – say – the dollar.
Hard facts which must be faced
Here are some hard facts about life with the Euro that have to be faced: facts that will not change and will dominate the long term future of Europe. These facts lock all nations inside the Eurozone into an economic prison from which there can be no escape – unless they leave.
1) COMMON CURRENCY – blessing and curse:
When nations share a common currency, they lose two vital control systems to balance boom and bust, inflation and deflation, over-growth or recession / depression. The first is a national exchange rate, and the second is a national interest rate. There are no other tools which are as powerful.
Why do these matter so much? You may not notice when all is well, but in rapidly growing economic crisis, loss of both controls can be as dangerous as sailing a medium sized boat in a severe gale with a broken rudder, broken mast and no engine.
To use another analogy, nations are like market stalls. Think of a local trader who sells oranges in a local fruit market. Every day, and from hour to hour, he varies his price to make sure he makes as much money as he can from his stock, and is left with as little unsold produce as possible. The value of his stock rises and falls.
Imagine a government official coming along and telling him that from tomorrow, whatever the market conditions, all oranges must now be sold at a fixed price – set at an average of his normal prices over the last three years. It will have a terrible impact on his business.
On a good day he will run out of stock early, while on other days he will be left with mounds of rotting fruit. Sometimes he will be fortunate and be able to buy oranges from farmers at low prices and make a profit. On other days he will struggle to be able to buy any fruit at a price worth selling. He will soon be out of business.
Every nation is similarly buying and selling its products in a market where conditions are constantly changing. All these products have to be paid for in local currency – pounds sterling in the case of the UK.
The more people buy, the more pounds they buy. As they buy pounds, the value of the pound increases in the global market. If they do not want to buy, the value of the pound falls until they are tempted to buy once more.
So when you have floating exchange rates, the price of goods in every nation rises and falls for buyers in other nations – even when the price remains the same inside the nation where those goods are made. So prices can stay relatively stable for trade inside a country, while export and import prices are adjusting rapidly.
Automatic adjustment for inflation
Suppose there is high inflation in the UK – with wages increasing by 20% a year. So the price of UK goods for people buying in dollars is rising by the same amount.
An American will soon find that they can get two prices for an almost identical product: high price from the UK, low from everywhere else. So they stop buying from the UK. If this happens on a large scale, as a direct result, the value of the pound starts to fall.
As the pound falls, two things happen which are helpful to the UK economy: the American buyer soon starts buying from the UK again, and the British buyer finds it increasingly hard to afford foreign goods – buying from local businesses instead, which helps support British jobs and communities.
So we can see that a floating exchange rate provides a helpful, natural balance to inflationary pressures – constantly adjusting prices of exports of a country, as the situation changes, and helping a nation to recover in a crisis.
Now let us look at the example of two nations within the Euro with no exchange rate variations. They always know the price they are buying and selling at because they never have to worry about exchange rate fluctuations. Business deals are easier and less risky. But other risks become greater.
If the UK joins the Eurozone and then has high wage and price inflation, UK goods will price themselves out of the wider European market very quickly, but the price of all imported goods from other European nations remains the same. Unemployment will then rise in the UK in our example, because people cannot sell outside the UK. Many businesses will shrink or collapse.
In this Eurozone example, the only way that the UK can become competitive again is if people are willing to cut their wages right back to where they were before they started to rise faster than their neighbours’ – that could be a 20%, 30% or even 50% cut. As it happens, they will have no choice. Those that continue to charge too much for their labour will soon be out of work.
As wages fall and unemployment rises, more people cannot service their loans, house prices collapse, prices of other assets also fall, loans become larger than the assets they were used to buy, people default and walk away from over-mortgaged homes, property prices fall even more, banks start to collapse and the economy spirals into crisis. Deflation of – say – 10-20% a year, for several years, can destroy a nation far more effectively than inflation of a similar order.
As prices start to fall, people stop spending, worried about their future, or because they hope for bigger bargains tomorrow. Shops start to close. Meltdown can follow.
This is the story of Ireland in 2011: they have seen wage cuts right across public and private sector to try to restore competitive prices – made worse because Ireland is locked into the Euro. In a similar situation, the UK currency has fallen by 20%, so British residents have found imports more expensive, but those outside the UK have found British products and services are now at better prices. Manufacturing exports are rising.
If Greece had stayed with the Drachma….
If Greece had remained outside the Euro, in 2010 and 2011 we would have seen a sharp fall in the value of the Drachma. Tourists would have flocked back into the country, taking advantage of cheap holidays, and Greek people would have had to get used to buying less foreign goods for a while, buying more from each other instead. The economy would have stabilized at a new level.
2) INTEREST RATES – LOSS OF CONTROL
When prices rise by - say - 5% a year, the value of cash falls by the same amount. So after a year, £100 is worth only £95. No one in their right mind would want to save money in such a situation, unless they receive interest to compensate them for the difference.
When money is (almost) free of interest, people tend to borrow as much as available, and spend rapidly. As they do so, prices rise, we see a boom. When money is very expensive to borrow, people tend to pay back debt, spend very little, and prices fall. So governments have a powerful lever to regulate demand, by varying the interest rates they are prepared to pay on government borrowings.
Regulating a house price boom
If there is a housing boom, a national government can offer savings certificates with a high rate of interest, encouraging people to stop spending and to save with the government. Mortgage interest rates then rise, because banks have to keep their borrowing and lending products broadly in step with what government is doing (market forces), and then house prices start to level off or fall.
But in the Eurozone, imagine we have three nations with house price booms, and three others where house prices which are collapsing. What interest rate should the European Bank set? How do you make sure that three national economies are slowed down, and three nations speeded up?
This was the dilemma when Ireland joined the Euro. The Irish economy was already growing fast, encouraged by cheap labour and low corporation taxes which attracted many large corporations into the country. At that very moment, this “tiger economy” entered the Eurozone, where interest rates were much lower than Ireland really needed. The reason was that Germany and other nations were struggling to grow, so the Central Bank had to keep rates down.
Irish borrowers enjoyed a bonanza: a frenzy of low cost house loans followed, driving up house prices even higher.
Dublin became a huge building site, with massive new estates springing up across the city. And still interest rates stayed low.
When the inevitable collapse came, triggered by the global economic crisis, Irish house prices fell by an astonishing 50%.
If Ireland had been outside the Euro, you can be sure that interest rates would have been much higher during the housing boom, and then slashed to almost zero as in the US and the UK – but instead, Ireland has recently been hammered by far higher borrowing costs than they needed, imposed by European Central Bank.
The reason: Germany and France’s own economies are now recovering, and of course we have all the newer additions to the Euro to consider, with higher growth rates than Ireland.
So Ireland has to an extent been driven into mega-boom and then battered by a mega-bust as a direct result of being inside the Eurozone. To an extent we can see the same has happened in Greece – one of the factors which contributed to the crisis in 2011.
So then, we can see that the combined impact of European-average interest rates and exchange rate means that individual nations inside the Eurozone have lost their two most powerful tools in controlling their own economies.
Government debt – ticking economic bombs
There is another huge hazard: lack of control over government debt in Euroland. If a nation like the UK is outside the Eurozone, and spends too much money, borrowing a huge amount in the market, or printing millions of pound notes, then its own currency become less valuable. So it faces the result of overspending in a very direct way, which is isolated from impact on other nations.
If the UK overspends, or misbehaves in other ways, it will have to face more expensive imports, cushioned by cheaper exports. Inflation will also erode its own government debt, but the government may find in future that it has to offer higher interest rates to get that debt refinanced in future.
(Incidentally, the UK had a huge advantage in the recent crisis: much of its debt was tied up in long term contracts on fixed (low) rates which could not be renegotiated, unlike countries like Greece who were faced with fairly immediate needs to go to the market for refinancing. So the UK has been able to sit back, not worried too much about who is going to buy UK government debt in 2010 or 2011 or 2012, with breathing space to cut government spending, increase taxes, and restore market confidence in the nation as a whole. Inflation is welcome then, as it cuts the value of government debt, at a time when the markets are unable to insist on a better deal.)
But if Greece does the same thing with Euro, running up vast debts which it probably cannot repay, the result is damage to the value of the Euro currency as a whole, which affects every other nation using the Euro. Greece will also find they have to pay higher interest on their debt in the global market, and they have to finance significant debt every few weeks.
In summary, the Euro project only works in a sustainable way if you think about Euroland as a single nation, a single community, a single inflation rate, a single interest rate, a single exchange rate, a single economic policy, a single European budget for public services, a single mechanism for borrowing money and repaying public debt.
That is the situation in the United States – with considerable freedoms for State governments. But the big balancing factor in the US is mobility of the labour force. So as one State or another booms or declines, unemployment and wage costs rise and fall locally, and millions of Americans relocate, chasing better wages and job prospects.
In Europe, we have seen increasing mobility – especially in the case of workers from nations like Poland and Romania – which has balanced out some of the latest crisis. For example, when the UK boomed, Polish workers flooded in. When the UK hit recession, many of them returned to Poland – one reason why unemployment levels changed less than some expected.
But we are still a very immobile cluster of societies compared to the US – for cultural and language reasons. We are still very separate nations.
Expect major changes
The current situation in the Eurozone is unsustainable: we have very separate nations from the cultural and growth-rate point of view, locked into an economic prison whose walls are defined by common exchange rates and common interest rates – which are by definition less than ideal for almost all Euro nations.
Their individual governments have lost huge economic power to Euroland, yet retain almost all powers to run up as much public debt as they want, spending freely on public services and failing to balance this indulgence with adequate taxation.
There is a hard choice facing some nations soon: they have to decide either to manage their own affairs, set their own interest rates, allow their currencies to float, manage their own taxes and spending – or to go the whole way and accept that in Euroland we all live and die together, which means accepting further loss of sovereignty, loss of freedom to overspend, less freedom to decide tax rates and so on.
But there is a further problem: while diplomats, beaurocrats and politicians debate these things, the future of the most vulnerable nations will be dictated by the markets themselves.
If pension funds, investment funds, banks, corporations and wealthy individuals all begin to worry about the economic future of a particular nation, that government will find it has to bribe investors with huge interest rates to raise money to pay its debts, or to refinance them as each loan comes up for renewal and renegotiation.
How big will those bribes have to be? Can that nation afford to offer them, or will such bribes simply make future challenges even worse? That is the plight of Greece today, with Spain, Portugal, Ireland and others not far behind.
What happens if a nation decides one day not to honor its debts, stops paying interest, refuses to repay loans? Much of that debt is probably held by its own banks, so the first thing we can expect is panic as millions of people rush to get their money out of those banks and preferably out of the country altogether. Banks can become insolvent almost overnight.
Huge amounts of debt are held in other European banks, with risks of default insured all over the world in ways that are very hard to monitor. So a major default could create an uncontrolled wave of further economic crises, lasting several years, affecting many Euro nations and far beyond – all at a time when governments have little extra capacity to stimulate their economies.
The same could happen if a nation was to leave the Euro in an uncontrolled and sudden way. If Greece for example was to re-issue the Drachma, all their debts would be revalued in the new currency, and as the new currency floats, you can be sure a lot of people will sell very quickly, fearing that the currency will collapse and their holdings will soon be worthless. As they sell, their own worst predictions will become true, because the very act of selling the currency will force a further spiral down.
Will the Euro survive?
So what is the answer? You can be sure that the European Central Bank, IMF, European government leaders and heads of banks will work very hard to transform and stabilize the situation in small, clear, well-anticipated steps. The aim will be to reduce the debt burden of Greece by one means or another, and (likely I think) manage an orderly exit from the Euro. This will be a huge cost and risk for EU nations, but the alternative, regular crisis bailouts with likelihood of little return, is also hideously expensive and also risky.
Will the Euro currency survive? Almost certainly yes. Will it have as many members as today? Almost certainly no. Could we have a two tier Euro – effectively splitting the currency into two kinds of Euro for two different kinds of nations? Possibly, but each smaller group will continue to face most of the problems above from common exchange and interest rates.
Would it make sense for a strong nation like Germany to leave the Euro? Possibly. Germany is a dominant economy within the EU so interest rate policy has to be set with that in mind, and Germany, like France, is often as we have seen at a different stage in its boom and bust cycles than many smaller economies, with different requirements. Taking Germany out of the picture could make alignment easier.
The German people are not impressed by the failure of the Greek government to manage its budget, collect taxes, deal with corruption, and keep the country stable.
There will be a limit to which any democratically elected government in Germany can go in bailing out nations like Greece, without losing an election. So we could see an ultimatum, if the situation deteriorates far enough, in Greece and other nations: “Either they go, or we go”.
