Eurozone: A failed experiment?

Classical economic theory tells us that there are five types’ of regional trading agreements that can be created to bolster trade amongst nations. The most binding of these agreements is the monetary union, and the only large scale example in contemporary times is the Eurozone. In this type of trade agreement, all barriers to import and export of goods and services are removed, and the member countries establish common economic policy for the union as well as adopting a single currency. It is a great boon to the member nations’ economies, by removing several of the impediments of international trade such as trade restrictions, and foreign exchange rates on the viability of business.

The Eurozone took shape in 1998, when eleven of the EU member nations met the Euro convergence criteria (). The Euro officially came into effect on January 1st

1999, Greece met the Maastricht Criteria in 2000, and adopted the Euro in 2001.

Sr. No. Criterion

1

Inflation of no more than 1.5 percentage points above the average rate of the three EU member states with the lowest inflation over the previous year

2A national budget deficit at or below 3 percent of gross domestic product (GDP)

3

National public debt not exceeding 60 percent of gross domestic product. A country with a higher level of debt can still adopt the euro provided its debt level is falling steadily

4

Long-term interest rates should be no more than two percentage points above the rate in the three EU countries with the lowest inflation over the previous year

5The national currency is required to enter the ERM 2 exchange rate mechanism two years prior to entry

Table 1: Maastricht CriteriaSource: Reuters

Subsequently, seven more nations complied with the Maastricht Criteria- with the latest being Lithuania on January 1st 2015- and adopted the Euro, totalling 19 out of the 28 countries of the European Union. Figure1: European Union & Eurozone

Figure 1: European Union & EurozoneSource: The Economist

The Eurozone worked very well in the initial years, the free trade, and the strong currency allowed many of the member nations to prosper. The European Union seemed to be a resounding success, from 2001 to 2008, the Euro strengthened vs the dollar from $0.84/€ to $1.60/€. Several economists even went so far as to predict that the US Dollar would collapse due to the surging Euro. Alas, come 2008, the world witnessed the greatest financial crisis since the Great Depression.

Figure 2: USD/EUR (2002-present)

Ireland, Spain and Portugal fail to make repay their debt

A number of countries in the Eurozone, namely Greece, Ireland, Portugal, Spain and later Italy faced sovereign debt crises and have now started to pose a serious threat to Europe and the European countries.

Spain, after the collapse of 2008, saw a rise in the levels of personal debt. Although the public debt stood at 60% of the GDP, the problem was due to foreign exposure of private debt. Spanish banks were relying heavily on whole sale finance from abroad.

Portugal had a large current account deficit and external debt which was fuelled by private sector borrowing. Greece, Portugal and Ireland were the worst hit whereas Spain & Italy were considered fiscally vulnerable economies.

As evident from the graph, the bond yield rate for Greece was the highest. This meant that the Greek government had the costly credit, due to lenders’ scepticism of the Greek economy. The factors contributing to this was the current level of debt held by the government as well as its ability to return it rather than defaulting on it.

Source: Thomson Reuters Datastream as on 11/08/2015

What is wrong with Greece?

Greece has been in trouble since the day it joined the Eurozone. Greece, at the time of the amalgamation, was unable to meet the Maastricht Criteria requirements. However it was only in October 2009 when they announced that they had been under reporting figures and had not met the criteria since 1999 that the Eurozone actually learnt of Greece’s real economic conditions.

Being a part of the Eurozone, Greece had access to cheap credit. However the sunny days soon ended and the Financial Crisis of 2008 occurred. Greece being a highly indebted countries was greatly affected by the crisis. Coupled with the rampant tax evasion problem faced by the Greeks, the government had no substantial revenue. Following the crisis, an even lower percent of the population was able to pay taxes, crippling the system further.

By March 2010, Greek government had approved a tough austerity package which included freezing pensions, tax on alcohol, fuel & cigarettes and pay cuts in the public sector.

To prevent the situation from getting any worse, the IMF, European Commission and the ECB had to step in. The collaboration, commonly known as the troika, in May 2010, approved a bailout package of the €110 billion ($146 billion). Along with it came a lot of sanctions namely cuts in spending and tax hike.

Greece accepted more cuts as a part of the deal however the unrest amongst the citizens was evident. Greek citizens were bitter about these austerity measures.

2004 2005 2006 2007 2008 2009 2010 20110

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Source: Eurostat

As the government had low revenue, they were laying off government employees. Unemployment in Greece was at all-time high. As evident from the graph, compared to other nation and the European Union, the employment rate of Greece was very low. Employees were disgruntled and the buying capability of the employees deteriorated. Demand touched new lows and the dissatisfaction was evident.

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Employment Rate: Q3 2014

Despite these measures, the Greek economy did not recover and in March, 2012 a second bailout package worth €130 billion ($ 170 billion) had to be approved. The Greek economy did not see any movement towards recovery and finally in 2011, after lasting negotiations, Europe’s leaders had to slash the Greek debt. Private investors would have had to write down the Greek bonds by 50%.

Source: Eurostat, Debt in the European Union

Finally a list of huge bailout conditions was proposed to the Greeks, which was accompanied with an

extensive dwelling upon the proposals. The midnight of June 30, 2015 went without a deal & Greece missed the deadline for €1.5 billion payment to the IMF which led to Greece falling into arrears.

The Greek referendum, in which the Greeks voted “No” to the bailout conditions might result in Greece leaving the euro colloquially termed “Grexit”.

Implications of the Grexit

A Greek exit will result in Greece switching back to Drachma which, given the current Greek economy, will be highly undervalued. Trying to service their debt using such an undervalued currency will result in hyperinflation. Simultaneously, being a major importer, using their devalued Drachma for such imports might cause recession. Greece is indebted to other European countries as well. In a situation where Greece defaults, it will afflict other European economies. Countries like Spain, Portugal, Italy & Ireland who have just recovered from their own Debt Crises may fall back into a crisis. It will further lead to a domino effect which will adversely affect the global economy which can cause a crisis much worse than the crisis of 2008.

Sadly, even if a Greek exit is averted, Greece does not have a bright future. It has slipped back to a mostly cash economy, with shuttered banks and capital controls. Dried up banks are depending on the Emergency Liquidity Assistance (ELA) nominally by the Bank of Greece but controlled by the ECB. To push growth, banks need to reopen and offer trade credits for imports. This in turn requires ECB to raise the cap on ELA which is currently at €89 billion. Just like the case of Cyprus two years ago, depositors in Greek will be reluctant to keep their cash back in banks. Along with strict controls, there will be austerity measures like increase in VAT, which contributes almost 1% of the GDP. The euro summit didn’t specify precise targets, but creditors have stipulated a budget surplus of 1-2% of GDP this year and next year. Pursuit of such targets will weaken a frail economy.

Grexit: Impact on the Eurozone

Should Greece decide to exit the Eurozone, it will be a herculean task, a process which would take months or years. The associated uncertainty that will prevail will adversely affect the euro and can damage the currency’s stability. The exit may be also be perceived as an inability to handle crisis by the Euro members and may spread a fear of exit by other crisis struck

nations. Countries like Portugal will be under extreme pressure with investors selling Portuguese bonds and look for ways to extract money from the local banks of the nation.

However the fact of the matter remains that it is very hard to evaluate and calculate the precise impact of the Grexit on other European nations as the extent to which it will be contagious cannot be accurately predicted.

References

1) http://glossary.reuters.com/?title=Maastricht_Criteria 2) http://www.bbc.com/news/business-13856580 3) http://europa.eu/index_en.htm 4) http://www.worldbank.org/ 5) http://www.economist.com/blogs/graphicdetail/2015/05/european-economy-guide 6) http://www.europeanfinancialreview.com/?p=4103