Written by Carlos T Mock, MD   

As Estonia became the 17th member to join the Euro on January first, 2011, we ask ourselves; is it worth it?

To outsiders, it may look a strange moment for the eurozone to be admitting new members when the single currency is embroiled in what some observers consider to be a battle for survival. Yet, Estonia’s eagerness to join despite the crisis provides a reminder of the euro’s appeal to some countries on the eastern fringe of Europe eager to cement their place in the west. While the debt crisis has sparked renewed debate over the merits of monetary union, Andrus Ansip, Estonia’s prime minister, says Europe must not lose sight of the bigger picture. “Every one in Estonia understands that the European Union started as a peacekeeping project and that the common market and the euro is a continuation of that,” he says.

Will the eurozone survive in its current form?

There are several reasons why markets have reacted poorly to Europe’s recent crisis management efforts. First, questions about the ability of the EU to make decisions. This is a matter of governance. Second, questions about the lack of a fiscal union. This is a matter of design. And third, political sustainability in times of harsh adjustment. This is a matter of remedial action. To address these questions, we need to consider three more precise issues. First, how likely is a wave of sovereign defaults? Second, will the eurozone make the changes needed to prevent these? Third, could the eurozone survive them?

Sovereign defaults:

Ireland: Ireland’s government has avoided immediate disaster by mustering just enough votes to pass its emergency budget. But now it must decide what to do next. Here, €6bn ($9.4bn) in new austerity measures are unlikely to be enough to put it back on the right path. Instead a more radical option should be seriously considered: leaving the euro. Sovereign default, massive bank recapitalizations, and sharply falling real wages are all given as reasons why peripheral euro area countries should hang on to monetary union. Yet, in Ireland’s case, all three are going to happen anyway. If Ireland’s government continues to guarantee bank debt, a restructuring of sovereign debt seems inevitable in 2013, when the present bail-out expires. Ireland simply has too much overall debt. A high-interest loan from the European Union and International Monetary Fund will only serve to buy a little more time. Further bank recapitalization is also so certain in Ireland that the EU, IMF, European Central Bank and Irish government have already set aside €35bn of the new €85bn bail-out package expressly for this purpose. On wages, given it is unable to devalue its currency Ireland must undergo an internal devaluation to regain competitiveness by cutting wages and bringing down prices. Real wages are therefore expected to fall over the next few years. All of this is pessimistic, but there is an optimistic case too: if Ireland withdrew from the euro it would actually have reasonably good prospects for growth. It has a highly skilled labor force, open labor and product markets and a fairly robust export sector. The export sector would be bolstered by an immediately devalued new Irish currency.

Spain: On December 15, Moody’s, said it may downgrade Spanish government bonds because of the country’s likely difficulty in raising large sums of money next year, the problems of its savings banks and the debts incurred by its autonomous regions. Spain was downgraded by Moody’s from the agency’s top rating of triple A by one notch less than three months ago because of weak economic growth, the difficulty of cutting the budget deficit and higher borrowing needs. In a statement on Wednesday, Moody’s said it was putting Spain’s current Aa1 ratings for local and foreign currency government bonds on review for possible downgrade, and was also reviewing the rating of the Fund for Orderly Bank Restructuring, known as the Frob from its Spanish initials. The markets reacted swiftly to the news. The euro fell 0.5 per cent against the dollar to $1.3319 and yields on Spanish 10-year bonds challenged euro-era highs with an 8 basis point jump to 5.6 per cent. Madrid’s Ibex 35 stock index fell 1.4 per cent and the broader FTSE Eurofirst 300 lost 0.3 per cent as the region’s banks came under pressure because of their exposure to eurozone sovereign debt. The announcement by Moody’s comes at a bad time for Spain, one day ahead of its last scheduled bond auction of the year and just as it is struggling to restore international confidence in its economy and its banking system. On Tuesday, Spain sold €2.5bn in treasury bills but had to pay more than one percentage point more in interest than it did only a month ago.

Portugal had to pay extremely high premiums to sell short-term debt in a further sign of the problems in the eurozone debt markets. Lisbon borrowed €500m of three-month bills, paying an average yield of 3.40 per cent compared with a yield of 1.82 per cent at the previous auction on November 3. The auction attracted bids of 1.9 times the amount offered compared with a bid to cover ratio of 2.2 in November.

Thus the question is whether these countries can avoid sovereign debt restructuring. The salient characteristic of lending to sovereigns is the absence of collateral. Thus, the safety of the creditors depends on their ability to sell debt to others at reasonable prices. If this confidence disappears, liquidity dries up and sovereigns are driven into default. What, then, determines confidence? The short answer is: sustainability. That itself depends on the relationship between prospective economic growth and the real rate of interest. The lower the growth and the higher the interest rate, the bigger the primary fiscal surplus (before interest payments) needs to be – and so the greater the political costs of achieving it. The bigger these costs, the less confident will investors be and the higher the interest rates will become. This, then, creates a vicious spiral. Vulnerable peripheral eurozone member countries now suffer from troubled financial systems, high fiscal deficits, rapidly rising ratios of debt to gross domestic product, elevated interest rates, poor prospective growth and the absence of a central bank that is sure to make the debt market liquid. Poor growth prospects, in turn, are partly due to loss of competitiveness. If these indicators were applied to normal emerging countries, a default would seem inevitable.


Will changes be made?

The answer is: probably not. Angela Merkel, the German chancellor, has ruled out two of the most widely backed ideas for combating the eurozone debt crisis. She saw no need to increase the size of the European Union’s €440bn rescue fund and said that the bloc’s treaties did not allow for the creation of a Europe-wide bond. Ms Merkel’s comments on Monday came as finance ministers from the six-country eurozone were gathering in Brussels for a regularly scheduled meeting where the need for more measures was debated behind closed doors.

Angela Merkel, the German chancellor, has called for calm in the European Union after an angry attack by Jean-Claude Juncker, prime minister of Luxembourg, who accused Berlin of being “un-European” and “a bit simple” in making some areas “taboo” in EU negotiations. At the same time she repeated her rejection of Mr. Juncker’s proposal for jointly guaranteed eurobonds to help finance the most debt-laden members of the currency union. “The discussion does not help us,” she said after meeting Fredrik Reinfeldt, the Swedish prime minister. Although Berlin remains adamant that Mr Juncker’s eurobond proposal cannot work without significant treaty change, there are signs that the German government may be prepared to seek some compromise on another plan: to raise the funds available in the eurozone rescue mechanism – the €440bn ($580bn) European financial stability facility – to enable the full amount to be payable for countries in difficulty. Under the present arrangement the fund can borrow €440bn on the bond market but can only pay out about two-thirds of the amount to troubled governments, mainly because it has to maintain a cash buffer to guarantee its triple-A status. An amendment to use the full €440bn is one proposal under consideration in Brussels and other eurozone capitals, although Germany has rejected as unnecessary any increase in its overall size. Mr. Juncker’s outburst, in an interview with Die Zeit, the German weekly newspaper, was the most dramatic demonstration to date of the worsening tempers within the EU. He accused the German government of rejecting his eurobond proposal “before it had been properly studied” and was baffled by Germany’s way of “erecting taboo areas in Europe and not even considering the ideas proposed by other people”.

The German rejection leaves the European Central Bank’s aggressive purchase of eurozone sovereign debt as the main weapon for the EU in fighting to keep the two most vulnerable countries, Portugal and Spain, from being forced into a bail-out. One reason is that the creditors want them. True, Germany has suggested this should apply only to future debt. But, in capital markets, the future is always now. Moreover, the funds now on offer are not enough to finance all weak countries for long enough to avoid defaults, particularly since the latter will need to deflate and restructure their way back to growth. As Desmond Lachman of the American Enterprise Institute argued in a recent paper for the London-based Legatum Institute, prospective growth is of the essence. But, in the absence of exchange rate flexibility and in the presence of high interest rates, cutting fiscal deficits on its own may well exacerbate slumps.

Could the eurozone survive a wave of debt restructurings?

The more a break-up looks possible, the higher the risk of a self-fulfilling dynamic. For this reason the European Union cannot afford doubts about the viability of the euro to spread and strengthen. What justifies these doubts? First, questions about the ability of the EU to make decisions. This is a matter of governance. Second, questions about the lack of a fiscal union. This is a matter of design. And third, political sustainability in times of harsh adjustment. This is a matter of remedial action. Many countries across Europe are making sacrifices in the name of the single currency. The early lessons from Greece are that harsh reforms do not necessarily weaken governments if the population regards them as necessary. But a backlash is likely when conditions set for assistance are inadequate or unfair – as was the case with the strings attached to the cost of the emergency loans offered to Ireland. This is why European leaders must urgently devise a strategy to help foster growth in crisis-affected countries, before the euro is blamed for their difficulties.

Still worse, once a country has been forced to restructure its public debt and seen a substantial part of its financial system disappear as well, the additional costs of re-establishing its currency must seem rather smaller. This, too, must be clear to investors. Again, such fears increase the chances of runs from liabilities of weaker countries. For skeptics the question has always been how robust a currency union among diverse economies with less than unlimited mutual solidarity can be. Only a crisis could answer that question. Unfortunately, the crisis we have is the biggest for 80 years.

“Tell me how this ends,” was the question posed by General David Petraeus about the Iraq war. European leaders are asking the same question as they contemplate the crisis in the eurozone. Having failed to construct a firebreak in Greece, the Europeans are hoping that they can stop the euro crisis in Ireland. But, even as an Irish rescue package is put together, the bond markets are already looking with unhealthy interest at Portugal. After Portugal, Spain is assumed to be next. And, if a really big economy such as Spain needed to call the financial fire brigade, the whole future of the euro would be in serious peril. The question of “how this ends” is therefore obvious and urgent – but also fiendishly difficult to answer. It is like watching a three-dimensional game of chess – in which the financial, economic and political levels all interact with each other. My current best guess is that the single currency will indeed eventually break up – and that the euro’s executioner will be Germany, the most powerful country and economy inside the European Union.