European Monetary Union - Are the Sharks Circling?
By Prof. Dr. Norbert Walter
 

Europe makes the headlines again, but all of the headlines are ugly! From volcanic eruption ash to bad governance, it is only negative news: Greece becomes synonymous with European institutional disaster; failing state finance translates into a failing European Monetary Union, at least for the majority of financial markets participants; risk spreads mount; and the Euro exchange rate is heading south.

Europe Fell From Grace
What has happened? Has Europe fallen from grace? The financial and economic crisis has hit home badly in Europe, in Switzerland, in England - obviously not part of the European Currency Union and equipped with a flexible exchange rate. Others like Spain or Ireland are part of the real estate implosion. They suffer from a decline in construction. Again others were hit by the downturn in international trade, not least those with a bigger manufacturing sector, like Slovakia or Germany for that matter. Quite a few suffer from bad macroeconomic policies that now have led to unsustainable government debt. This holds true for members of the European Monetary Union (EMU) like Greece or Portugal, but equally for countries like the Baltic States or Hungary. Each of them had to pursue restrictive fiscal policies in the middle of a recession, all contrary to the general economic wisdom of Keynesianism.

Do such observations mean a thing for the debate about appropriate conclusions for the countries concerned? Particularly what do they mean for the problem countries who are members of the EMU?

What´s Wrong With Greece But Right With Japan,
the UK, and the U.S.?
But before going into these therapeutic considerations, allow me a few words about the diagnosis. Greece represents 3 percent of the EMU´s GDP. Thus it is of lesser importance to the Euro region than the Saarland is for Germany, or the new Länder for that matter. The debt implications of integrating the Saar or the new Länder did not cause a sovereign default for Germany, nor did it bring about the D-Mark's demise.

But it is fair to say, the German Länder are expected to be bailed out, while Greece is not. So we have to study the characteristics of Greece by its own (de)merits. Yes, the Greek government debt is more than 100 percent of GDP. Yes, they have a deficit of more than 10 percent. Yes, Greece has almost 30 percent of its GDP from activities in the shadow economy. Yes, Greece spoiled the opportunity for fundamental micro- and macroeconomic reforms after benefitting from joining Europe and the EMU. Low-cost financing was not used properly for productive private and public investment; leisure and consumption was enjoyed instead. Such behavior was neither sanctioned by increasing risk premiums by financial market participants - at least not until very recently - and not by peer pressure or directions from EU Commission or Council.

So yes, the malaise is here, it has arrived. But consider, isn't the debt level of Japan considerably higher (some 200 percent of GDP)? And aren´t the UK and the U.S. in the same ballpark as Greece with their government deficits? And why would an asset holder invested in deficit countries worry so much about the chicken feed from Greece and so little about the avalanches of debt of the UK and particularly the U.S.?

And how about the quality of governments involved? Haven't we seen swift and courageous action by the Greek government, while we don't know what quality of government we will see in the UK or in Japan over the coming months?

Financial Markets Worry in a Very Biased Way
So, while Greece certainly is a case to worry, it is very difficult to see the need to worry specifically for Greece and to neglect the much more substantial concerns resulting from holding government assets from these other sinners. Financial markets worry in a very biased way. Just look at the yields the respective governments have to offer to attract the savings of the world: The U.S. still gets its long-term financing for 4 percent while Greece has to pay 8 percent.

On top of the government actions, the announced reviews and help by the IMF and European partners should support the Greek solution. So far, however, no traces of trust exist for the EMU member, and risk premiums are still trending higher.

And the Euro - after months of strength - has fallen from grace. The Euro has depreciated more than 10 percent of late.

Some promoters of conspiracy theories have argued that the Greek story is an invention of Euro-region companies in the manufacturing sector who just want to become more price-competitive. While this argument does not defy belief, it is equally obvious that the recent appreciation of the U.S. dollar is anything but helpful for Detroit's need to get going again, and it certainly flies in the face of Obama's projection to double U.S. exports. Is Wall Street again not talking to Main Street? Will the tendency for a weaker Euro not develop into a trend and be reversed soon?

Are the Sharks Circling?
But back to the main hypothesis: Those attacking Greece really mean to attack the Euro. It is argued EMU is not viable; it is argued that Greece and the other members of the Euro would be better off if Greece leaves the EMU. This implies that Greece would reestablish its own currency and the new Drachma allows for a dramatic devaluation, thus ignoring its price competitiveness. It then can escape the orthodox fiscal and monetary restraint it otherwise is bound to (by following the Stability Pact and not having any monetary flexibility). This is an interesting view. But why are the non-EMU members unwilling to go down this road? Probably because their debt is not in domestic currency, or because there is little money illusion left to be exploited by such macro policies at home.

For small, very open economies, freedom of one's own currency is pointless. This is the economic policy advice given to the small, open economies by the dominant economies. Such advice, if followed, will not produce the promised result.

To stick to their guns and stay within the EMU however does not equal an easy way out. We spoiled the chances for a smoother adjustment during the last decade; now the best alternative is to get out of the cul de sac by walking backwards. This will limit growth for the adjustment period in which one has to again become competitive by cost control and advancing productivity gains.

The leisure and fun part is over! The party is over, even for the circling sharks, if Europe's elite stands up and stands together.

Prof. Dr. Norbert Walter is managing director of Walter & Daughters Consult and was chief economist of Deutsche Bank Group and head of Deutsche Bank Research until 2009. Prof. Dr. Walter is a regular contributor to the Advisor and a former AICGS Fellow.

This essay appeared in the April 29, 2010, AICGS Advisor.