Eurozone Crisis Part 3

Economic Perspective:

Economically, the crisis has been more damaging than currently presumed by the rest of the world. Few of the economic highlights of the crisis must be scrutinized carefully for further learning.

One of the major learning has been the limitation of a single currency system. It lacks the central Treasury mechanism which can control the inherent trade imbalances which result in huge budget deficits, much like the gold standard era.

Another major reason why Europe is engulfed in this turmoil is the single currency system applied to the divergent economies. This hampers the interest rates and eliminates the possibility of crawling your way out of such situation through the devaluation of currency.

With abandonment of the euro, countries such as Spain, Italy, and Greece etc. can use an exports route for recovery by devaluation. However, Abandoning Euro itself is not a plausible solution at the moment.

Consider the example of Greece. At present it owes more than 400 Billion Euros (about 200% of its GDP) to other EU countries. If it abandons Euro, its Nominal GDP will become more than half; raising its debt in tremendous manner (twice the current) in nominal terms, which will not be repaid resulting in its default.

Similar conditions exist in other countries such as Portugal and Ireland. Moody’s recently downgraded both these countries. Soon to follow is Greece, and some fear that France might be in queue, too.

Britain is relatively safe as it is a non-Eurozone country. At any moment it can choose to devalue its currency and use exports to come back in shape. However it’s not as easy as it seems. Devaluation of currency has several implications. One of the major implications is the loss of at least some credibility in terms of a nations’ political and economic superiority.

Devaluation of currency causes drop in monitory value of the external debt. For example; if Britain owes 100 Pounds (GBP) to India which is equivalent to approx. 8500 INR at the moment. If Britain devalues its currency to 75 INR per GBP; then in it has to pay only 7500 INR to India, causing a loss of 1000 INR to India.

Another thing that goes against Britain is that it sells almost half of its current total exports to EU countries. Thus, recovery through devaluation has major hindrances.

When whole of the Europe is literally engrossed in brainstorming, USA is sitting on the boiling pot. Although many American money market funds are not directly exposed to “Junk” bonds of indebted nations, they still hold a large portfolio consisting of European bank debt; which in turn hold the abovementioned “Junk” portfolios. This exposure effectively amounts to trillions of dollars. Thus, if domino effect starts in Europe, we know be certain about where its end will be. It’s certainly no good news for the already embattled American economy. Deposits in the US banks can also surge when money market funds redirect themselves. With huge piles of cash in hand and no takers for loans, American banks may be caught in unyielding money trap. ^[2]

Solutions could be many. Imposing a greater fiscal integration of member states is one of them. With greater integration, responsibilities will be well managed. Unlike Greece, where there is still doubt about its accounting procedures.

Another tangible solution could be, issuing jointly guaranteed bonds. It reduces the overall risk for the investor by principle of diversification, and thus they will be eager to pick them up.

In immediate term such issue could halt the crisis, but on strategic level better integration of EU and inclusive nature of commission is the only way out in longer run.