Euro Crises: Tear Europe Apart or Cement it Together?

Sorry folks (especially US folks) - the worst may not be over yet. I have remained skeptical of the economic recovery because of contagion in the Eurozone, and the huge piles of bad debt hiding in China.

Turns out that the Eurozone is in terrible shape. Ireland, Portugal and Greece are all on the brink of requiring massive bailouts (well - massive for normal people - hundreds of billions of dollars, not massive for America, which seems to think any bailout under $1 trillion is just not worth talking about).

Portugal is currently claiming that it does not need a bailout. Greece will pretty much take any money that they can get. But Ireland is the real sticking point. They don't want the rest of Europe's money.

Why is that? Well - the why is the original risk of the Euro, and why I always thought the single currency was a bad idea. When the Euro was being created, I was a headstrong high school student competing in Econ Challenge and Fed Challenge (econ nerd contests) for my school. I was asked by a board of economists if I thought Euro was a good idea, and I told them flat out no. The issue is ambiguity: the Euro leaves countries with only partial control over their fiscal policy and absolutely no control over their monetary policy. In return they got big piles of cash from other EU countries as "development funds," as well as lots of FDI from other Eurozone countries.

The question of currency pegs (or in this case, a common currency, but it has the same effect) in order to stimulate growth in developing countries (Ireland, Portugal and Greece are still 'developing' relative to their European peers) is of particular interest to me, and something I have studied extensively. Mostly, I looked at the dollarization of LatAm countries, in particular Argentina.

The issue is this: the value of a currency peg is in the monetary stability it creates, especially when the currency your are pegged to (or part of) is your major source of FDI, or a global reserve currency.

The problem is usually this: pegging your currency (or joining the Euro), if you do it well, leads to high levels of FDI, and GDP growth. What do high levels of FDI and GDP growth do? They create bubbles, especially in your fiscal policy (taxes are always going up, you can budget huge spending etc). You see, economists tend to take the slope of current GDP growth and draw a line out to infinity. Normally, you would counter bubbles in growth with raising interest rates... but you can't, because you don't have any monetary policy any more. Even worse than that, the country--or ECB--which controls your interest rates is keeping them damn low usually, for the benefit of the much larger and more stable nation(s) it represents.

This is fine.... while everything is going well: money is cheap, companies love you, neighboring countries' presidents envy the new Mercedes Benz limo you roll in (it has a Grey Goose martini bar).

But when things start to turn on you, you end up with huge fiscal deficits and no ability to adjust your monetary policy other than total collapse (de-pegging the currency and going into hyper-inflation mode is usually what happens). Because your fiscal policy relied on--what you thought were sensible--economic estimates of future growth and tax revenues, even if you have a fiscal straitjacket (EU countries are required to have deficits of no more than 1.5% of GDP) you can end up wildly overspending when your economy heads south.

This is where Portugal, Greece, and Ireland now find themselves. They are facing down huge budget deficits which were created because their spending was based on projections, while revenues are based in reality, and governments change direction slower than oil tankers. Options historically available at the point include de-pegging (leave the Euro), defaulting on debts, and then printing money like your name is Barack.

But these nations have another option, the Roman option: simply accept Roman rule, and all will be well with the world. You can still have your government, you can still call yourselves a country, but on anything big you have to defer to Rome.

And by Rome, I mean Brussels, but it is pretty much the same thing. When the Roman Empire expanded they allowed local rulers to remain local rulers as long as they accepted the ultimate authority of Rome. And paid their taxes. Brussels is offering pretty much the same deal: we will bail you out, if you agree to give up national sovereignty, especially on fiscal policy.

It is a very interesting time in history. Because if Ireland accepts, it sets the EU on a path of unification and eventual aggregation of sovereignty (think 13 colonies -> the United States). Once you give a political body control over something (such as your ability to spend money) you are going to have a hell of a time getting it back.

On the other hand, if Ireland decides "f* it all, we'll follow our own road," it is quite possible that the Euro will collapse, or at least fall back to an inner core anchored by France, Germany, and Benelux. That would reaffirm the British (and my) view of the EU: that it should be an economic union, dedicated to lowering trade barriers, and that's all.

Ireland, as of today, is still indicating that they will refuse bailout funds from the EU, as that bailout includes stringent EU and IMF imposed limitations on sovereignty. British conservatives are proposing a "pounding" (my word, not theirs) of Ireland - offering the pound as an international currency alternative to the Euro - something which is exceptionally unlikely in reality.

What will actually happen remains to be seen - but right now Ireland is playing chicken with the EU, and I wonder who will turn first, if anyone.

Interesting times indeed.

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