The GoLive Indonesia Project collaborating with Persatuan Pelajar Indonesia Australia (PPIA or Australia-Indonesia Student Association) at the University of Adelaide organised their third academic workshop on 13 July 2011. Associate Professor Colin Rogers of the School of Economics at the University of Adelaide explained about the economic consequences of the Euro.
Following the global financial crisis, concerns about rising government deficits and debt levels have alarmed financial markets across the globe which include some Eurozone members namely Greece, Ireland and Portugal. Greece’ GDP growth recorded at 5% in 2006 dropped to -5% in 2010 (see graphics of the Euro crisis here) .
Is there a solution?
There are at least five possible scenarios might happen in Greece according to the BBC news. These include getting bail outs from the International Monetary Fund (IMF) and the European Union. No free lunch, obviously! The loan package would only be delivered if Greece agreed to take some Austerity measures such as tax increases, spending cuts and privatisation. The second option is debt-restructuring. However, the ratings agencies would probably treat a debt restructuring as a default anyway. The third option is to give up Euro temporarily. This may help Greece’s exports and cut labour costs but might come at the expense of soaring amount of debt. The last option is default. Surely, the EU will do their best to stop this from happening. Whilst financial turmoil is happening in an economy, political changes often happen.
Prof Rogers viewed that the crisis has shown problems with the governance structure of the ECB. He viewed that the ECB has to be responsible for two things: price level stability (this is the objective of the ECB with the inflation rate targeted at 2%) and also financial stability. These responsibilities cover both the provision of liquidity during crises and the guarantee of solvency. Its responsibility to ensure solvency is important due to the structure of the European Union which causes the inability of its members to use state-backed money.
In 2010 when Ireland was in crisis, the country was given a special privillege to print money and this has helped the country to prevent from a liquidity crisis into a solvency crisis. What the ECB does now, however, is not necessarily helping Greece to get out of the solvency crisis. Prof Rogers concluded that the only sensible way out of the current muddle is for the ECB to accept that it is responsible for the solvency of all countries using the Euro. Moreover, the ‘third party’ such as the IMF should not be part of the solution.With very low (or negative) economic growth rates, there is a serious concern that Greece and other countries who receive loans from the IMF and ECB could not repay these loans at 5% interest rates.
What’s lesson to be learnt for Indonesia and Asia as a region? See our upcoming post.
“The Economic Consequences of the Euro”
Author: Associate Professor Colin Rogers
The Euro is facing the moment of truth as it grabbles with debt crises that afflict Greece, Ireland and Portugal and fears that any default by these members will cause financial havoc in the Euro-zone and go global via international funds holding Euro debt.
Using the lessons learnt from gold standard collapse in the 1930s this brief note explains how the European Central Bank (ECB) has failed to learn those lessons. As a consequence its current actions will either drive crisis members into default or subject them to a decade or more of no growth and despair.
The fundamental lesson learnt from the gold standard was that gold was not a suitable basis for a monetary system because the money supply could not be controlled by the ‘central bank’. Hence it could not guarantee the solvency of the state. Consequently, any shock to the system such as WW I, which led to a redistribution of gold reserves and the misguided attempt by Britain to return to gold at the pre-war parity, automatically created condition in which a liquidity crisis morphed into a solvency crisis. Britain left gold in September 1931 because it was insolvent.
The key lesson that monetary theorists learnt from this, and which the ECB has forgotten, is that central banks must guarantee the solvency of states using their inconvertible money.
Today all monetary systems consist of inconvertible monies. In such systems the central bank is responsible not just for price level stability but also for financial stability.
That responsibility covers both the provision of liquidity during crises and the guarantee of solvency. Without that guarantee and the ability to create money, states using inconvertible monies might just as well be on the gold standard. In effect that is precisely where the Euro-crisis economies now find themselves.
When countries joined the Euro they gave up their ability to create their own monies in exchange for the Euro. Now they find that although the ECB came to their rescue with liquidity support during the global financial turmoil it now refuses to guarantee their solvency! Instead the ECB is forcing not only Greece (who was guilty of malfeasance) , but any crisis economy, to borrow from an IMF-EU stability fund in exchange for the implementation of austerity packages. As many have realised, and this is reflected in the interest rate spreads and credit default swap prices, this strategy will fail. It will fail because the rates charged for these loans are too high relative to the potential growth rates that crisis countries can achieve so they are headed into a debt trap. The austerity packages slow growth and destroy confidence, the polar opposite of what the ECB expects. At best, crisis economies will default, and at worst they will be subjected to a decade or more of no growth and despair.
On current policy settings the Euro is headed for disaster and the question is simply not if but when that will happen.
The only sensible way out of the current muddle is for the ECB to accept that it is responsible for the solvency of all countries using the Euro.
Having accepted the role as central bank in a system of inconvertible money – the Euro – it cannot abrogate that responsibility without placing the entire Euro experiment at risk. Yet by pretending that it on the gold standard and cannot guarantee the solvency of all members, the ECB is doing just that. So the way out is obvious. The ECB must immediately abandon its current strategy and take on responsibility for the solvency of all crisis economies. Unless the European elite can do this the Euro will flounder.
The advantages of following this policy are multi-facetted and self-reinforcing. First, crisis-economies can borrow directly from the ECB at low rates and once the market realises this the risk premia of their bonds will collapse. Second, the ECB can then dismantle the charade of re-cycling Euros through the IMF-EU stability mechanism that is causing so much political heat in both debtor and creditor countries.
The IMF is not part of the solution to the Euro muddle it is part of the problem.
Third, the atmosphere of crisis will then evaporate and cooler heads can plan any changes to Euro operating rules without driving crisis economies into the ground. The current plan to hold what amounts to a fire sale of Greek government assets, is not only a dumb move on its own terms but is a sign of panic that only fuels the feeling of crisis.
So the way out of the Euro muddle is clear. Unfortunately it appears that no-one at the ECB can see it!
Colin Rogers is an Associate Professor of the School of Economics at the University of Adelaide. His research interests include foundations of monetary theory, open economy macroeconomics, the Economics of Keynes. See his university homepage for more details about his work.