The fight to save the euro

What’s happened?

Europe’s state finances have been going sour for years. In particular, national debts (what countries owe) and budget deficits (annual overspends) grew to dangerous levels in the 2008/2009 Great Recession. But markets had assumed that if the eurozone ever got into a real financial pickle, Germany – the true core – would pick up the final tab. That big trouble has now arrived. Greece, Portugal and Ireland have already had bail-outs.

Meanwhile, Spain and Italy are now under the market’s microscope. But the Germans are reluctant to continue to pay other countries’ bills. What’s more, they won’t let the European Central Bank (ECB) print extra money to fund more bail-outs. Net result: panic. Borrowing costs for peripheral eurozone countries have hit their highest levels since the single currency started.

What can be done?

German chancellor Angela Merkel insists that keeping all 17 nations in the eurozone will “require a fundamental change” to “turn it step-by-step into a political union”. As fund manager John Hussman puts it, that would mean “a European federal system whereby each country surrenders… the ability to set fiscal policy without broad approval from a central European authority”. It’s the only way Germany would be likely to “agree to a change in the ECB’s mandate to allow it to purchase weaker European debt”. In other words, in future, Germany would be giving the orders and controlling the purse strings.

Would this work?

Not for long. European anti-austerity protests are becoming more strident. Citizens of Greece and Portugal (and, indeed, Italy) aren’t likely to tolerate state spending being slashed even more, particularly if the commands come from Berlin. Furthermore, another recession would mean “the willingness of individual European countries to give up their own fiscal reins may vaporise”, says Hussman. That leaves just two real choices. Either Germany will leave the eurozone in disgust, or the region’s indebted states will slink out by the back door – the latter is the more likely. In both cases, the defectors would be likely to revert to their former currencies.

How would that help?

If Germany were to depart to re-establish the deutschmark, the euro would drop. That would help the region’s other exporters (see below). But shorter-term, it wouldn’t help cut the huge debts racked up by troubled eurozone countries. In contrast, if one or more of the latter defected, their ‘new’ currencies would plunge against the euro. That would raise the cost of repaying euro-denominated sovereign debts even higher. So a default on part, or all, of those borrowings would then be a certainty. That would hit many of Europe’s banks that have lent the money. Few investors would then be prepared to lend eurozone defectors extra funds. So their governments would have to run better-balanced budgets, which would mean austerity measures being applied anyway. Imported goods would become pricier, pushing up inflation, squeezing disposable incomes, curbing consumer spending and lowering living standards.

How easy would a currency switch be?

Huge legal and practical problems would emerge, says Joshua Chaffin in the FT. “Euro-denominated contracts from property to salaries would have to be re-drafted. There would also be a wave of litigation from foreign creditors, who’d fight efforts to repay cross-border obligations in a new currency.” Computers would need reprogramming. Everything from launderettes to vending machines and cash points would need modifying. In fact, stopping runs on eurozone defector countries’ banks could be “the most sensitive task”, says Chaffin. “Citizens would scramble to pull their savings before they could be converted – you’d have suitcases of money flying out of the country.”

So why go it alone again?

Having control over your currency has some big benefits. Via quantitative easing (QE), America and Britain can create extra cash to buy their own government’s debt. Pumping more money into the system risks stoking inflation. But if a currency is falling anyway, and QE kicks in, the value is likely to drop further. That’s good for exporters. Tourism should also benefit, extra jobs would be created and growth boosted. If several countries drop out of the euro, they could even form their own currency bloc. “If they cut back their… public sectors and invest in the most sustainable parts of the economy,” says Iain Murray in The American Spectator, “the future will look rosy for these newly liberated economies.”

How will this affect Britain?

The eurozone is Britain’s biggest trading partner. So any break up would have a big effect on our economy. A lower euro – or the lower ‘new’ currencies of eurozone defectors would cheapen our imports and make our own exports more expensive. That could help push down inflation, although our balance of trade, and hence economic growth, would suffer. But the real damage is likely to come from Europe’s looming economic slowdown. Britain is only recovering slowly from the last major contraction of 2008/2009 and could easily be dragged back down into recession. Worse, many of Europe’s banks have funding problems that would only deteriorate with a eurozone sovereign debt default. Indeed, we could see a new credit crunch crossing the Channel that would crush lending in Britain too.

Category: Economics