In recent months, Greece’s financial troubles have returned to the forefront, exposing potential turbulence within the 19-member monetary union that makes up the eurozone currency bloc. The Greek government, under Prime Minister Alexis Tsipras’ Syriza party leadership, was threatening to default on its €460 million payment owed April 9th to the International Monetary Fund, but averted such a crisis (Bird). On Tuesday, Greece was several hours late on a pension payment under the specter of another potential default. Such an event would have a momentous impact on the currency at large; Greece would be booted from the bloc, borrowing costs would increase substantially for the other member states, and Italy, Spain and other troubled nations would be watching closely as they consider their own potential future defaults.
The Foundation of the Common Currency
The European Union traces its roots to the immediate post-WWII landscape. East Germany had fallen under the Soviet Union’s Iron Curtain, and the major European powers desired to keep a watchful eye on West Germany’s steel production in the interest of avoiding future conflicts. That evolved to a free trade agreement among most of Europe by the end of the 1950s. The thinking of leaders of the time was that greater integration would breed a higher level of international interdependence, thereby decreasing the probability of a major conflict. The intentions were mostly political, not economic.
The Maastricht Treaty was signed in 1992, an agreement to create a monetary union in Europe. The countries that ratified this treaty agreed to eventually abandon their regional currencies and switch to the euro. In other words, the signatories agreed to cede their sovereignty over their own monetary policy to a European Central Bank, which would make one policy for all of the member states. However, because of the political difficulty of transferring debts among nations, each nation would retain its individual power to tax and spend.
This was an attempt to establish a common currency across a region that economists would not describe as an optimal currency zone. This means that the different member states in the eurozone are prone to asymmetric shocks; a banking crisis in Ireland may cause a national recession that may coincide with an economic boom time in Germany. Because of this, these nations would choose widely divergent monetary policies when left to their own devices. When combined, the European Central Bank is forced to choose a middle ground policy that is sub-optimal for both nations.
There is one significant template for implementing a successful common currency over a sub-optimal currency zone: the United States of America. The nation’s first Secretary of the Treasury, Alexander Hamilton, recognized this problem. To combat it, Hamilton insisted that the newly minted federal government assume the debts of the states. This was highly controversial in states that had paid off their Revolutionary War debt already, such as President Washington’s Virginia, but would allow the federal government full power over fiscal policy within the union. When one region of the country was disadvantaged by the common currency, the federal government could compensate that region by its fiscal allocations. This happens naturally because regions performing well pay higher taxes and those performing poorly receive more welfare attention.
Why This is a Problem
By assigning to the European Central Bank monetary policy and retaining the sovereignty of the individual nations over fiscal policy, the Maastricht Treaty created a situation that would inevitably lead to currency wars in Europe. The euro would be too strong for some economies because of the heavy influence of Germany, which has historically favored an expensive currency. The exports in those countries, as a result, are too expensive.
To compensate for the disequilibria, the nations for which the currency is too expensive are incentivized to attempt to devalue the euro through fiscal policy. In other words, countries like Greece, Italy and Spain are likely to spend large sums in an attempt to increase the money supply. These countries ultimately accrue more national debt than they can pay off, imposing serious strain on the currency.
Setting interest rates at the European Central Bank results in improper borrowing rates for individual nations. This was recently a problem in Ireland, for instance, as the Emerald Isle’s inhabitants were offered cheaper debt than their economic situation dictated because of the common European rate (Federal Reserve Bank of San Francisco). Too much private debt accumulated in Ireland, and the island nation experienced a banking crisis that reverberated internationally.
Unless substantial changes are made to the euro, such as the creation of an American-style common Treasury to which there is prohibitive political opposition or a reduction in the scope of the currency, the nations that require a weaker currency will continue to accumulate excessive sums of debt. Eventually, there is going to be a default on a nation’s sovereign debt that sends shockwaves throughout the European economy as well as the global economy.
What Happens Next
Several European nations have public debt situations that have reached critical mass. The situation in Greece is desperate, and Italy and Spain will follow suit in the coming years. Many of Europe’s current crop of leaders are committed to upholding the currency. The stronger nations are willing to extend buyouts to the troubled nations, and very likely will do so with Greece. This, however, is not addressing the underlying problem.
Inevitably, a new generation of leaders will emerge with fewer legacy concerns tied up to the success of the currency. Greece’s current government was elected on the promise to stand up to the ECB, although they later reneged on that promise. A similar political party has emerged as a serious threat in Spain. Eventually, these nations will default and leave the currency. The tumultuousness this will introduce to the union will make it clear to the stronger nations that a return to regional currencies is the proper arrangement in Europe.
Greece has already begun preparations to issue its former currency, the drachma, in case the nation is booted from the eurozone shortly. If this happens, Greece will be free to devalue the drachma as they choose in an effort to cheapen their exports, increase Greek industrial production, and hopefully boost employment and wealth within their borders. Italy and Spain will be watching, as will other nations without similar monetary needs to Germany, such as Ireland and Portugal.
Bank accounts holding euros will replaced by the new regional currencies of the nations those banks are held in. There will be an initial shock, for sure. Eventually, international trade would return to equilibrium and global markets will be all the better for it. Without an American-style common Treasury (which would be politically impossible to establish in Europe), the euro is inoperable and must be replaced.
Bird, Mike. “Greece made its big IMF debt repayment”. Business Insider. 9 Apr 2015. Web. 1 May 2015.
“What is Taylor’s Rule?” Federal Reserve Bank of San Francisco. Mar 1998. Web. 23 Mar 2015.