Monday, May 31, 2010

Why the single EURO currency fail to work?

THE crisis in Greece and the debt problems in Spain and Portugal have exposed the euro's inherent flaws. More than ten years of smooth sailing since the euro's creation, the arrangement's fundamental problems have become to surface with obvious reasons.

The single currency for 16 separate and quite different countries seem to have failed and the shift of single currency meant that individual member countries lost the ability to control monetary policy and interest rates in order to respond to national economic conditions. It also meant that each country's exchange rate could no longer respond to the effects of differences in productivity and global demand trends that have accumulated. The single currency weakens the market signals that would otherwise warn a country that its fiscal deficits were becoming excessive. A country with excessive fiscal deficits needs to raise taxes and cut government spending, as Greece does now, the resulting contraction of GDP and employment cannot be reduced by a devaluation that increases exports and reduces imports.

Why the United States is able to operate with a single currency, despite major differences among its 50 states? There are three key economic conditions - none of which exists in Europe - that allow the diverse US to operate with a single currency: labour mobility, wage flexibility and a central fiscal authority. When the textile industries in America's north-eastern states died, workers moved to the west, where new industries were growing. Unlike the unemployed workers of Greece, Portugal and Spain they do not move to faster-growing regions of Europe because of differences in language, history, religion, union membership, etc. Moreover, wage flexibility meant that substantially slower wage growth in the states that lost industries helped to attract and retain other industries.

US fiscal system collects roughly two-thirds of all taxes at the national level, which implies an automatic and substantial net fiscal transfer to states with temporarily falling incomes.

The European Central Bank (ECB) must set monetary policy for the euro zone as a whole, even if that policy is highly inappropriate for some member countries. When demand in Germany and France was quite weak early in the last decade, the ECB reduced interest rates sharply. That helped Germany and France, but it also inflated real estate bubbles in Spain and Ireland. The recent collapse of those bubbles caused sharp downturns in economic activity and substantial increases in unemployment in both countries.

The introduction of the euro, with its implication of a low common rate of inflation, caused sharp declines in interest rates in Greece and several other countries that had previously had high rates. Those countries succumbed to the resulting temptation to increase government borrowing, driving the ratio of government debt to GDP to more than 100 per cent in Greece and Italy.

Until recently, the bond markets treated all euro sovereign debts as virtually equal, not raising interest rates on high-debt countries until the possibility of default became clear. The need for massive fiscal adjustment without any offsetting currency devaluation will now drive Greece and perhaps others to default on their government debt, probably through some kind of International Monetary Fund-supported debt restructuring.

The euro was promoted as necessary for free trade among the member countries under the slogan 'One Market, One Money'. In reality, of course, a single currency or fixed exchange rate is not needed for trade to flourish. The US has annual trade turnover of more than US$2 trillion (S$2.8 trillion), despite a flexible exchange rate that has seen sharp ups and downs in recent decades. The North American Free Trade area increased trade among Canada, Mexico and the US, all of which have separately floating exchange rates. Japan, South Korea and other major Asian trading countries have flexible exchange rates. And obviously, only 16 out of EU's 27 member states use the euro.

Despite its problems, the euro may survive the current crisis but not all of the euro zone's current members may be there a year from now. In retrospect, it is clear that some of the countries were allowed to join prematurely, when they still had massive budget deficits and high debt-to-GDP ratios. Moreover, some countries' industrial composition and low rates of productivity growth mean that a fixed exchange rate would doom them to large trade deficits.

Some mechanism of enhanced surveillance and control may be adopted to limit future fiscal deficits. But even with a smaller group of member countries and some changes in budget procedures, the fundamental problems of forcing disparate countries to live with a single monetary policy and a single exchange rate will remain.

The euro rulebook doesn't work !

Business Times, Sept2010

WHAT does a country need to do to make a success of the euro? The European Commission and the European Central Bank would say the recipe is simple: Cut your budget deficit, slash wages, keep taxes competitive, boost your exports, and live with austerity.
There is just one problem: Ireland has been following precisely that formula and it hasn't done much good. The government is being squeezed at a time when the cost of bank bailouts is soaring. Blame it on the banks.
If there is one country that proves what a mess the single currency has become, it isn't Greece, or even Spain or Portugal. It's Ireland. When countries break the rules and then get into trouble, it isn't that surprising. But if they stick to the rulebook and still run into as many problems, it suggests there is something badly wrong with the system itself.

There was a stark reminder that Ireland is still a long way from market redemption, almost two years after the credit crunch burst the real-estate and asset bubble that had been building up in the country for most of the past decade.

Ireland now has its lowest rating since 1995. Irish bonds plunged on the news. The spread over German bunds widened to a record.
It isn't hard to understand why the decision was made. Ireland ran a budget deficit of 14.3 per cent of gross domestic product last year, the largest of any euro-area country. The gap will narrow to about 11 per cent this year, according to European Commission forecasts. That is a slight improvement, but hardly enough to reassure the bond market.

There is a mountain of debt building up and the economy remains in a terrible state. Over the past two years, it has shrunk about 10 per cent, one of the worst recessions in the developed world. There isn't much sign of a bounce back, either. The Irish central bank predicts the economy will expand 0.8 per cent this year, a figure it revised up from the 0.5 per cent contraction it forecast in April.

And yet, Ireland has been exemplary in its austerity drive. Public-sector salaries have fallen by an average of 13 per cent. Taxes have been raised where necessary, but not in a way that will hurt business. The Irish have been willing to tighten their belts and adjust to hard times. There was no sign of the street riots, strikes and political protests that took place in Greece.

Ireland is doing exactly what it has been told it should be doing. It is following the path laid down for Greece, Portugal and Spain, and doing so with admirable self-restraint and discipline. There ought to be some reward for all that effort. But there is very little sign of it.

Ireland had one of the most successful economies in the world when it joined the euro in 1999. All it has got out of monetary union is massive financial and real-estate bubbles, the collapse of which will scar the country for a generation.

If austerity doesn't work for Ireland, it is hardly going to help Greece, Portugal or Spain. The whole experiment with monetary union is doomed if the euro's leaders don't jettison their simple recipe.

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