2011 could be a make-or-break year for euro

2011 could be a make-or-break year for the embattled euro, which will almost certainly face the prospect of gradual disintegration if the eurozone doesn’t move towards fiscal union, according to economists.

“In many ways, the eurozone is undergoing a public sector version of the problems which hit the interbank market in 2008,” notes HSBC group chief economist Stephen King.

“Talk of default and restructuring has increased hugely over the last few months. But in the event of a default, a Pandora’s Box of uncertainty would spring open, unleashing all sorts of unpleasant effects.”

In such an event, adds King, the developed world’s bond markets would have “crossed a financial Rubicon, with creditors finally recognising that their investments were no longer safe.” And in the process of rushing for the exit, the financial engine, “already spluttering, would be in danger of failing altogether.”

How might such an eventuality be avoided? Eurozone members, notes King, no longer have the option of ‘stealthy default’ - by printing money to create higher inflation or a lower currency. “Eurozone debtors must either repay their debts, negotiate a restructuring or vaguely hope that a sudden surge in economic activity provides the higher income to alleviate currently stretched debt-income ratios.”

So, the obvious way forward is for the eurozone to come up with a political settlement, he adds. “Monetary unions do not work very well — and tend not to survive for very long — in the absence of some kind of political and fiscal union. On some occasions, political unions can emerge from financial crises.”

Moves towards a political and fiscal union would provide “a neat way of sharing the burden between debtors and creditors within the eurozone and, perhaps importantly, provide acceptance that the responsibility for the zone’s current difficulties lies with both debtors and creditors,” notes King. “After all, if Germany chooses to run a persistently large current account surplus, someone else needs to run an equally large deficit.”

And, with the eurozone’s overall balance of payments in neither surplus nor deficit, Germany’s excess savings were “inevitably converted into the excess borrowings of the peripheral nations.”

German savers contributed to the conversion by offering to lend to their European partners at incredibly low interest rates. “This was a crisis born not just from the silly investments of the borrowers but also by the irresponsibly generous lending by the creditors.”

Earlier this week, European Union leaders agreed on a principle of a new and permanent ‘European Stabilisation Mechanism’ (ESM) that would replace the European Financial Stability Facility (EFSF), a 440 billion euro ‘rescue fund’ that is set to expire in July 2013, points out BNP Paribas economist Clemente De Lucia. “Like the EFSF, the new fund will provide emergency financial support to countries cut off from the market, albeit under strict conditions.” 

Although financial markets weren’t overly enthused by this move, the agreement on the ESM marks an important further step towards fiscal union, reasons Societe Generale economist Klaus Baader. That’s because, through the ESM, euro area governments “are committed to assisting member-states who run into financial difficulties, on a permanent basis. Second, by submitting to strict conditionality, member-states who do require assistance effectively give up their sovereignty over their fiscal policy. To that extent, this falls “well short of full fiscal union — in which one institution decides on all public sector revenue and expenditure measures - but it is a step on the way,” adds Baader.

Monetary authorities around Europe “face difficult policymaking decisions in 2011,” concurs Moody’s Analytics economist Melanie Bowler. Divergent growth and inflation paths will cloud monetary policy decision, and the European Central Bank’s one-size-fits-all monetary policy “is expected to be tested heading forward.”

The “ultimate solution” for the eurozone, adds King, is likely to include some form of ‘Act of Union’ — a political settlement that more clearly defines the responsibilities of both creditors and debtors and includes more clearly defined punishments for those who fiscally misbehave, “including, perhaps, a temporary suspension of fiscal sovereignty.” But that, he reckons, will take time, and so financial uncertainties “are not going to disappear any time soon.”