How The Eurozone Was Flawed From Birth

Written by Amber Yuan, WealthLift Finance Columnist in Featured, Stock Market News | 0 comments

Many financial headlines refer to “concerns over the Eurozone,” and although there definitely is day-to-day speculation and market movement due to these concerns, this article will aim to highlight the fundamental issues driving the continent-wide debt crisis.

The European Union (EU) as we know it began in 1993 with the signing of the Maastricht Treaty. During the negotiations for the treaty, the to-be European Union laid the ground rules for Economic and Monetary Union (EMU) with the ultimate hope of creating a common currency among its member nations – the Eurozone. To ensure progress toward the goals of the EMU, the EU member states adapted the Stability and Growth Pact in 1997. The Pact stipulated that EU member states seeking to join the Eurozone would have to meet two criteria: 1) an annual budget deficit less than 3 percent of GDP and 2) a total national debt less than 60 percent of GDP. Outside of the Stability and Growth Pact, the EMU also targeted a 2 percent inflation rate for all potential Eurozone members. Under these requirements, eleven countries joined the Eurozone in 1998, and in 2002 the Euro started physical circulation as a common currency.

The country in the headlines, Greece, had originally applied to join the Eurozone with the eleven original members but was denied because of its high inflation rate. However, Greece was admitted to the Eurozone in early 2001 as it showed progress to meeting the EMU’s goals – at least on paper when Greece submitted its public finances to join the Eurozone. In reality, Greece failed to book its military expenditure, which averages 3 percent of its GDP (Greece is, surprisingly, one of the top arms importers as it cites Turkey as a huge security threat). Greece also undertook a secret 2.8 billion dollar loan from Goldman Sachs (NYSE: GS) to erase another 2 percent off its debt. Because the interest rates of the loan were tied to the Euro, the strengthening Euro meant that Greece had to pay a much higher value back; the repayment was ultimately valued at 5.1 billion Euros and would contribute directly to Greece’s debt woes.

This reveals two initial problems with the Eurozone. More obviously, where was the oversight for Greece’s financial information? The EU’s ultimate goal of political and economic integration for European nations probably meant that the standards of the EMU were more flexible than they appeared. In fact, swap deal with Goldman Sachs was only discovered during Eurostat investigations in 2010.

The other question is one that raises a functional problem within the Eurozone. How would the terms of the Stability and Growth Pact be enforced? On the eve of the Euro crisis in 2009, Greece reported a deficit to GDP ratio around 10 percent, far over the 3 percent stipulated by the Pact, while its debt to GDP ratio was well over 100 percent. Italy, Portugal, and Ireland’s debt to GDP ratios were also far above the “allowed” 60 percent. Countries joined into the Eurozone without completely meeting the Stability and Growth Pact requirements, and while progress was expected to be made to reach the allocations of the Stability and Growth Pact, the progress never really happened.

Only when countries’ not meeting the Pact’s stipulations become a pressing issues (read: Eurozone sovereign debt crisis) did the EU move to make the terms of the Stability and Growth Pact more binding. As recently as March 2012, the EU presented the Fiscal Compact that required Eurozone countries to write the 60 percent debt to GDP ratio into law. If countries were over that limit, they would have to reduce it at a rate of 5 percent a year or face a fine up to 0.1 percent of their GDP. Currently, the controversy over the leftist governments in France and Greece is over the ratification of the Fiscal Compact. The Fiscal Compact represents a solution to the problem of enforcing the Stability and Growth Pact, but with the politics of the Eurozone’s member nations, it is dubious whether or not the best economic solution will prevail.

This brings up another question, the fundamental question on the idea of the Eurozone — how to feasibily bring sovereign countries together under one currency. The incentive is clear: a common currency facilitates cross-border capital investments and allows its people greater flexibility in employment. But the common adoption of the Euro also saw countries with a stable, industrial economy like Germany and countries with a weaker economy like Ireland unite under one currency, under one monetary policy. Especially when countries like Slovenia and Estonia adopted the Euro in the latter half of the 2000′s, the disparity of the economies of Eurozone members became even more apparent.

The problem, theoretically put, is this. Economies like that of Ireland, Portugal, and Greece rely on tourism and exports of non-industrial products that require a weak currency, and thus, a higher inflation rate than the 2 percent targeted by the EMU. On the other hand, Germany’s industrial power, especially in the automobile and technology sectors, means that the German economy favors the stability of a stronger currency. In addition, the memory of hyperinflation in the 1930′s Weimar Republic (which is one of the causes of Hiter’s rise to power) means that Germans will avoid high inflation rates at any cost and that the 2 percent EMU target is perfect for them.

Logically, now one can seee that placing these two completely different economies under one currency and an uniform monetary policy is not so great an idea. Either there is a low inflation rate and the economies of Ireland, Portugal, and Greece suffer while the Germans are happy, or there is a high inflation rate that allows those three countries to grow their tourism industries while the Germans are unhappy. So far, and especially given Angela Merkel’s prime position in the European Union, it has been the former.

So what does Ireland, Portugal, and Greece (one can add Spain and Italy to picture now) do to compensate for an inflation rate that is too low to grow their economy?

They spend. After all, although the EMU aimed for a uniform monetary policy through the Stability and Growth Pact, the countries of the Eurozone maintained sovereing fiscal policies. Greece put welfare money in its citizens’ pockets through the guise of salaries for government positions. Forced to by the low inflation rate of the Euro, the governments of these countries spent huge sums on construction packages and Socialist welfare benefits to maintain their economies — and ultimately adding to the deficit to GDP and debt to GDP ratios that the Pact tried to target, toothlessly.

And this is where issue of bond yields come into question. Greece’s spending had become so rampant that many doubts were raised as to whether or not they could pay back the money it borrowed to spend. To compensate for these growing investor doubts, the yields on Greek bonds soared, and in February of 2012, yields for the benchmark 10-year note rose above 35 percent. Obviously the Greek government could not pay back such high yields, and investors in Greek debt were forced to agree on a 50% “haircut” in bond repayments — meaning they would only receive half their invested value back. (Luckily, this wasn’t considered a ‘credit event’ that would have triggered credit default swap repayments. Think 2008 and AIG.)

The story of bond yields isn’t rosy with other countries, either. 7 percent is considered the threshold for concern as to whether or not the borrowing government can pay back its investors, and Italy and Spain have hovered close to that threshold in the first half of 2012. The European Central Bank was forced to offer dirt-cheap loans to commercial banks to buy Italian and Spanish bonds to drive the yields down. For a while it worked, until all the loaned money was spent, and the Eurozone crisis sprung anew.

With all this in mind, one has to wonder how sustainable this Eurozone project is. After all, there is rampant speculation that Greece will be exiting the Eurozone and that investors are bracing for it. But will Greece’s exit really abate the problem? Spain and Italy, although their price of debt is nowhere near as high as Greece’s, could be next — and their exit would definitely create more instability.  Its quite possible by next decade, we could be looking at the EU as a mere blip in the storied history of Europe — a failed experiment in political and monetary unification.

Amber Yuan is a WealthLift Finance Columnist and a first-year student at the University of Chicago, pursuing a major in economics and a minor in statistics. Outside of class, she is involved in UChicago Model United Nations and in ILC, where she has learned everything she knows about finance. A Gold Award Girl Scout, Amber also represented her hometown of San Jose at the 2011 Miss Teenage CA pageant. But if you had to describe her in one word, it would be “Madridista.” Amber is just [kind of] obsessed with Real Madrid.

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