The European experiment with a common currency is teetering on collapse.
In the last week, Germany could not sell a significant share of a new bond issue, and France, which also enjoys an AAA credit rating, saw interest rates in resale markets for its bonds rise to alarming levels. European banks are scrambling to hold onto deposits and borrowing securities from insurance companies to post collateral at the European Central Bank. Many European companies with strong balance sheets face prohibitive borrowing costs or are locked out of bond markets altogether.
Capital markets recognize what French President Sarkozy and German Chancellor Merkel won’t—the euro makes little sense. The panic that could follow stubborn efforts to save the common currency is causing private institutions and sovereign wealth funds to flee the debt of even the strongest European governments.
When the euro was created, wages, private debts and government bonds were converted from national currencies into euro according to prevailing exchange rates at the end of 1998. To the extent those rates reasonably reflected market prices, the euro adequately priced labor, private contracts and public debt across borders.
Unfortunately, those cross-border relationships change over time. Member states in the currency union have labor market policies, tax systems and social programs that vary more widely than those of the 50 U.S. states. As productivity and investment grew more rapidly in Germany and other strong economies, labor and exports became overpriced in Greece, Italy and other troubled economies.
Generally, the ECB has not intervened in foreign exchange markets and the value of the euro has tended to reflect wages, productivity and economic strength of the 17 euro countries as a whole. The upshot—the euro is undervalued for the German economy, making it an export juggernaut, and woefully overvalued for Greece, Italy and other Mediterranean countries making them debtor states.
For the latter, imports were financed by private borrowing from stronger EU states—Mediterranean country banks financed some mortgages and consumer debt by borrowing from German and French banks—and by governments borrowing from abroad—Mediterranean states sold bonds to German and French banks, Sovereign borrowing shored up social programs made expensive by less productive private sectors and padding public payrolls to hide unemployment.
The EU sought to harmonize tax structures, spending and economic regulation across member states, but those efforts did more to open private sectors in weaker economies to import competition than to raise productivity and lower labor costs. And those initiatives along with a single currency raised expectations among voters for social benefits closer to par with Germany and other strong economies.
The upshot is that governments in Greece, Italy and several other states borrowed much more money than they can repay.
Austerity and loans from Germany, France and other strong governments won’t help. To pay what they owe, even with large haircuts for private creditors, Greece, Italy and other troubled economies must earn euro by exporting much more than they import. However, the structure of the Euro Zone leaves their labor and exports too overpriced, unless they endure tortuous recessions for 5 or 10 years to sharply push down wages, and raise productivity to competitive levels.
The draconian austerity prescribed by Germany would leave those economies without sufficient infrastructure and burdened with outdated private capital. No matter how much wages fell, those handicaps would keep overall productivity too low for exports to be adequately competitive.
The only sane option is for Greece, Italy and other troubled economies to earnestly reform social programs, drop the euro and reintroduce their national currencies, convert the face values of government bonds and private loans into those currencies, and let falling values for those currencies in foreign exchange markets impose haircuts on creditors.
Devaluation would permit the Mediterranean economies to increase exports and repay more of what they owe. The losses imposed on creditors by devaluation would be much less than the losses they will endure in the panic building in European capital markets and long recession that now appears inevitable.
Prior to the euro, the EU enjoyed much success increasing intra-European trade, specialization and incomes by eliminating tariffs and other barriers to cross-border commerce, and a common currency has actually subverted that process.
Germany and France should facilitate an orderly exit from the euro for Italy, Greece and several others, or heavily indebted countries will not be able to repay even a reasonable fraction of what they owe.
If Germany and France continue to cling to the myth the euro is essential to European unity, the EU will likely collapse altogether in the contagion and acrimony of the sovereign defaults and bank failures that follows.