Europe fell in a deep recession together with the entire globalized world due to the so called subprime mortgage crisis. However, while the US is managing to recover its economy and it’s now growing at a sustainable rate, Euro Union is somehow struggling in returning at a pre-crisis level and it is actually facing a second recession (so called “double dip”) that is affecting mainly the countries of the South Europe. Since 2010 thus, Greece is having major problem in rolling over its sovereign debt and it had to obtain a bail-out from the other European countries. Similar destiny has occurred to Portugal and Ireland; moreover despite a massive bail-out, Greece is now on the edge of the default and a dramatic exit from Euro currency. Other countries like Spain and Italy are facing the recession and the increase of borrowing cost of their own national bonds.
Right after the borrowing costs surged to an unsustainable level Greece in the 2010, the European Central Bank decided not to guarantee all the Greek national debt in a way like Federal Reserve did for the corporate and government sectors right after the default of Lehman Brothers, starting to lose credibility in the eyes of international investors which began to doubt about the integrity of the European System.
Moreover, European Central Bank decided not to opt for any form of quantitative easing due to a strong intransigence of Germany, not following the strategy used already by the Federal Reserve and the Bank of England; Germany thus indicate that the mission of the European Central Bank is to keep the price stability and to maintain an inflation around 2%. It could be said that while U.S.A. and U.K. were following a neo-Keynesian or expansionist monetary policy focusing on avoiding any liquidity shortage in the economic system and indicating the growth as the main target to reach, the European Central Bank was following a monetarist policy or contraction monetary policy which tend to set as the main target the reduction of debt and deficit level of European Countries through austerity measures.
In order to prevent a contagion from Greece to other European countries, the European Commission decided to build up a so called “firewall” called EFSF which is basically a fund, funded by the same European countries in proportion to their economic capacity that has the possibility to buy sovereign bonds of the countries which could face an unsustainable increase of their borrowing costs in the secondary market; moreover ECB would have repurchased some sovereign bonds through a so-called “Repurchase program” in order to prevent any speculative attack towards any European country. However, this strategy has shown several flaws from the beginning which were confirmed during the 2011 (Ireland and Portugal had to receive a bail-out while Spain and Italy saw their borrowing cost increasing dramatically) and the 2012 (Greece near to the default, overall recession in Europe and the contagion that is spreading through core countries such as France). There are several reasons, which indicate the failure of this strategy:
-the firewall set up by the EC was not sufficient despite it has been increased several times (nearly 800 billion Euros in the 2012);
-during 2011, the ECB increased the interest rates twice (up to 1,5%) instead of lowering to a level close to zero (like US or UK did);
-austerity measured imposed on countries in difficulties (i.e. Greece) depressed their economy sharpening also their recession;
-European Countries showed a lack of leadership and unity together with political myopia;
-ECB, unlike other major central banks, is not a “lender of last resort”. This issue increases the risk for international investors, which might demand a higher premium (or they might just avoid the purchase) for keeping European sovereign bonds as there is nobody to guarantee their repayment.
The Euro zone can be indicated as that group of European countries which are united by a single currency. However, this is an anomalous Union in economic terms because it misses two fundamental parts in order to be a full functioning union. First of all the actual Euro zone has no political union and in particular it has no fiscal union. The lack of fiscal unity among the European countries is indeed one of the key problem that the recession started in the 2008 and still going on in Europe during the 2012.
When European Union formed in 1999, the issue of a list of countries united by the currency but not by a fiscal policy was well known, considering that there were no Unions in the past that survived with merely fixed exchange rates. However this issue was somehow shaded during the first decade by the lowering of the borrowing cost (i.e. Italy) of government debt to historical low levels together with a low inflation rate (for example Italy passed from inflation level of 12% to 2.5%).
The European crisis which started in Greece and spread to all the peripheral European countries finally brought up the problem of a spurious Union. A fiscal unity (together with a political one) is necessary in the Euro zone case due to the fact that the countries which are part of the Euro have historically very different level of competitiveness. In economic terms this means that for instance Germany and Italy have different levels of current accounts and different level of Unit Labor Cost. In a situation where Germany and Italy have the control of their own national currency (Deutsche Mark and Lira Italiana), Italy can increase its competitiveness devaluing its currency (Lira) towards Mark; in this way the Italian goods become cheaper and the level of exports growth while the one of Germany decrease (switch in current accounts).
Moreover, Italy has the possibility to raise the inflation cutting the real wages therefore improving the Unit Labor Costs. This is indeed what was happening before the countries started using the same currency. In the actual case where Germany and Italy have the same currency, Italy cannot use anymore the monetary policy of devaluation; moreover in order to center the Maastricht parameters which imply to have an inflation rate of around 2%, Italy cannot increase its inflation rate like it did in the past.
It is obvious that in this way the two countries will never converge economically as it is mandated by the European Union Pacts, but instead they will tend to diverge more and more. Thus, Germany will gain more and more competitiveness and Italy will lose it progressively. This issue is what has indeed happened after the Euro currency replaced all the national currencies and in particular sharpened due the Economic crisis of the 2008. Germany’s current account improved during the last ten years and the Unit Labor Cost slightly declined, while the Italy’s current account progressively deteriorated and the Unit Labor Cost literally skyrocketed.
It seems clear that in order for the Euro to survive, European countries need to create a full union, which includes also fiscal and political union in addition to the monetary one. Moreover, it is necessary for the European Central Bank to become a fully independent bank similarly to the Federal Reserve with the possibility to become a lender of last resort.
References
Krugman, P. (2012) End this depression now. New York City: Melrose Road Partners.
Lynn M. (2011) Bust: Greece, the Euro and the Sovereign Debt Crisis. Hoboken: Wiley and Sons
