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Is it a European crisis or a crisis of the Euro?

By Fotis Fitsilis*

The Euro is the most powerful European symbol. Its failure would shake the faith of

Europeans in the basic idea that lies behind the European Union. If the Eurozone

breaks apart, the project of the European Union, which took decades of political

efforts and sacrifices to reach todays magnitude, will go many years back.

Judging by the initial appeal of Greece, Ireland, Portugal (and later Spain and Italy)

for a support mechanism for the Euro, it is obvious that things have become very

serious for the Eurozone. If along the way some other country needs support, it is

doubtful that the current support mechanism will be able to correspond, without

affecting the strong economies of Central Europe, France and Germany. Let us

examine briefly how we got here.

The debt crisis we are experiencing was primarily created by what economists call

financial leverage. According to a simple definition, the financial leverage is a process

of utilizing borrowed money to multiply gain. It is also about excessive borrowing,

mainly on the part of the banks. The loans that initially aimed at creating growth,

were given unsparingly to businesses and consumers, creating distorted conditions

in markets such as housing, stocks, bonds etc, situations that are often referred to as

"bubbles".

The leverage procedures are not always harmless. When a company uses greatleverage in funds, it may have significant profits, when markets move upwards. On

the other hand, it is particularly vulnerable even to small market fluctuations. It is

important to mention that Lehmann Brothers displayed on its balance sheet a

leverage factor of about 31! They utilized funds 31 times bigger than they really had!

Greece still suffers from the shocks of the global economic downturn from 2007 and

on. The Greek economy is mainly a service economy, with chronic structural

problems and a permanently negative trade balance. The accumulated deficits

gradually led to a large public debt, unable to be served by the powers of the Greek

economy alone.

When 50 years ago, the Canadian economist Robert Mundell published his work on

optimum currency areas, he could not have imagined that his theory will play an

important role in the formation of the Eurozone. As basic conditions for the proper

operation of the currency areas Mundell named the following:

- Freedom of capital movement and

- Freedom of movement for workers within the single economic space.

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To these two the former German Chancellor Helmut Kohl has added a third. The

need for political, and hence economic, integration, which, unlike the first two,

never became reality.

To compensate the lack of a general economic policy on a European level, the

Stability and Growth Pact (SGP) was created. The SGP is a political agreement that

lays out the rules for the budgetary discipline of the Member States of the European

Union. According to the SGP Member States must keep their public deficits under a

3% GDP to deficit ratio. Until now, this rule has been violated almost 100 times by

everybody in the European Union and this with almost no consequences. The

inability for common coordinated action of the Member States magnified the effects

of the economic crisis driving the Eurozone to a breaking point.

Such economic practices mainly affected weaker Member States just like Greece.

After the outbreak of the crisis in 2007 it was increasingly difficult for Greece toborrow money from the international capital markets on affordable terms (level of

interest rates). This led to a signing of a Memorandum between Greece and its

lenders, which is basically an agreement of strict economic and financial policies in

return of cheap loans. Following the signing of the Memorandum in 2010 there

were three possibilities for the Greek economy.

A. The Memorandum becomes a success

In this case, in accordance with the provisions of the Memorandum, from 2013onwards, Greece should come out of the recession, with its deficits to zero and a

regenerated economy. The country would come back to the growth track.

Unfortunately, the policy mix was poorly balanced, unsuitable for the purpose and

was entirely rejected by the citizens. A second Memorandum tried unsuccessfully to

correct things and a third is in the planning.

B. The Memorandum fails and Europe seeks a central solution

The chronic structural problems in the countries of Southern Europe produce deficits

that lead to large public depts. It has become obvious that the accumulation of debts

cannot be continued for an infinite time. If the targets of the above-mentioned

Memorandum for Greece are not met (something that is evidently true at the

moment) European leaders will be forced to seek a comprehensive solution to the

problem. The founding of an independent European Monetary Fund (the European

equivalent of the IMF) and the creation of European bonds, so called Euro-bonds,

may be part of the solution. Only a comprehensive restructuring of the European

economies will lead to a long-term stability in the Eurozone.

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C. The Memorandum fails and the European Union cannot offer a central solution

It is an ominous prospect. With no major reforms economic and social indicators in

Greece will hit the bottom. If additional funds cannot be raised from the

international capital markets, an exit from the European currency seems inevitable.

The consequences will be severe, not only for Greece but for all countries in the

Eurozone.

There are politicians and analysts that foresee a turbulent future for Greece. They

are virtually betting on an unstructured Greek default. But nothing should be

taken for granted unless it happens. We should not forget that the decisions

concerning the future of the Greek and European economy are not purely economic.

These are primarily political decisions. They are decisions that will determine the

future of the entire European Union for decades to come.

SOURCES

- The Economist Online, "They're bust. Admit it.", 31.3.2011,

http://www.economist.com/node/18485985

- Michael Sauga, The Fundamental Problem with Efforts to Save the Euro,

Spiegel Online, 30.3.2011,

http://www.spiegel.de/international/europe/castles-in-the-sky-the-

fundamental-problem-with-efforts-to-save-the-euro-a-753509.html

- Robert Peston, Markets call time on Iceland, BBC News, 4.10.2008,

http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/10/creditors_

call_time_on_iceland.html

- "Financial leverage", Wikipedia,http://en.wikipedia.org

*Fotis Fitsilis is an electrical engineer (PhD) and an economist. He is the Head of the

Department for Scientific Monitoring and Reporting in the Hellenic Parliament. This

is an updated English version of an article that was posted on 17 April 2011 in the

Neos Agon newspaper ofKarditsa, Greece.

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