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3 Paths for Europe - Analyst Blog

The underlying cause of the Euro crisis is the massive internal European Trade imbalances, not fiscal irresponsibility on the part of the weaker "Club Med" countries leading up to the 2008 Financial meltdown (with the exception of Greece, which had both big fiscal and trade deficits).

Indeed, if you had looked at just the budget deficits of the countries in Europe in 2007, you would have predicted that Spain and Ireland would be the areas of strength and Germany would be one of the countries in trouble. Looking at the trade deficits would have given you the right list of weak versus strong countries.

Germany (and countries like the Netherlands and Finland, but for simplicity sake I will just refer to all of the strong countries as Germany) is FAR more competitive than the "Club Med" countries (Which for simplicity I will simply call Italy). As a result, it exports far more goods and services to a country like Italy than it imports from them.

If there were no Euro, this would be an easy problem to solve, and would take place naturally through the free market. The Lira would fall relative to the Mark. Presto-chango , Italian goods become cheap in Germany, and German goods become expensive in Italy. With a common currency, no such devaluation is possible. Thus there are only three ways that the relative competitiveness balance can be restored.

  1. Italy could institute structural reforms to its labor markets and other policies. Cutting the red tape needed to start a new business would also help a great deal (and there is far more red tape in Italy than Germany, and Germany still has much more than the US). Germany did this several years ago, and the efforts have paid off. The problem is that is a long-term solution, and the process will take years to have a noticeable impact. The financial markets are not going to wait years. At best, we are hoping they will wait weeks.
  2. Germany could accept a higher rate of inflation than Italy, perhaps by instituting a big fiscal stimulus. The German response to this idea has Frau Merkel channeling her inner Herman Cain: "Nein, Nein, Nein." For historical reasons (The Weimar Republic), Germany has an absolute phobia about inflation.
  3. Prices could fall in Italy. That means deflation, and deflation means years of negative or at best very weak economic growth and very high levels of unemployment. It means tough austerity measures with taxes going up and services going down. It also means that the ratio of debt to GDP is not going to fall very fast, as the denominator is working against them.

The fiscal and banking problems plaguing the continent are a symptom, not the underlying disease. Without a doubt, they are a serious symptom and need to be addressed, but alleviating them will not cure the disease. The pact reached a few weeks ago that got everyone all excited did make some progress on moving towards a common fiscal policy, towards the creation of a real "United States of Europe." That does help address the "original sin" of the Euro: a common monetary policy but not a common fiscal policy. However, it does nothing to address the trade imbalance problem.

Is It Workable?

There are also major issues of if it is workable or not. Countries that have budget deficits of more than 3% of GDP would face automatic penalties. But if you take today's situation, how exactly would imposing a large fine on Italy help improve its current fiscal situation not make it worse? It wouldn't.

The ECB could help out by backstopping Italian debt and effectively printing Euros. That would help lubricate the adjustment problem by raising the overall level of inflation in Europe. If a 5% differential in inflation is needed over several years to bring Germany and Italy back into competitive balance, 6% inflation in Germany with 1% inflation in Italy would be MUCH less painful than 1% inflation in Germany and 4% deflation in Italy.

Any central banker worth his salt knows that deflation should be avoided at all costs. Common debt, in the form of Eurobonds would be a big step forward in having a common fiscal policy and could greatly ease the overall problem. Once again, though, Germany stands in the way.

Unfortunately, it looks like we are mostly seeing option number three (with a little bit of option one, but that is much too slow a process to make a difference). This means that Southern Europe is going to be hurting for a very long time. They are losing a great deal of their sovereignty as their budgets will have to be reviewed and approved by Brussels (in reality Berlin).

Merkel has played her cards brilliantly with her obstructionism. She will effectively be forming German domination of all of Europe, without German taxpayers being on the hook for the common debt. The cost will all be borne by Italy and the rest of Club Med. Those costs will be very heavy and will probably result in substantial social instability. Italy will no longer be a rich country in a few years.

All in all, it would have probably been best if the Euro were never created. However, we cannot go back in time to change history. At this point, any country that left the Euro would face massive bank runs, and that would spread to even the healthy countries. The continent would be instantly be plunged into a downturn rivaling the Great Depression. That experience in Europe did not end well, to say the least.

Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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