Tensions within the Eurozone put the single currency’s future at risk


IT SEEMS improbable that fiscal issues in a small country such as Greece could make the government of a country as large as the US worried about contagion. Yet this is exactly what has happened. This is only so, of course, because the US government is mindful of its own fiscal shortcomings and because the crisis in Greece is a reminder to all governments as to what can happen when a country fails to control its budget.

Fear of contagion has caused the vast majority of the world’s major stock market indices to give up their year-to-date gains. American indices were generally slower to follow their Asian and European counterparts into the red and some Latin American indices continue to hold up well. That said, it seems that investors are no longer as optimistic about the outlook for world growth as they were only a few months ago.

The same conclusion can be drawn from oil prices. The West Texas Intermediate contract has dropped from a high at around $87 a barrel just a few weeks ago to a recent low closer to $65. The market is concerned that the need for drastic fiscal repair in many countries within the industrial world is now so severe that growth in the US, the UK and the Eurozone will remain in the 1-3 per cent region over the next year or two. This is probably not strong enough to support oil above $80 nor to support equity gains similar to what we saw in the first few months of this year.

The process of fiscal repair has only just kicked off in the UK. The new government has announced £6.25bn of spending cuts, slightly larger than the £6bn touted in the Tory election manifesto. These savings, though, are closer to a net £5bn, the IFS calculates, and are just the tip of the iceberg: the UK government is expected to start swinging the axe at the 22 June emergency budget and initial signs are that the unions are not pleased. The degree to which the electorate accepts austerity will play a crucial part in any recovery of sterling against the euro.

However, fiscal repair in the US will not start properly until next year. In the meantime, the US seems to be better placed than either the UK or the Eurozone in terms of growth. Many recent US data releases have held good news and the Federal Reserve has recently revised up its 2010 forecast for GDP to 3.45 per cent, well above market estimates for the Eurozone (1.1 per cent according to the Bloomberg survey). Stronger growth will lessen the need for heavy-handed fiscal reform. The US government will also benefit from the heightened demand for US Treasury assets as investors seek out safe havens. This will keep down the costs of maintaining its debt.

The fiscal repair process in the Eurozone is far more complicated. If EU officials are to reinforce their commitment to the euro then the Eurozone’s fiscal stability pact will have to be strengthened. EU officials are no doubt currently chewing over a number of proposals to tighten it. However, this is a case of locking the stable door long after the horse has bolted. To make up for the lack of budgetary prudence exercised by some Eurozone members in recent years, others are now being required to guarantee their debt. While this may work in a federal system, in Europe it is running up against that critical issue of sovereignty.

German tabloids have not held back from venting their dismay about the whopping contribution that Germans had to pay to the European Union-International Monetary Fund package. The results of the 9 May German regional election also captured the doubts of many Germans towards what some have termed a transfer fund. Granted, the Greek PM is still promising to pay back the loans but scepticism on this point is clearly widespread.

The lack of desire in Germany to bail out Greece reflects the fact that the Eurozone is very much a cluster of sovereign states. The monetary union that was accepted brought promises of monetary stability but breathed nothing about fiscal union. Eleven years on, most Eurozone members still have no wish to give up their autonomy over fiscal policy and move closer to federalism.

The EU may eventually need to recognise that Greece will have to be allowed to default on its debt and even exit the Eurozone for the greater good of the system. This would means heavy losses for some investors but it would remove a lot of uncertainty from the market. Last week there was a first hint that a process for debt restructuring should be built into the Economic and Monetary Union (EMU) framework; Chancellor Merkel suggested that orderly insolvencies of states will have to be studied. She also indicated that Germany would not be prepared to keep on funding less prudent EU nations.

If the doubts about the future stability of the Eurozone project continue, then they will almost inevitably have a detrimental impact on growth. This supports the view that EU ministers should act quickly to restructure Greek debt. For now, selling pressure on the euro can still be considered relatively orderly. What could force the EU to take action would be the start of out-of-control volatility in the euro’s value.