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Looming Euro Crisis?

June 28th, 2017 by

Even before its inception, skeptics have been predicting the downfall of the euro, the common currency of the member nations of the European Monetary Union. Many saw this project as doomed from the start. Nonetheless, the currency quickly became the biggest rival to the U.S. dollar in international markets.

After nearly two decades on the scene, could the euro collapse? This question has become less and less far-fetched with each passing year.

Pan-European Project

Since at least the 1970s, policymakers in Europe (and, to a much smaller extent, in Britain) have developed various means for integrating the continent, both politically and economically. They created and for the most part joined the European Community, the forerunner to the European Union (EU) and the governing European Commission (EC). The notion of a common currency was agreed upon by a treaty among the member nations in 1992, and was first implemented in 1999.

Going on almost 20 years now, there has been plenty of time for speculation to begin about whether or not the euro experiment is teetering on the brink of failure.

The gravest concerns about the collapse of the euro were at their height about five years ago, when a general financial meltdown and the Greek debt crisis were hitting Europe hard. There was considerable speculation that the currency may fall into price parity with the dollar, or even depreciate further than that. Thus far, that hasn’t happened.

EU breakup

However, the fundamental flaw of the euro remains the same: There are several economies of different sizes that all must use the same currency. Aside from functioning as a medium of exchange and a unit of account, a currency is also broadly a reflection of the strength of the issuing economy. As an example, even though the U.S. government has flooded the global markets with a huge supply of dollars, the greenback’s value hasn’t collapsed (yet) because the American economy is perceived as strong.

We often hear of Europe referred to as a single market, but this is only partially accurate. Yes, trade barriers and migration restrictions between European borders have been abolished now that we have the EU. Nevertheless, there is still an obvious difference on the ground between the “Portuguese market” and the “German market.” They are one fluid economic zone in principle, but not necessarily in practice.

Convergence Needed

The problem is a matter known as economic “convergence.” In order for the euro to really work, the various economies around Europe should begin to converge in terms of GDP per capita. If not, a given country’s economy may be mismatched with the value of the euro. Such a mismatch places downward pressure on exports, for example, if a country’s economy is not large enough to justify such a strong or “expensive” currency. In other words, Portugal would benefit from a weaker currency, but that can’t happen while it’s part of the eurozone.

Critics of the eurozone project have warned that these economies must converge before a common currency is successfully introduced, but the proponents of European integration went ahead with the plan anyway, assuming that the currency itself would help bring about convergence. While much of Northern Europe boasts similar levels of GDP per capita, their neighbors in Southern Europe (particularly Spain, Greece, Italy, and Portugal) have not seen comparable growth in the era of the euro. If they were, the different colored lines on the Bloomberg chart below would all be moving toward the same point. If anything, some of them have actually grown farther apart.

No Solution In Sight

A number of pundits believe that the end of aggressive stimulus by the European Central Bank (ECB) could significantly worsen the problems the euro is facing. The ECB has pumped some €2.3 trillion of liquidity into the eurozone, which many acknowledge has helped “paper over” the risks associated with a dysfunctional monetary system. Removing this quantitative easing could actually reverse the modest level of financial reintegration that has been seen since the worst fears of the euro crisis abated.

The sentiment that individual European nations have ceded too much sovereignty to the EU has been growing stronger, resulting in the wave of populist political movements around the continent (and the world). If the euro (or the monetary union that uses it) begins to collapse, it would undoubtedly supplant the 2008 crisis as the most important economic event of the 21st century so far.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.

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