European Reality Check

The first reality check is to recognize that the EU is a failed experiment. The EU was a noble idea aimed at allowing the free flow of people and trade throughout the EU. A further objective was the development of a common currency, the Euro. There was a flaw in the original plan which allowed individual countries to retain their sovereign governments and control of their own fiscal destinies. The EU was in control of the monetary levers. Individual countries agreed to limit their government deficits to less than 3% of GDP but there were no measures to deal with countries that did not comply with this requirement.

Prior to the introduction of the Euro, investors considering purchasing the sovereign bonds of countries like Greece, Italy, Spain and Portugal, had to factor in the possibility (probability?) of currency losses in the drachma, lira, peseta or escudo during the period of the investment. The arrival of the Euro allowed investors to believe that the currency risk had been eliminated. They were buying the sovereign bonds of EU countries denominated in Euros and thus the risk of currency loss was ignored.

This enabled those countries involved to issue vast quantities of new sovereign bonds at very favorable rates, funding budget deficits well in excess of the 3% of GDP that they were obliged to respect. These countries now have debts which are incapable of being repaid under any normal circumstances.

The second reality check is to recognize that individual EU countries do not have the ability to create vast amounts of new Euros to inflate their debt problems into oblivion. Thus EU countries that are experiencing difficulties have limited options.  To repay their sovereign debts these countries must first achieve budget surpluses, which requires economic growth. To do this they need to improve their competitive positions relative to their northern neighbors. Denied the ability to quickly improve their positions by devaluing their currencies, these countries are forced to adopt austerity policies aimed at deflating internal wages and asset prices to the point where they eventually become competitive. This is a slow process that causes a lot of financial pain resulting in social unrest and riots.

If the social unrest gets to be excessive, these countries may consider another option to get rid of their debt. It is an option that is being ignored because of the drastic consequences for the EU and the Euro if this course of action was adopted. This option is to “wipe the slate clean” by declaring bankruptcy, defaulting on their debts and starting afresh with a new currency of their own. The new currency will quickly depreciate to the point where their competitive position will become attractive. With no debt to service and with a competitive economy, the country could adopt disciplined monetary and fiscal policies, hopefully followed by economic growth.

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