Sunday, May 08, 2011
The euro needs more than sticking plaster
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Reports of a Greek exit from the euro, or debt restructuring, were dismissed as “stupid” by senior European Union officials, and “flippant” by the Greek government. But we are into one of those ‘no smoke without fire’ periods, symptomatic of what has happened to the eurozone over the past 12 months.

First there was Greece, a year ago. Then six months later there was Ireland. Now, thanks to acting Portuguese prime minister Jose Socrates we have the broad outlines of Portugal’s EU/International Monetary Fund rescue package.

Portugal will get 78 billion euros, about a quarter of it to prop up her ailing banks. The rescue means there have been three eurozone bailouts in the space of a year, at roughly six-monthly intervals.

While things look less worrying for Spain at the moment — and stopping the rot in Portugal is important — at this rate of attrition Madrid might be nervous about whether it can get through November.

And if Spain had to be helped out, not only would that use up most of what is left in the rescue fund, but the next most vulnerable, perhaps Italy and Belgium, would come under the spotlight for 2012.

Last week I argued that the debate over fiscal austerity and economic growth is more nuanced than it often appears. In Portugal, however, it is not nuanced at all.

The terms of the rescue package will require Portugal to cut her budget deficit from 9.1% of gross domestic product last year to 3% in 2013.

That will cause the economy to shrink by 2% both this year and next, according to Fernando Teixeira dos Santos, the country’s finance minister, under the impact of spending cuts equivalent to 3.4% of GDP and tax hikes of roughly half that amount. Britain’s modest growth, by comparison, looks enviable.

Euro membership does not look very appealing for the three rescued economies at the moment. Ireland has just revised down her growth forecast to just 0.8% this year.

The Organisation for Economic Co-operation and Development (OECD) predicts that the Greek economy will shrink by 2.7% this year, followed by growth of 0.5% next.

It is not just budgetary austerity. While the eurozone is fraying round the edges the currency itself is strong. In what some currency analysts call the ugly contest between leading currencies, the euro is less ugly than most. So the pound is back down to 1.13, suffering as a result of Britain’s weak growth figures.

The euro’s appeal is driven, at least in part, by interest rate expectations. While 4% inflation has not prompted the Bank of England to move, and is now unlikely to do so for some time, 2.8% inflation is too high for comfort for the European Central Bank.

The ECB has already raised its key refinancing rate once, to 1.25%. There was some relief on Thursday it did not signal a second increase, in June. But the consensus in the markets is that the stay of execution will be temporary, and that there will be a hike, to 1.5%, in July.

This will not be a problem for Germany and the eurozone’s other stronger members — though evidence is beginning to emerge of a slowdown in growth across the region — but it is a severe problem for the troubled peripheral economies.

Not only are they having to cope with eyewatering fiscal austerity but monetary conditions are tightening too, on top of the sharp rise in their government bond yields. The eurozone, pinnacle of Europe’s integrationist ambitions (so far) is looking battered. Parts are held together only with artificial support.

Where does it go from here? Its crisis is not a new banking and financial crisis but an aftershock of the 2007-09 global financial crisis. But it could become a new and serious banking crisis in its own right if the path to restructuring Greek, Irish and Portuguese debt is mishandled.

At some stage holders of these debts will have to take a loss, a “haircut”, as is usual after sovereign debt crises. But with German and French banks having an exposure of 340 billion euros in Greek, Irish and Portuguese debt, this has to be delayed until banks are healthier. British banks are in for 250 euros, mainly from Ireland.

Avoiding a Spanish rescue is one priority. Another is managing the restructuring of the troubled peripheral countries’ debt in a way that does not collapse the banks, which means doing it slowly.

Beyond that, serious thought has to be given to the future of the euro. While the financial crisis was the trigger for the eurozone’s sovereign debt crisis, an underlying cause was the loss of competitiveness, typically between 25% and 30%, for Greece, Portugal, Ireland and Spain since the single currency was born in 1999. The assumption that economic convergence, and more importantly convergence of costs, would follow euro membership has proved false.

That leaves two choices. Either the rescued countries, alongside fiscal austerity, commit themselves to win back competitiveness within the euro. Their voters might be prepared to make the sacrifice but you would not bet on it. So far, the response to the eurozone’s crisis is a sticking-plaster one, albeit one that, bizarrely, could cost Britain more than £13 billion ( £4 billion for Portugal alone) if guarantees are called in.

The alternative is that, in time, some or all of these economies leave the euro. Economists do not get everything right but most of us knew a euro open to all-comers would not work. To paraphrase Groucho Marx, you would not want to belong to a club of which Greece is a member. That, certainly, is how many Germans feel. In the long term, Europe will need a new currency arrangement.

Whether that involves a northern euro and a southern euro, or a single “hard” euro around which other national currencies float, can be debated. As with debt restructuring, it cannot happen immediately, but it will have to happen eventually.

Nicolas Sarkozy intends to use France’s G20 presidency this year to push for international monetary reform, by which he means the future role of the dollar. He should look closer to home. After the past year, the euro badly needs reforming too.