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Is two-tier eurozone the answer?
The ongoing sovereign debt crisis has revealed major cracks in the foundation of the single currency area. France and Germany feel that one way to consolidate the eurozone and avoid future crisis is to move towards a new club of ‘core’ euro countries, and abandon the rest. But, is it really the solution?
Issue Date - 08/12/2011
The sovereign debt crisis has just claimed two of Europe’s most venerable leaders – George Papandreou, the third member of the Papandreou family to serve as the Greece’s Prime Minister, and Silvio Berlusconi, the famous Bunga Bunga organiser who dominated the Italian political scene for nearly two decades. The reason is simple. Markets have lost faith in policymakers’ ability to do what it takes to carry out serious structural reform, bring down debt, and stimulate growth in their respective countries.

. In fact, this lack of political ability to deal with the escalating debt crisis has not only increased the investors’ nervousness, but has also put a question mark on the future of the eurozone. The truth is that risks of the EU splintering have really mounted, to an extent that the German Chancellor Angela Merkel and the French President Nicolas Sarkozy have already acknowledged at the recent G20 summit (in Cannes) for the first time that they might abandon Greece to its fate, a devastating shift from leaders who had always insisted for the eurozone to remain intact at any price. There is more. Talks are doing the rounds that they are even contemplating a new club of core euro countries – abandoning the rest – that can live within the rules.

No doubt, European policymakers are certainly under tremendous pressure to bring growth back on track without compromising on austerity measures. But then, is it logical to support creation of a two-speed Europe and shun the development of the single currency area which supports heterogeneous nations?

A closer look at the numbers and one can easily understand the real problem. While yields on 10-year government bonds in the eurozone’s third largest economy, Italy, have officially crossed the breaking point of 7% (the highest in the eurozone history and above the level at which the fiscally troubled Greece, Ireland and Portugal were forced to seek bailouts), interest rates remain above 3.6%, 4.51% and 3.58% on French, Spanish and Austrian bonds respectively. This makes the situation really worrisome as credit rating agency Moody’s analysis suggests that borrowing costs even above 6% could endanger the sustainability of public finances. For instance, while in Greece, it took less than a month to seek an international bailout once the yield on 10-year government bonds passed the psychological 7% level, in Ireland, the yields moved from 7% to 9% in about four weeks before the country sought external help after its yields breached that level.

Interestingly, markets have managed to survive the devastating blows that Ireland, Portugal and Greece made on the single currency area so far, but then how long can the single currency area remain on its feet? If markets begin to question solvency of eurozone’s third biggest economy, the single market project will surely be at risk. Agrees Tu Packard, the West Chester based Senior Economist at Moody’s Analytics as he tells B&E, “Soaring government bond yields is the market’s way of saying it is fed up with dysfunctional domestic politics in Italy and Greece. Investors have lost faith in Rome’s and Athens’ ability to do what it takes to carry out serious structural reform, bring down debt, and stimulate growth. And they are not confident in the ability of eurozone leaders to resolve this mess. As a result, the crisis deepens, financial markets are in an uproar, and the single market project is at risk.”

Even Italy cannot afford to stay out of the market for long. The government has to repay around €100 billion of short-term debt and €200 billion of long-term debt next year, €200 billion in 2013, and another €120 billion in 2014. If maturing debt is financed at 7%, Italy would have to pay an additional €22.7 billion over the next three years to service the debt, wiping out almost half of its projected savings through 2014 and pushing the country closer to insolvency. And if this happens, no one can save EU from disintegrating.

Further, the fault lies in the formation of the so-called single currency area. When Economic and Monetary Union (EMU) of EU adopted euro as its sole legal tender on January 1, 1999, the major mistake that it made was that although it integrated currencies of several eurozone members, it left their fiscal policies completely uncoordinated. No doubt, there was that convergence criteria which specified that a country could become a member only if its fiscal deficit was less than 3% of its GDP and its public debt was less than 60% of GDP. Seems all fine, but once you entered the EU, it seemed you could throw caution [and these rules] to the wind – Spain, Portugal and Greece being keynote examples.

In fact, this exact issue was one major reason that forced UK to stay away from the euro. The country had even warned the EU off a colossal mess in the future, were the EU to continue not enforcing the debt/deficit requirement post membership of the nations.

As expected, today, the situation has worsened to an extent that the European Commission is now even proposing to centrally reinforce economic governance in the EU, which means that the member states will have to submit their national budgets to the EU for approval. No doubt, this, to some level can fix the problem. But the fact is that this quite simplistic diktat doesn’t even stand a chance – given the deep egotistic behaviour that member states, led by stalwart France, have shown very evidently in the past, which proves that they would never be ready to surrender their so called national sovereignty. It’s not only the fact that the moment a nation loses control over fiscal decision making, it ceases being a standalone nation, but also about the fact that even if national heads agree to this ‘solution’, the taxpayers would throw it out to the dogs.


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