The Future of the Euro

One of the most interesting aspects of the 3-year-old European debt crisis has been the resilience of the euro. Throughout 2011 it was a sweetheart currency, in spite of being caught up in a whirlwind of worries: Concern about the health of the major banks; rising debt to GDP ratios throughout the EU; fears of a Greek default; and turmoil in the stock and bond markets. In 2012 the crisis has escalated markedly, and suddenly there’s the ubiquitous question “Can the euro survive?”

In part, the gravity of the crisis has simply dragged down a relatively healthy currency over time. And there is consensus in the financial markets that the slide is likely to continue, intensifying attention to the question, will the euro survive? Europe is mired in a banking crisis, a sovereign debt crisis, a currency crisis, and a recession all at the same time.

Among other things, the euro suffers from the lack of competitiveness of EU members. Until recently Germany was the exception, but now even its labor costs are rising.

While a weakened currency can help competitiveness by making exports cheaper and encouraging foreign investments, none of that has happened this year. On the contrary, the dollar has slowly gained strength, which contributes to the depression of the euro.

Germany is under pressure to put more of its flagging financial strength at the service of the euro, but experts wonder if pouring more German money into depressed peripheral countries that are perceived as lacking fiscal discipline would salvage the euro in the end. Since the election of French socialist president Francois Hollande in May, German Chancellor Angela Merkel has repeatedly resisted increased euro zone debt consolidation without stronger fiscal and political union.

In the meantime, while eroding, Germany’s stronger competitive position prevents the euro from devaluing to the point where exports would be helped. Since Europe is mired in recession, the outlook for the currency is not good.

The upside is that EU leaders can save the euro. But they’ll have to match their verbal commitments to monetary union with action aimed at the real fiscal and political integration that Merkel wants. In a nutshell, they must voluntarily reduce the power of member nations to determine their own destinies, and increase the role of the EU parliament along with the authority of the European Central Bank. It also means tackling the EU-wide debt consolidation that Merkel resists, along with a credible plan for growth. Without the authority to enforce fiscal discipline and foster economic growth, Brussels cannot reverse the current slide.

Recent events provide a glimmer of hope. Last week at a summit meeting in Brussels, EU leaders pledged to create a central agency to regulate banks. Although it’s not clear what powers the new agency will have, stock markets rebounded at the news. Then over the weekend, doubts set in, largely because of the lack of detail. What the last-minute overnight session produced is a document calling for an “effective single supervisory mechanism.” Understandably, investors want to know what that means.

There are some indications of how the new agency will look. Its head office will be at the existing European Central Bank, and it will have staff to work alongside national bank supervisors. The ECB itself will have an increased role in monitoring the health of national banks, and there will be some sort of mechanism to enforce a standard for banking practices.

Agreement at last week’s summit meeting was not limited to the creation of a regulatory agency for banks. EU leaders also signed up for other stabilizing mechanisms.

  • In the coming weeks a bailout fund called the European Stability Mechanism will go into effect. It will be capitalized to the tune of 500 billion euros, or $633 billion. The fund will start to operate as soon as the countries contributing 90% of that capital ratify it. What’s most important, it will be able to recapitalize banks directly, without increasing the sovereign debt of the countries hosting the banks.
  • The leaders moved forward on a plan for a euro zone-wide banking union that would include rules to either shore up or phase out troubled banks. According to the plan, national authorities would have to set up resolution funds and intervene with troubled banks to require recapitalization or closure. However, acting on the union’s requirements would still be left to national governments, which leaves many observers doubtful, since the union would have the power to sell-off debt or close banks. Crucial questions remain such as “Who decides which creditors get paid first?”

If EU leaders continue to make timely progress toward the centralization of fiscal authority in Brussels, the euro stands a good chance of survival. But the time is fast approaching when they’ll have to institute unpopular political change too. The euro zone, and the EU in general, need a democratically elected EU president and a bicameral legislature that can pass laws applicable to the entire region. And that means EU-wide law enforcement.

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