Wearing thin: will the Eurozone survive the ongoing monetary crisis?

On the eve of John F. Kennedy’s presidency, fifty years ago, the prolific economist J.K Galbraith wrote a cautionary letter to the idealistic young president. He warned him that “politics is not the art of the possible. It consists in choosing between the disastrous and the unpalatable.” Euro zone policy makers - currently having to gulp down a noxious brew of sovereign debt, fiscal imbalance and financial instability - may also be tempted to take this cynical view. 

And the situation is getting worse for the common currency. What began as a Greek tragedy is starting to look like the ‘Rape of Europa’: the Greek structural deficit will be even harder than predicted to rein in; the Irish banks are still starved for capital after a €70 billion bail out; Spain is suffering under strict austerity measures with twenty per cent unemployment; and Portugal – stunned after the resignation of prime minister, Jose Socrates –is under pressure to go for a bail out despite its protestations that this is not necessary.

Nor is the contagion confined to the periphery of the Euro zone: the Italian economy is labouring under a burdensome debt worth 115.8 per cent of its GDP, and further handicapped by weak political leadership from its gallivanting prime minister, Silvio Berlusconi. The French economy is hardly faring much better, still straitjacketed by state regulations and powerful worker’s unions. Even the evergreen German economy has stalled -- withering from a diminishing global demand for German exports and now facing increasing domestic political problems.
Such a sustained bout of economic malaise in the Euro zone brings up an uncomfortable question: could the Euro zone make a sturdier recovery if it ousted some of its deficit ridden members, or even ditched the common currency itself?

Leave my house!
Certainly the argument for an expulsion mechanism appears seductive at a first glance. Casting out troubled economies could feasibly be beneficial to the expellers and the expelled. For the well-run core members of the Euro zone, it would be a blessing to no longer have to rummage in their taxpayers pockets to pay the price for the mismanagement of other governments.

And for the troubled states of the Euro zone, expulsion—temporarily or permanently-- would give a struggling state like Greece an excellent means for recovery that the Euro zone denies: the ability to tailor its exchange rate to fit its fiscal policy. This chance to devalue its currency could lower the cost of the nation’s workforce, making its exports more competitive in international markets and stimulating growth. Since they have no control over the exchange rates in the Euro zone they have to turn to other ways of restoring competitiveness to the workforce like slashing workers wages and pensions. All of these remedies actually reduce the flow of consumer spending, leading to an even worse economic condition.

But beneath this alluring facade, expelling or suspending member states from the Euro zone is an ugly policy. Besides the tremendous technical and bureaucratic difficulties that changing currencies would entail, there are no clear criteria for what would constitute fair grounds for punishment. Even if the exile was a voluntary one, it would be hugely destabilising for the financial markets if the Euro zone operated like a buffet where countries could come to take what they want and leave once they are glutted. And once nations realized that they were being undercut by those opting for lower valued currencies, they would follow suit. A race to the bottom would ensue, ending in a mass exodus from the Euro currency.

Put away the dominoes?
With both the Sovereign debt crisis and the banking crisis submerging individual Euro zone states, a chorus of commentators has argued that it might be better to dive off the ship before it sinks. Dani Rodrik, Professor of International Political Economy at Harvard University, has noted that because the monetary union is not “politically integrated enough” to have “the institutional capacity needed to manage the crisis”, the Euro zone may well have reached the point where “an amicable divorce is a better option than years of economic decline and political acrimony.”

There is only one country that could make that executive decision: Germany. It is the leading economy in the Euro zone and as long as Germany remains interested, the Euro show must go on. However, if Germany were to decide that its economy was being held back by flagging peripheral states like Ireland, Greece, Portugal and Spain, and decided to revert to the D-Mark of the 1990’s, the euro would crumble.

But the notion that Germany would benefit from leaving the Euro zone is an illogical one. Speaking at the Kennedy School of Governance, Lionel Barber, the Editor of the Financial Times, makes the point that the “D-mark would go through the roof” resulting in a loss of international competitiveness that would mean “Germany’s export-led economy would suffer, with corresponding soaring unemployment.” Germany traditionally supports the single currency because it brings financial stability and is a cap on inflation – key German concerns, even now. Also, many German banks have heavily invested in operations in peripheral member states and would have a lot to lose if the euro failed. So a German evacuation from the Euro zone would be unwise to say the least.

United we stand, divided we fall
Keeping the euro may well be unpalatable: over twelve years it has created huge imbalances, allowed waves of irresponsible lending to peripheral countries and left nations ill-equipped to stomach global financial recessions. But its dismantling or its contraction would be disastrous. And one would be fickle indeed to presume that trust in the Euro creed had evaporated because of an unforeseen global economic downturn. As Martin Wolf observes, “Economic self-interest and political will would combine to preserve the common currency, in spite of the difficulties.”

The task is now to face those difficulties to make sure the Eurozone does not just survive as an underperforming currency divided between the debtors and the creditors, but realizes its vast potential.

From my lens the crisis could actually be a veiled gift because of its capacity to generate innovation. We have seen the rapid expansion of the Euro zone’s European Financial Stability Facility (EFSF) by €440 billion, a move towards more efficient restructuring of tax, and revamped forms of surveillance to guard against excessive borrowing. These are essential palliatives to anaesthetise sickly economies while real cures are concocted. To really reinvigorate the Euro zone, money must be injected into the banking system to encourage lending; strong political leadership must focus on intra-European infrastructure like smart electricity grids, broadband connections and high speed rail. The Eurozone will certainly survive, but if it adapts in this way, it will also thrive.