I recently read an excellent article on the Eurozone from John Greenwood, Chief Economist of Invesco Ltd. In it he argues that there are now only two possible outcomes to resolve the debt crisis – unilateral default and exit by Greece and possibly other economies or full fiscal union. Prolonged austerity will not work.
The first scenario with a Greek exit runs the risk of contagion. A default on all external debts and a new depreciated drachma would rapidly restore Greece’s competitiveness and growth. This would then become an attractive option for Portugal, Ireland, Spain and Italy. Exit would lead to a run on the banks as depositors including foreign institutional lenders seek to protection funds from conversion to new drachmas, escudos, punts, pesetas or lire. Greenwood also detailed the difficulties in constructing sufficient firewalls and concluded there would be grave consequences for financial markets.
Full fiscal union means a move to central control of Eurozone government revenues and expenditures with a federal government issuing bonds on behalf on all states collectively. Greenwood sets out some examples from history. The one I found most interesting was the monetary union of the United States. The US created a fiscal union before a monetary union, following the War of Independence where the federal government would bail out the indebted states and pay off foreign creditors in exchange for powers to raise revenue in future. Greenwood argues if Brussels took over the debts of Greece etc. the immediate credit crisis would recede and Euro credit could rank alongside US Treasuries.
In the 1830s, following a slump in the rail road boom, many US states became over indebted again. However the federal goverment which had established a good name in the credit markets did not bail them out to avoid undermining this. Monetary issues were not finally settled until after the Civil War.
Various commentators have argued Euro monetary union was destined to fail as it was flawed from the outset. Greenwood concurs that it is a huge mistake to combine economies with different per capita income, productivity and social systems into a single currency. Booms and busts in the periphery will inevitably lead to debt and banking crises undermining the integrity of monetary union. The Eurozone will need to move to a fiscal union with the powers to tax, borrow and spend in the name of the union. If the federal entity is financially secure it can impose a no bail out policy. There would be no repeat of the Eurozone capitulation to bail outs to date that now threatens the monetary union. Greenwood finishes that we’ll know in a few weeks whether we will see break up or full fiscal union.