Two-tier euro would be a paper exercise and won't solve crisis

Dr Constantin Gurdgiev

December 12 2010 04:47 AM

Since its inception, the euro has been embroiled in one financial crisis after another, from the collapse of the exchange rate mechanism in 1992 to the current ongoing sovereign and banks crises.

In between these big events there was a decade of serial mismanagement of the monetary policy and political capture of the currency. The depth and the duration of the current crisis have startled all policymakers within the EU. This should not have been the case were they to pay attention to the realities of European project. You see, Europe has a mosaic of states with a number of different, if often overlapping, problems.

Greece, Portugal and Italy form a group of countries with crony and cosy relations between the state and a number of long-term subsidies-dependent political groups. This has resulted in government spending overstretch. Fiscal and growth crises characterise these states, manifested in very high levels of public indebtedness.

Spain and Ireland also witnessed an explosion in government spending, but the crises have been catalysed by the financial sector meltdown.

A merger of banking and public debts has yielded the very same outcome as in other PIIGS (Portugal, Italy, Ireland, Greece, Spain) -- a debt explosion.

Then, there are countries with unsustainable demographics. Belgium, Austria, Germany, Slovenia, Czech Republic, Poland and Hungary are all heading in to a Japanese-style depression, albeit at varying speeds. Some might appear relatively healthy today, but this is underpinned by artificially elevated savings and export (including EU transfers) surpluses. Perhaps the only unifying feature of the entire EU is a basic deficit of economic literacy. Delivering on the promises of the social welfare democracy requires significantly higher levels of borrowing (by the state or private sector or both) than the anti-entrepreneurial culture of ageing and entitlement-driven Europe can sustain.

Recent debates -- in Ireland and Germany alike -- about the ongoing fiscal and financial storms ravaging the eurozone have been quick to offer a half-way house solution between the stringent adherence to the euro and the break-up of the common currency area. This involves introduction of a two-tier euro. The plan, seriously under consideration in Berlin and Paris since the onset of the Greek crisis, envisions the creation of a 'strong euro' for Germany, France, Austria and possibly the Netherlands. Contrasting this, a 'weak euro' will circulate across the peripheral states, which include Ireland and the rest of the PIIGS.

In theory, having a two-tier euro will allow the ECB to tailor its monetary policies to the needs of two different regions. In practice, barring de-politicisation of the ECB, it is hard to imagine Frankfurt being capable of deploying well-targeted and consistent monetary policy to either group of countries.

On the ground a two-tier euro will be a disaster for the future of the EU, and also for countries like Ireland. Conversion to a weaker euro will deflate Ireland's real wealth, savings and incomes, but will do absolutely nothing for our main problem.

Because our public and private debts were incurred in the common currency of today, their 'weak euro' equivalent will simply have an added zero at the end of its nominal value.

The real liability will likely rise post-conversion, as PIIGS' economies continue to lose economic ground into the future.

The debt mountain hanging over Ireland is so vast that a 'new' euro will come with interest rates in excess of 12 per cent per annum, implying total collapse of future investment and further increase in the real debt burden. In the meantime, we will be importing inflation through devaluation and the banks' funding costs.

Decimated private savings will push households even deeper into austerity. Our domestic sectors will be starved of both capital and consumer demand. Gains in export competitiveness due to weaker currency will be offset by the uncertain nature of the 'strong' and 'weak' euro exchange rate.

Incidentally, for the very same reasons, adoption of the national currency for Ireland is also a prescription for a disaster but with an added bitter pill. A national currency will have to be managed by the very same FAS-esque civil servants and regulators, and influenced by the very same politicos who couldn't manage our economic boom.

In reality, the entire conversation about re-setting the clock on the euro is an economically illiterate deus ex machina for avoiding the inevitable. Without serious structural reforms to the public and domestic private sectors, and barring the cancellation of some of our massive debts, we have little hope of an economic recovery. And without the latter, there is absolutely no point in printing new currency bills.

Paraphrasing Bill Clinton's famous expression, it's the debt, stupid. Not the currency.

Dr Constantin Gurdgiev is adjunct lecturer in finance with Trinity College, Dublin

Cambiz Alikhani, page 31

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Two-tier euro would be a paper exercise and won't solve crisis

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