Could we see European Monetary Union begin to crumble under the stress of a deflationary slump around its periphery in the next 12-18 months? It's certainly a possibility that bears serious consideration, as I can't see how countries like Ireland or Greece can conceivably grow their way out of their current debt overhang, unless they can restore a competitive exchange rate. Greece will have a 13% fiscal deficit this year, an 8% current account deficit, and the government debt/GDP ratio will hit 135% by 2011. If it wasn't sheltered inside the Eurozone, the Drachma would be currency confetti by now. Without Europe-wide interest-rate cuts to US or Japanese levels (which would be unthinkable to those German savers) or a huge fiscal bailout from core Europe (ditto) the risks of one country going for the nuclear option is rising, and if that happens it will be swiftly followed by a number of others. The alternative is for brutal spending cuts and tax hikes (and Ireland has begun slashing public sector wages by up to 20% to limit its fiscal overshoot) which add to domestic deflationary pressure. However, cutting nominal wages is always very difficult , as seen even in the 1930's US depression, because wages are 'sticky' in economic terms. Although only fringe parties in Italy have so far openly discussed the possibility of unilateral abandonment of the Euro, there is no question that the scenario has been 'gamed' at the ECB and German finance ministry.
The structural problem with the Euro has always been that it exists in a monetary but not fiscal union i.e. Europe has a Fed in the form of the ECB, but no central Treasury, with fiscal policy devolved to the member nations subject to agreed deficit limits.This fundamental flaw is now causing intense pressure (and particularly deflationary pressure on the periphery; Ireland is seeing CPI deflation of 7-8% this year for instance. Euro entry caused the speculative booms in the periphery, and now its strength is risking a deflationary depression in those same countries. The bond markets are already reflecting a two-tier Europe as spreads have soared for Spain, Ireland Greece and Portugal (and to a lesser extent Italy) compared to German Bunds and 'core' Europe. If we get another debt crisis leg, in 2010 or 2011 (and if market rates spike on a crisis of investor confidence, it may become self-fulfilling as corporate insolvencies follow) one policy option will be to allow those countries to devalue within the EMU framework and return to an ERM style system where a new 'Euro-Lite' pegs to the core Euro in a trading band. It would be messy and a last resort, but has been quietly discussed in German policy circles. I'd put the probability at 20-25%, which certainly isn't yet reflected in the euro/dollar exchange rate but will be in 2010; I'd expect to see the euro slide to as low as 1.20 at some point in the next 6-12 mths on such fears.
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This week, S&P downgraded its outlook, but not its rating, on Spain which along with Italy and Portugal, holds a similar debt profile to Greece's. Italy, widely perceived as the most vulnerable Euro member after Greece, would be simply too big to bail out, even if Germany and France taxpayers were willing to do so. German economists are nearly unanimous in believing that bailing out Greece would just set a dangerous precedent that encouraged further reckless fiscal policy in Italy and Spain. Years of hard won productivity gains have hugely improved German competitiveness versus the 'Shamrock and Sangria' periphery of the eurozone (where wage rises outstripped local productivity), but at the expense of weak domestic demand. If the eurozone were to unravel, Germany would experience a big real appreciation, reversing those gains.
One way of relieving pressure would be for governments to collectively issue eurozone bonds, rather than their own national bonds. This would help address the problem of poor liquidity that has affected many of the smaller eurozone financial markets and reduce borrowing costs for most euro-zone countries. But German borrowing costs would rise, as it shared its fiscal credibility with the rest of the eurozone and arguably, would be seen to let profligate countries off the hook. Above all, the issuance of euro-zone bonds would require a far greater degree of political integration in the eurozone in order to curb the budgetary autonomy of member states. For large, inflexible economies like Italy and Spain, default within the currency union is arguably a worse option than default and simultaneous exit. This would at least help to restore competitiveness and get the economy growing again, at the cost of near-term increasing foreign currency debt and longer term importing inflation. If one country were to leave, pressure on others to follow suit would be intense.
The structural flaws at the heart of the European project threaten to be cruelly exposed over the next couple of years and it will take a degree of political generosity and economic wisdom rarely seen on the continent to avoid serious market upheaval. I've been a dollar bull for the last couple of months on a stronger than expected US recovery. I called the dollar right in 2008 against the overwhelming consensus, and I'm pretty confident the crowd will stampede my way again, this time chased by angry Greeks bearing bottles of petrol rather than olive oil.
