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A Faltering Experiment

By Shivani Vohra

Greeks protest austerity measures at a May Day rally in Athens

“A Greek, an Irishman, and a Portuguese go into a bar and order a drink.  Who picks up the bill? A German.”

When the European nations signed the Maastricht Treaty in 1992, they clearly never fathomed the global recession and recent instability of the union.  The idea was simple: to create a single currency in order to enable goods and labor to move more freely across borders, thus fueling economic growth.  To prevent financially unstable countries from joining, applicants would go through a screening process that required meeting four main criteria: nations would have to maintain low inflation rates, a target ratio of annual government debt to GDP, an exchange rate range, and low long-term interest rates.

These criteria seemed simple enough and 17 countries eventually embraced the Eurozone.  But they ignored the fundamental economic trilemma. Nations in a currency union can have three goals: fixed exchange rates, open financial markets, and monetary independence.  In any given financial union, as history and contemporary economics has shown, these three objects cannot be simultaneously achieved.

The United States’ currency union has survived because it has accepted the costs that come with the benefits.  The federal government consistently redistributes tax revenue from wealthier states to those areas that are struggling.  Since the 2008 crisis, the Fed has maintained the interest rate at virtually zero in hopes of stimulating economic growth.

The Eurozone countries right now are not in sync.  Greece, Italy, Ireland, Portugal, and Spain risk defaulting on their sovereign debt.  Conversely, as of November 2011, Germany reached its lowest unemployment rate in twenty years.  Indeed, the Eurozone members are at such different places economically that no single solution appears to be able to resolve the situation.

According to economist Nouriel Roubini, the Eurozone has four options, none of which are ideal.  The Central Bank can lower interest rates, depreciating the Euro.  Germany, however, does not like this option as it violates the mandate to prevent inflation.  Moreover, it remains unclear that this move would be sufficient to help the Eurozone.  Both the United States and Japan, for example, have kept interest rates close to zero and it has not helped either country completely recover.

The second option is to allow for a lengthy recession with the hopes that the countries will eventually recover.  Of course, the Greek and Italian citizens are very much opposed to this idea, as are the many investors afraid of numerous international defaults.  Door number three is to allow Germany and other financially solvent nations to continue subsidizing the poorer countries, perhaps permanently.  This is the route the United States favors (it would bind the Eurozone closer together).  The Germans, however, chafe at the idea of continuing to bail out the Greeks, Irish and Italians.

The final and perhaps scariest option is the default of the countries and breakup of the Eurozone.  Countries, including the United States, have defaulted on their debt before.  Other nations have broken away from fixed currency metrics, such as the Gold Standard in the past.  But never before has a large currency union spanning numerous nations, such as the Eurozone, completely collapsed.  No one really knows what the implications of a collapse would be.  It would very likely lead to a global financial meltdown.  With increasing trade and global capital flows, nearly every nation has some European assets and exposure to Eurozone risk.

Members of the Eurozone, of course, are scrambling to ensure that a default does not happen.  As of November 30, 2011, the U.S. Fed, China, and several of the world’s other central banks reached an agreement to provide emergency dollar loans to European banks in a successful effort to calm investors’ panic.  Germany, however, continues to stall at a major bailout, harping about Greek and Italian financial irresponsibility and lack of discipline.  No one disagrees with the Germans’ point.

But at this stage, if the Eurozone collapses, everyone — including Germany — will likely go down with it.


Shivani Vohra is a junior in Davenport College.