The sovereign debt crisis in Europe has reached fever pitch once again as problems in Greece have escalated in recent weeks. When the euro was issued as a common currency among the 16 nation-EuroZone, Milton Friedman, one of the most powerful and famous economists of the 20th century, stated that the EuroZone would not survive through its first major recession. Well, a little over ten years later, Milton Friedman’s words are being tested.
EuroZone Structural Flaws
The EuroZone was formed in order to create a more prosperous Europe. A common currency would significantly reduce trade costs and open up a much more competitive international market. The problem is that, although every nation in the EuroZone shares the euro as a common currency, they each still have their own individual fiscal policies. This presents a major problem, and this problem is being brought to the surface in Greece.
Fiscal Individuality Leads To Abuse
Since each country can set its own fiscal policy, that means that each country has its own individual power to raise or reduce its deficit, raise or reduce taxes, raise or reduce government spending, etc. Some countries in the EuroZone, like Germany and Finland, run very conservative fiscal plans, while other countries such as Greece, Spain, and Portugal have, over the last ten years, tended to run very liberal fiscal plans. The dichotomy between these two camps has produced extreme imbalance between the core (healthy) countries in the EuroZone and the peripheral (weak) countries in the EuroZone.
The Solution
When Greece faced sure sovereign default at the end of 2009 and into 2010, the International Monetary Fund had to step in with the European Central Bank and provide emergency funding for the indebted nation. The IMF does not give a country like Greece all of the cash at once. Instead, it is disbursed in tranches. At each stage of funding, Greece is required to have met specific pre-determined fiscal and monetary goals. For example, it may need to reduce its deficit by X, or perhaps cut X% of its government spending, etc. If a country fails to meet these requirements, they will not receive the IMF funding, and then they will spiral into sovereign default. This is the exact scenario that is now playing out in Greece.
Where We Go From Here
The future of the EuroZone is not in question at this point. The question is whether Greece will remain part of the EuroZone or not. Much of that depends on Greece’s ability to pass another round of austerity measures through the Greek parliament. There has been enormous civil backlash against further austerity measures, which are composed largely of cutting wages and government programs. Early this week, the parliament passed a confidence vote in favor of Mr. Papandreaou, which is a very positive sign that the most recent austerity measures may indeed be passed. If they are, then much of the fear surrounding Greece will most likely subside. Furthermore, Greece announced early this week that it has decided to sell off over 50 billion euros of state-owned assets in order to raise more money to avert a default.
Effect On EURUSD
Currently, the EURUSD exchange rate is actually handling the Greek crisis exceptionally well. The pair is still trading well above the 1.4000 area at 1.4400. In May of 2010 when the fear surrounding Greece was at its apex, the EURUSD traded as low as 1.1875 at most forex brokers. Therefore, if the Greek crisis does pass over and the country is able to secure further IMF and ECB funding, then it seems that the uptrend in EURUSD could continue.
The primary driver of currencies over the long-term is the short-term interest rate target that a country’s Central Bank sets, and currently the rate increase outlook is much more positive for the European Central Bank than the Federal Reserve.
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