Is Euro on the Verge of Collapse?

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  1. So what is wrong with it?
  2. How different are Euro economies, really?
  3. How Euro economies were brought together: Convergence criteria
  4. Do Convergence criteria still hold?
  5. Conclusion

The thought that Eurozone had its demons first crossed my mind in one of the classes I took on my exchange semester in Albacete, Spain. That was the course where the professor intended to explain the fundamentals of how world economy was working — and did a very good job at it!

Historically — if the word is applicable to the 22 full years of the union (hey, it’s younger than me!) — euro has been perceived as one of the stable currencies. The International Monetary Fund (IMF) data shows that the share of euro in the world foreign exchange reserves has been sitting at around 20% of the total amount — that is the money that Central Banks, Governments of different countries put aside to feel secure. This is no small thing — the share of euro is second only to US Dollar, dominating the world economy since Bretton Woods with astonishing 60%. The remaining 20% of the reserves is distributed among other major currencies like Japanese yen and Pounds sterling.

US Dollar is by far a dominating reserve currency (~60%), followed by Euro (~20%)

So what is wrong with it?

The idea of euro is beautiful. Its banknotes, wide and crisp, breath the sense of joy and prosperity to their owners.

The problem is, a currency is not just means of payment for us, people. In itself, it is a powerful tool to regulate the economy and make sure that the society will not suffer from surging prices, lack of employment opportunities, or issues with competitiveness of its goods on international trade arena.

There are two types of methods that governments can employ to regulate the national economy: monetary and fiscal policy.

  • Monetary policy has to do with money. Governments, with the help of Central Banks, specify key interest rate, participate in foreign exchange (FX) trades, make banks hold cash in their reserves, or even print more money.
  • Fiscal policy is all about how much the Government earns and spends — things they do with our taxes. The tools for fiscal policy are taxation and government expenditure.

These measures are often taken jointly to either boost or moderate economic growth at different stages of macroeconomic cycle. The cyclic nature of economic development is out of scope of this story, but I might write another one, explaining the phenomenon — let me know if it would be interesting!

One problem with monetary unions, including Eurozone, is that member states lose autonomy over their monetary policy. Put it simply, Greece cannot just decide to print the cash that it needs. Germany cannot lower its interest rate to near-zero level by its own decision. Spain cannot devalue its currency to increase competitiveness of its goods for international trade. Their hands are tied as long as there are other members, possibly (and likely) in very different economic situations, that are using the same currency. This calls for a one-size-fits-all monetary policy for all economies that use euro.

How different are Euro economies, really?

You’d be surprised.

Let’s take a look at two indicators that, ceteris paribus (a fancy way economists say “other things being equal”), tell us where an economy is situated in terms of its economic cycle: inflation and unemployment.

These indicators are known to be in a sort of inverse proportion to each other, a relationship that is described by Phillips curve. Intuitively, low unemployment means that people have jobs, earn money and are ready to spend it well, competing for the goods in the market and pushing the prices up — as in the definition of inflation. High unemployment, on the other hand, commonly indicates a state of overproduction, when there are not enough buyers for the goods that are produced, prices for those eventually going down, and people losing jobs as corporations take the hit.

Here is how unemployment and inflation values are dealt among the Euro countries, latest estimates for those coming from March 2022. The size of the bubble is the latest available gross domestic product (GDP) growth rate.

Unemployment, inflation & GDP growth rate of Euro economies. Data from Eurostat

First thing that stands out is that the bubbles are all over the place. Let’s take out a broad brush and add some context.

Inflation has been high throughout 2022, well beyond reasonable thresholds of the so-called “built-in” healthy inflation that gives room to economic growth. Main reasons for it seem to be a shock-increase of energy prices and expectations of supply chain disruptions due to heavy turbulence in geopolitics.

But even with this background, we can clearly see the drastic differences in positioning of the Euro countries on this map. With some countries showing good growth with healthy inflation and moderate unemployment (Slovenia, Malta, Finland), others seem to be in a different part of the graph, price level pushed further up by the employed people (the Netherlands), another group suffering from structural deficiencies, finding themselves at a different layer of inflation/unemployment ratio (Baltics, Spain, Greece).
All of those — managed monetarily as if the subject was that small purple circle between Finland and Slovakia. Fair proxy, right? :)

OK, we saw the bubbles. But what will be the real implication if there are all regulated by one-size-fits-all activities? Let’s see what happens if European Central Bank (ECB) starts raising interest rate here and now, and definitively so. With reported inflation of 7.4% — and skyrocketing, it’s not like they have a choice.

More expensive money means hard times for corporations— people will lose jobs (hello, Southern Europe!). Poor availability of credit will also reduce consumption and hinder what does not seem like an easy ride for the economies with low-positive or even negative quarterly growth. The measure would actually be a good fit for the selected minority — the Netherlands, Germany.

Did the Governments forsee such issues at the very roots of the union? They did, and that brings us to the next, and most exciting part of the story.

How Euro economies were brought together: Convergence criteria

When the Eurozone was assembled, some smart people did the math and agreed on a number of criteria that had to be met by a candidate economy to be considered for membership. That was done to ensure that they would cope with constrained monetary policy going forward. In my own words, the criteria go as follows

  1. Stable prices: inflation no higher than 1.5% above the average of 3 best performing members. This is important because monetary policy is often employed to fight inflation — so the members need to be in the same boat during that journey;
  2. Public finance in good shape: budget deficit no more than 3% of GDP, accumulated government debt no more than 60% of GDP;
  3. Stable exchange rate of national currency with Euro before joining;
  4. Long-term bond yields in the same ballpark: interest rate no more than 2% higher than the average of those observed by 3 members with lowest inflation. Failing to comply with this presents an increased risk that there will be imbalanced capital flows accelerating destructive processes — institutional investors would go for higher return in the same currency.

These conditions were met when the union was created and welcomed new members. What about now? Are they, still? Let’s find out!

Do Convergence criteria still hold?

Out of the list of criteria at hand, it makes sense to visualize them in pairs:

  • inflation and long-term interest rate (as of March 2022), because the two are actually related. There is so-called national Fisher effect which states that the yield will be trailing the inflation at a constant distance of real interest rate;
  • budget deficit and government debt, both — over 2021, because the former accumulates the latter. If a government spends more money than it collects in taxes, it will increase the amount it owes to someone.

We also plot the boundaries of convergence criteria for reference. The size of the bubble now is the actual size of the national economy (GDP, 2021). If a country is within the plotted rectangle on both charts, it means that it remains compliant with convergence criteria.

Convergence criteria are hardly met today

Let’s start with a fun fact?

No member of Eurozone is compliant with the full set of convergence criteria.

Before exploring the current state of affairs further, I would like to show you how this picture has evolved since 2010/2012 (I could not get earlier data from Eurostat without sweat and tears).

Note that the boundaries for “allowed” inflation and interest rate are dynamic as they are benchmarked against “3 best-performing states” every year.

Eurozone debt situation has never been in good shape, but the current divergence in inflation is unprecedented

Deficit and accumulated debt have been an Achilles heel of the Eurozone for a while, culminating in Greece default in 2012 and the bailout that followed. The years of pandemic have not helped in that regard, as governments had to inject some money to cover for the idle time all over the economy.

What is notable, and more important, is that never before Eurozone had to deal with inflation at the level that we are witnessing in 2022. The fact that many economies are not in great shape cause further rumors of stagflation — combination of surging prices with slow or negative economic growth.

Stagflation is regulators’ nightmare. There is no single good response to it. One thing is certain — the interest rate cannot remain at near-zero level when money is losing its value faster than ever before (artistic exaggeration excused). What will happen to the picture we saw earlier when ECB proceeds to the raises of key interest rate, following the Fed’s (Federal Reserve — kind of a Central Bank in the US) steps of the first quarter ?

While helping tame inflation, a higher interest rate would increase discrepancies in Eurozone economies

Inflation would hopefully calm down.

The raise of key interest rate would amplify the distance between current long-term bond yields of the member states, throwing Southern Europe out of the acceptable range.

The accumulated debt of the same states would receive a synthetic boost as the money of the investors would follow a higher potential return.

The hand-drawn bubbles in the chart below represent positions in which we will find many Eurozone economies in 2022–2023. For comparison, on the right, there is a picture that we saw in 2011, a year before Eurozone experienced its first partial default of a member and officially claimed sovereign debt crisis. The resemblance is alarming.

Raising key interest rate would bring us to a situation that was last observed in 2011

Conclusion

This story is already getting so long! Yet so many things remain unmentioned.

Together, we have discovered that the discrepancies among Eurozone economies have already broken through estrablished limits and keep growing fast. We see that the situation today is developing in a similar pattern that was observed accompanying sovereign debt crisis of 2011.

What do you think about the future of euro? Share in the comments!

This was my first story on a macroeconomic topic — I hope you liked it! Let me know if there are other perspectives that would be interesting to explore in a similar fashion. Questions that pop into my mind include:

How far will stock markets fall? What to do with savings? What will happen to house prices?

Hope to see you again in the stories to come!