Why Does EU try to Save the Euro?

Readers Question: Every country’s economy has their own dynamics. Competitiveness is more or less adjusted by appreciation and depreciation of individual currencies in free economies. Then why is EU pressurizing Greece to stay in Eurozone? Except borrowings at a cheap interest rate, what are other real advantages of Euro?

There are a few advantages to the Euro, such as:

  • Lower transaction costs
  • Fixed exchange rates give greater certainty to business
  • Greater price transparency and competitive pressure within Eurozone.

For more see: advantages of Euro

However, these advantages rather pale into insignificance when compared to the very serious costs of membership. See: Problems of Euro

Before the Euro started many assumed the Euro would enable countries to borrow at low interest rates (and for a while even Greece could benefit from low interest rates). But, now Eurozone economies face much higher borrowing costs than they would outside the Euro. (EU Bond yields)

You are right that in a single currency, countries have become very uncompetitive, and the only solution is to force internal devaluation on southern European countries. But, they won’t be able to restore the 30% loss of competitiveness without a period of prolonged mass unemployment and low / negative growth. This is a very bad situation to be in. The dynamics of the Euro will push low growth and deflation on the southern, uncompetitive members.

The EU might not want to admit it, but if they were starting the Euro again, they would either – definitely not do it or if they did pursue the Euro, they would be very selective. All the southern European countries like Spain, Italy, Greece, Ireland, Portugal would not be admitted. They would also probably set up a single currency with fiscal union and the ECB as lender of last resort.

If Greece could painlessly leave the Euro, it would be in everybody’s interest for them to leave.

Why Then Does EU want to Keep Greece and Italy in Euro?

  • It is very difficult to leave the Euro. See: Costs of leaving the Euro. If a country left the Euro, its new currency would experience a rapid devaluation. Therefore, there would be capital flight out of that country. (e.g. investors would try to protect their savings by keeping money in Euros and out of Greece)
  • EU banks have invested money in countries like Italy and Greece. If they left the Euro and devalued, the EU banks could lose significant sums of money; this could precipitate a credit crunch. I think this is one of main reasons for trying to keep Greece and Italy in the Euro.
  • Knock on Effect. If one country leaves the Euro, it would seriously undermine confidence (if it is possible to undermine confidence more). Markets would then fear a wider breakup. This would increase pressure to start selling other government bonds – like France.
  • Political Motives. The Euro is at the heart of the EU’s strategy for closer economic and political union.

 

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2 thoughts on “Why Does EU try to Save the Euro?

  1. Thanks for the reply.

    1) It is true that if a country left the Euro will face a rapid devaluation and there would be a capital flight out of the country. However, my point is the capital flight will not happen in a big volume which will really affect the overall economy. Government can put some restriction to control this activity until the situation improves.

    2) Devaluation will happen to the new currency of the outgoing country. Euro value will remain more or less same, so EU banks might not face loss of significant sums of money. Euro will be unstable for a short period of time.

    3) Euro will lose confidence. However, continuing like this will eventually bring EU to lose confidence in near future.

    4) Therefore, it is better for some countries to leave Euro and face devaluation and unemployment for few years in pace of an indefinite period of low growth and deflation. There are examples with us like old Soviet Union.

    Please comment.

    Manish

    1. Yes, good points. I’m not entirely sure of all the implications involved in leaving the Euro. For example, I’m not sure on the extent of capital flight if you left the Euro. It may be difficult for government to impose satisfactory capital flows.

      One way of thinking about issue is? Can it get any worse for Greece anyway? Greece may be better off leaving and accepting whatever costs may be involved. Otherwise they may find themselves repeatedly in this position of being uncompetitive, deflationary pressures and high unemployment.

      Italy would be different because of the sheer size of the Italian bond market. I think Italy has 5th largest bond market in Europe.

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