Perilous Cliffhanger for a Falling Euro Zone

European leaders recently put together a nearly US$ 1 trillion bailout package for the troubled economies of Southern Europe. The package was designed to shock and awe – and it did. But after a couple of days, all that shock and awe wore off, and the euro fell below its pre-bailout trading levels. The market quickly came to grips with the fact that more debt does not solve a debt crisis.

A behavioral change on the financial market triggered the European crisis. Basically, sovereign debt got a fresh look. Markets recognized that debt had contributed to liquidity crises in some countries.

But behind the towering debt levels and fiscal deficits are structural issues tied to declining competitiveness and the high costs of running European welfare states. And these issues cannot be easily resolved.

On the surface, the euro zone's problems are not as severe as those in the United States, Britain or Japan. Data suggest the euro zone is economically healthier than the other wealthy markets. Its deficit last year was 6.3 percent of GDP, compared to 10.6 percent for the United States (local and federal government budgets combined), 11.5 percent for Britain, and 9 percent for Japan. Total sovereign debt in the euro zone stood at 79 percent at the end of 2009, compared to 70 percent for the United States, 68 percent for Britain, and about 200 percent for Japan.

But the euro zone is not a nation. It does not have the power to avert default on sovereign debt as nations do by, when push comes to shove, asking a central bank to monetize debt, thereby depreciating the currency and encouraging inflation. Euro zone countries as individuals do not control the European Central Bank. So when a small country such as Greece gets into trouble, the ECB can act independently by enforcing debt discipline and refusing to monetize debt.

But if the ECB chooses to monetize one country's debt, it dilutes the value of the euro and effectively spends other countries' money without their consent. Unlike the U.S. Federal Reserve, it does not have the flexibility to bail out troubled debtors.

Credit default swaps on sovereign debt are an oxymoron. But the market is apparently too big for that. And "too big to fail," unfortunately, applies to Greece. Its debts are held by major western banks, insurance companies and pension funds. If Greece defaults, some of these institutions would be insolvent, forcing the ECB to bail them out. Hence, it might make sense to bail out Greece.

However, bailing out Greece is not like a Wall Street bank bailout whose price can be determined. Greece runs a huge budget deficit, and its debt has been growing at a double-digit rate. Indeed, without specific bailout conditions, Greece might spend even more, accelerating its debt growth.

The need to add conditions to the package is why the International Monetary Fund was brought into the picture. The IMF adjustment system has a mixed track record, although it succeeded a decade ago during the Asian Financial Crisis. An export boom, strong global economy and devaluations were keys to success. Critics of an IMF-style adjustment say it requires retrenchment during an economic downturn and could be self-defeating by creating a vicious cycle of declining aggregate demand and fiscal revenue. For that reasons, an economy may have to contract much more than necessary to reduce a fiscal deficit in order to achieve an IMF-stipulated target.

The current bailout program calls for 10 percent of GDP in Greek government expenditures. We've never before seen anything like this succeed. It's difficult to imagine that Greece, with its modern, service-centered economy, could withstand a 10 percent of GDP spending cut amid a weak economy. Its economy could simply collapse. Hence, the condition is either not meant to be met, or calamity is looming. The market has not found a path through this jungle-like mess.

North-South Divide

Other countries in Southern Europe also have high fiscal deficits. Since the market demands higher interest rates to finance these deficits, fiscal shortfalls are getting bigger and growing faster. The market foresees Greece-like events in Spain and/or Portugal a few years down the road and, thus, is now treating them as crisis hotspots. The market is turning capricious and cruel.

The US$ 1 trillion fund to help distressed economies is all about the good credit of countries such as France and Germany guaranteeing the debts of countries with poor credit. The problem is that aggressive fiscal budget cuts in these weak countries are unlikely in coming years, and the market won't return to finance their deficits. As a result, this strategy could drag everyone down, turning credit-worthy countries into paupers.

Many analysts have argued that the euro is an unsustainable, two-headed monster. In pre-euro days, countries in Southern Europe had weak fiscal balances and high inflation. They also suffered from frequent currency devaluations, which relieved some of the pressure. Northern European countries had strong fiscal balances and low inflation rates, while their currencies stayed strong. To reflect differences in currency strengths, interest rates were high in the south and low in the north.

After the euro was launched, the market assumed interest rates would converge toward the low German level. This assumption made a generation of traders rich: All they had to do was buy bonds issued by southern countries and short bonds issued by northern countries. So many got involved in these trades that the forecasts became self-fulfilling. A bubble grew as falling credit costs encouraged southern countries to borrow and spend more.

As southern economies boomed, their inflation rates fell. The market saw expectations fulfilled and put more money into the trade. Meanwhile, these economies were losing competitiveness, and trade deficits were rising. No one paid attention to trade deficits when money was plentiful. But over time, foreign debt rose until the day arrived when the market looked at debt levels and decided borrowers could not repay, thus triggering the crisis.

Southern countries in the euro zone couldn't devalue currency to vent internal pressure. Despite fiscal imbalance, their national institutions and sociopolitical dynamics have prevented rapid adjustments. Now, as a result, they may have to abandon the euro.

The end of the euro would certainly be good news for Germany. But, practically speaking, it's virtually impossible. One reason is that Europe's financial institutions are exposed to debts and deposits in every euro zone country. If the euro breaks apart and every country goes back to a national currency, deposits would be shifted to countries with strong currencies. So countries that are expected to have weak currencies would have to devalue massively on day one. But if that happens, financial institutions in strong currency countries would suffer huge losses on their exposures to weak currency countries. Deposit inflows would raise liability levels for strong currency countries, pinning them with financial losses to the point that they have to print money to bail out their financial institutions while their currencies collapse.

I'm afraid euro zone countries are stuck with the euro. Southern countries will need assistance for years to come. In addition to the bailout fund, the ECB will be forced to buy southern country bonds to stabilize euro zone financial institutions; the move would be similar to what the Fed did to stabilize Fannie Mae and Freddie Mac. The process will increase the inflation rate for the whole euro zone.

The market expected southern countries to become like northern countries. The irony is that it will be the other way around.

New Era

The U.S. financial crisis ended unfettered capitalism, and the European debt crisis means the same for an unfettered welfare society. The post-World War II welfare model Europe built is under attack from rising life expectancy and a declining birth rate. Meanwhile, Southern Europe has lost manufacturing competitiveness to developing countries. So as costs rise and incomes decline, foreign debt is the only way to maintain living standards.

This is why Greece's problem is not a short-term liquidity issue: The entire country must accept a major reduction in living standards in order to stabilize. It will eventually get there, but the process could be long and painful.

What confronts southern countries may spread north. Northern Europeans have done well selling machinery, automobiles and upstream manufacturing products. But their advantages are eroding, as more production shifts to low-cost countries. So while northern countries currently feel victimized by their Southern neighbors, the rise of the developing world means that they'd likely end up in the same boat anyway.

Britain is in even worse shape, with a budget deficit like Greece's. The latest election led to a coalition government that's unlikely to make dramatic changes. A crisis for the pound would be much worse than the euro's situation.

Currencies in emerging economies were devalued a decade ago to deal with their financial crises. The U.S. housing crisis led to dollar's devaluation. Now, the euro zone crisis has led to the euro's devaluation.

On a global level, this pattern of rotating currency devaluation is inflationary. The global money supply has risen faster than GDP for a long time due to devaluation-prone crisis management. Weaker global growth seems disinflationary, but over time it leads to more money supply and adds to inflation.

The real tragedy for the world is the destruction of paper currency value. Policymakers react to a crisis by diluting currency value. The short-term consequence seem small, but eventually global confidence in paper currency could evaporate as the world heads into an unstable era of high inflation.

For now, though, the market is focused on the euro. And for good reason. The ECB had been expected to implement a harder monetary policy than the Fed. But under the circumstances, that's unlikely. As a result, the euro should be re-priced to reflect looser ECB policy ahead. How much should the euro fall? That's a tough call. A currency that's re-priced tends to be overshot. I suspect the euro's weakness is entering the overshooting range. So it may fall to 1.15 against the dollar, but could recover to 1.25 before the year ends.

This crisis will have a significant impact on the global economy. The proof is in currency value. An easing of monetary policy is expansionary for an economy but leads to a weaker currency that takes market share away from others. Tighter fiscal policy is contractionary at home and abroad.

The euro adjustment is so big (the euro zone is close to one-fifth of the global economy) that its impact on others must be significantly negative. The net effect probably shaves a half-percent off the global economy, which means the IMF soon may have to revise its 2010 growth rate forecast to 3.5 percent from 4 percent.