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Saturday, January 23, 2010

The beginning of the end for the euro as Europe's single currency by Dr. Douglas O. Walker

Greece is in the news and the news is not good, for Greece or for the countries of the eurozone.

The state of that nation's finances is terrible, and international ratings agencies have downgraded its credit rating because of a huge burden of public debt and a large budget deficit. Output declined last year and forecasts indicate another drop is set for this year, with unemployment reaching double-digit levels. However Greece decides to deal with its mounting economic troubles it faces a prolonged squeeze on its living standards as it addresses unsustainable fiscal imbalances and a current account deficit of more than 10 per cent of its GDP.

A major constraint on the ability of the Greek authorities in dealing with their deteriorating economic situation is their inability to change their exchange rate. Greece is part of the eurozone and its monetary policy by the European Central Bank in Frankfurt, not in Athens, constraining its policy options when dealing with its problems. Add to this a fiscal policy in disarray and the stage is set for continuing problems aggravated by a fixed exchange rate increasingly at variance with their domestic economic circumstances and needs.

Let me add many economists -- I was one of them -- were never a supporter of the euro precisely because we did not think Europe as a whole was sufficiently integrated to allow a single currency to operate across such a varied economic landscape with such diverse policy objectives and different institutional structures. But I was sympathetic to the need to reduce the transactions costs associated with currency conversions and fluctuating exchange values, and I hoped that the introduction of a single currency would sufficiently discipline economic policy and improve economic performance so as to limit any problems caused by the introduction of a rigid and unchangeable unit to effect transactions and carry out investments over such a wide area. Opening up Europe as a whole to flows of people and capital was also a good idea that could help a continent overcome a terrible history of nationalistic turmoil.

Our fear was the euro would shift the internal balance of payments adjustment process among these countries entirely to changes in the level of income (and hence employment), as fixed exchange rates inevitably do, rather than allowing changes in relative prices to absorb some of the adjustment effects, as more flexible exchange rates tend to do. Wider swings in growth and more persistent external imbalances would result if a fixed exchange rate were imposed and the unemployment rate would be higher. If this happened, the economic situation in some of these countries would worsen over the long-run, not improve, at least relative to the other countries. This is what appears to have happened to Greece.

The smaller and more peripheral countries of the eurozone now have a difficult decision to make. By accepting the euro they have turned the conduct of their monetary policy over to the European Central Bank. It is no longer available to them as a domestic policy instrument. Moreover, now their fiscal policy must be directed at their external concerns rather than their internal problems. For these countries, fiscal policy is no longer a domestic policy instrument. The fixed exchange rate of the euro has become the sole concern and focus of economic policy in these countries. They will either have to discipline their internal policies to the demands of their external monetary relationships or they will have to abandon the euro.

In the case of Greece, any attempt to meet the targets of the Maastricht Treaty that created the European Union and led to the introduction of the euro will only deepen the recession that has taken hold in this country. Similarly, any attempt to restore the competitiveness of the Greek economy with respect to the other members of the eurozone will mean years and years of at best slow growth and continual pain. For Greece, a break with the euro seems inevitable. The sooner Greece leaves the eurozone, the better.

Greece is not the only eurozone country struggling to meet the demands of a fixed exchange rate that is stifling its economy and imposing high costs on its citizens. In many of these countries the euro was adopted mainly for political reasons, with too little thought given to the costs associated with changing their national currency arrangements. Some of these countries are accumulating a mountain of external debt that will be very difficult to pay off or even reschedule. In these circumstances, they should give thought to abandoning the euro and adopting exchange rate arrangements which provide them with more flexibility than the euro.

While the euro will not end as the official currency of the European Union and will not be dropped by its major member-states, neither will it be the single and only currency used in the EU. Perhaps after some time Greece and other countries will be able to adjust their domestic economies to the requirements of a wider economic area and harmonize their domestic policies in a manner consistent with the rest of Europe. But until they do, pressures on the euro will continue and its will continue to unravel as Europe's most important currency .

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