Is the Plan to Save the Euro Working?

It has been just under a month since the EU and the International Monetary Fund came through with a trillion dollar lifeline to prevent the malaise in Greece from spreading to the rest of Europe. Is it working?

Like everything having to do with the EU right now, the answer depends on whom you ask. Providing emergency funds to Greece at what amounted to the 11th hour, ensured Greece could meet a looming repayment deadline. Without the backing of the EU, Greece would have had no choice but to default, and there is no telling what damage would have resulted. Several other countries in a similar situation, seemed to finally grasp the seriousness of the predicament and have implemented self-imposed “austerity” programs to reduce spending in a bid to reign in their own burgeoning deficits.

Despite these first, tentative steps towards economic responsibility, it is obvious that investors are not yet convinced crisis has been averted. The euro continues to lose value on a daily basis, and is near a four-year low; global stock markets are also in freefall with no reversal in sight. In fact, ratings agent Fitch Ratings, is so bearish on some eurozone countries, it recently demoted Spain’s credit rating to AA+ from AAA.

In addition, cracks are starting to appear in the eurozone foundation as the EU splinters into two factions – those desperately in need of money to prevent total collapse, and those forced to contribute to the emergency fund in order to protect their own economies. So, is the plan to save the euro working? You be the judge.

At the beginning of the year, the euro was trading at US$1.4369, but has been on an almost straight-line decline since then. By June 1st, the euro was down 18.6 percent to 1.2112. So strong is this downward trend, that when the EU announced that it had come to terms on a bail-out plan, the news caused barely a ripple. Traders paused for all of a second or two before redoubling their efforts to short the beleaguered currency.

The reason for this is simple. The massive injection of cash may have prevented an immediate collapse, but it does nothing to address the fundamental problems that cultivated the crisis in the first place. Investors definitely understand this and from this perspective, they are giving the bail-out plan a failing grade.

Rules, What Rules?

To understand how the debt crisis came to be, you must first understand how several of the eurozone members routinely flouted spending rules intended to hold the line on individual sovereign debt. All countries are required to prevent total debt obligations from exceeding 60 percent of Gross Domestic Product, while annual government deficits are similarly capped at 3 percent of GDP. Currently however, only two countries – Luxembourg and Finland – are in full compliance.
 
So how is it that 14 of the 16 eurozone nations were allowed to continually ignore the rules? It probably comes down to a combination of lax enforcement, combined with a bit of old-fashioned deception that allowed this practice to go on for so long. For example, it was recently revealed that billions in debt was hidden (I’m looking at you, Greece) using currency swaps to obscure the true level of indebtedness. By exchanging foreign debt denominated in dollars and yen for euros, at what could only be described as a “fantasy” exchange rate, Greece received far more euros than the combined debt was really worth. This exchange rate trickery enabled Greece to show a grossly inflated balance sheet. Of course, when the time came to repay the debt, Greece had spent the euros it received in the original transaction, and was unable to come up with the cash to meet the new debt obligation.

This is just one example of how a determined eurozone country was able to circumvent the (nudge, nudge, wink, wink) debt rules. Historically, little has been done to deal with serial offenders and as Olli Rehn, Economy Commissioner for the EU told reporters in early May, there has been a long-standing “chronic failure” of several countries to comply with eurozone budget requirements. I would suggest that there is a similar long-standing “chronic failure” on the part of EU authorities to police the actions of member states.

On a final note on this topic, all eurozone countries were issued with a “free pass” during the recession as governments spent billions in various stimulus schemes to prop up their respective economies. While this may indeed have fallen under the guise of “extenuating circumstances”, it would appear that ignoring budget regulations has indeed become standard procedure.

Potential for Social Upheaval

To address the larger problem of severe overspending, governments are looking high and low for areas where they can trim spending. Most citizens paid from the public purse, and even those on state-sponsored pensions, can expect wage freezes, while many will face pay cuts. Almost all citizens will pay considerably higher taxes.

For those living in countries where “cradle to the grave” government care is seen as a basic entitlement, the shock of losing this level of attention, will be pronounced. The truth is however, governments can simply no longer afford to spend at the current rate, but many chose to willfully ignore this reality.

Predictably, organizers were quick to call for action resulting in large-scale demonstrations and riots as people in Greece took to the streets to protest the loss of government-sponsored programs. Sadly, this violence could be simply the tip of the iceberg as further spending cuts are unfurled across the region. The added instability arising from street demonstrations is the last thing cash-strapped governments in the eurozone need to face right now in what is sure to be a long, hot summer in Europe.

Content is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Business Information & Services, Inc. or any of its affiliates, subsidiaries, officers or directors. If you would like to reproduce or redistribute any of the content found on MarketPulse, an award winning forex, commodities and global indices analysis and news site service produced by OANDA Business Information & Services, Inc., please access the RSS feed or contact us at info@marketpulse.com. Visit https://www.marketpulse.com/ to find out more about the beat of the global markets. © 2023 OANDA Business Information & Services Inc.