Just to summarize things – the Euro is unworkable as is. The problem is an inherent one within the construction of the single currency system. Ultimately, the root cause of the problem is the fact that none of the countries within the Eurozone are sovereign in the Euro. Because of this, they are currency users and not currency issuers. But as a single currency system and trading partners, there is also no balancing mechanism via floating exchange rates. So there’s an inherent and persistent trade imbalance within the Eurozone.
The USA suffers from the same imbalance which is offset by the fact that there is a transfer union via the Federal government. The reason why the USA doesn’t have periodic solvency crises is simple – the Federal government is the supplier of dollars and our government understands that the bankruptcy of a state is akin to a mini bankruptcy of the USA. That is something the nation as a whole has rightly decided is intolerable. After all, we are United in this monetary union. The same cannot be said of the Eurozone.
Because there is no balancing mechanism via floating exchange rates or a transfer union, the single currency system is inherently susceptible to imbalances in trade which necessarily coincide with budget woes. As currency users, these nations all suffer from solvency risk in that they cannot always pay in Euro. That’s where we are today. And the current account deficit nations (who borrowed from the current account surplus nations) are now in trouble. The truth, however, is that the entire union is in trouble because they are inextricably linked via the single currency. Greece’s debt is Germany’s debt just like the homeowner’s debt in the USA was the banking system’s debt. We all know how that ended up.
So, where do we go from here? I have maintained the position that there are only two options. Complete dissolution or fiscal union of some sort. Dissolution, is, in my opinion, not an option. Too much time and effort has been put into the union. Plus, it is workable. It just requires some compromise, work and time. In the end, I think the EMU has the potential to be a great monetary union that more than rivals the one constructed in the USA. Clearly, there is much history and infighting to overcome though.
The decision Europeans need to make is whether this union will involve these periphery nations or not. I think the direction is clear. The core nations know that disorderly defaults would be catastrophic for the entire region. Markets appear to be finding some comfort in recent commentary on this. The lesson of Lehman has been learned (or at least we think). So, the worst case scenario here is a sovereign default that potentially leads to defection. That could lead to a partial break-up of the EMU. And some of the rumors of the last week certainly prove that leaders in Europe are debating the option. If it happens, the market disruption could be very traumatic. That is why I have maintained that it is unwise to place substantial equity market bets in one direction based on what appears like a coin flip at this point….
In my opinion, I think the EMU will continue to kick the can until they are forced to break out a bazooka of some sort. This means they either implement Eurobonds, Euro TARP or some other measure that leads in the direction of effective fiscal transfers and fiscal union. As is, the EFSF cannot fix the Euro problems and the ECB is unable to control interest rates with their current form of bond buying (they should target rates and not size).
In the end, the Euro still requires much work. So, the key to the endgame here is to keep an eye out for what I believe is an inevitable fiscal transfer of some sort. This would mostly likely occur in the form of Euro TARP or Eurobonds. At that point, the Europeans will have finally swallowed the pill that will get them on the track to actually solving the inherent problems in the EMU. Unfortunately, the leaders in Europe are slow to act and the austerity measures are already driving a stake into the heart of every periphery nation. All of these other measures enacted thus far are proving futile. Further implementation of them could only further infect an already dying patient. This matter requires swift action and slow moving politics is getting in the way.
To be perfectly honest, I still have no idea what they will end up doing (I like to think I can predict the madness of men, but predicting the madness of politicians is a whole other ballgame). So flip a coin if you must place bets here. Nothing like gambling the lives of millions of people on the incompetence (or competence?) of a few political decisions….
Addendum – I must say that I am surprised by some of the responses I am seeing to the idea of the United States of Europe. Many of these critics are Americans who act as though it is absurd to arrange a monetary system with a central treasury and a currency supplier. But let me remind these critics (most of whom claim to be “patriotic Americans”) that this is exactly what the USA did way back in 1791 when we formed the first Bank of the United States under the guidance of Alexander Hamilton (in large part, for similar reasons due to economic turmoil and an unworkable monetary system). You might disagree with the arrangement of a Federal government infringing on state rights, etc. But one thing no one can argue is whether this system has worked since its inception.
In fact, one could argue that the structure of this monetary system has helped to unleash the greatest economic engine ever known to man. Its smooth working payments system, trade balancing mechanism and reduced economic turmoil helped to grease the engine of the single greatest economic miracle of modern times. So, you might be a “patriot” and you can even call this “central planning” if you prefer, but that doesn’t mean you necessarily have a good argument against the Europeans copying a model (the USA) that has worked pretty damn well. Then again, many of these “patriots” would rather have us revert back to a single currency system such as the gold standard even though the Euro proves the hell that is accompanied by single currency systems….
* Edited on 9/14/11
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.