Greece is back in the headlines in recent months with concerns over a Greek exit from the EMU at the forefront. The problem in Europe is relatively simple, but the solutions are anything but. I’ve received a number of emails in recent weeks asking me to explain what is going on so I figured a brief overview and refresher might be useful.
The best way to think about the EMU is to think about the USA. The United States is a single currency system with 50 independent users of a federally issued currency. There is no foreign exchange rate between Mississippi and California for instance, but the states are inextricably linked by the federal government. What isn’t well known in the USA is the extreme trade imbalances that exist between the various states and how many states receive significant fiscal transfers from the federal government (ie, from the trade surplus states).¹ States like Texas and California are enormously productive states running the equivalent of a trade surplus and taking in far less in government aid than states like Mississippi or New Mexico as a result because they simply don’t need the extra fiscal transfers.²
This is analogous to the EMU because many of the peripheral countries (like Spain and Greece) are trade deficit countries that are perpetually exporting Euros in exchange for goods and services. And because Greece and Spain can’t issue Euros or rely on currency rebalancing (which would theoretically make Greek exports less expensive relative to German exports thereby increasing demand for Greek exports) then they rely on deflationary rebalancing via wages and internal price changes. In essence, they have to undergo a recession or depression to rebalance.
So, the kicker here is the solvency issue. Greece can’t issue Euros in a discretionary manner to impact the exchange rate and they also need to obtain Euros to remain solvent.This introduces the potential for a very real solvency issue. Greece could literally run out of Euros due to the political arrangement. Of course, Mississippi could also run out of dollars, but the difference between Mississippi and Greece is that there is a federal government in the USA which shoulders $18 trillion in debt. If Mississippi had been in the US single currency system for the last 197 years without any federal aid I have no doubt that they would have undergone countless solvency crises. Instead, they receive huge amounts of federal aid which essentially come from the wealthy states and helps keep everyone solvent. The federal redistribution system helps raise all boats by keeping state solvency concerns from causing widespread financial turmoil every few decades.
Now, the difference between Mississippi and Greece is that you have hundreds of years of historical animosity between various cultures and governments which makes integration very difficult. When I run into someone from Mississippi here in California I could really care less about their history or their politics. Politically, we might be far apart, but it’s nothing like the cultural divide that exists between Germany and Greece. And this makes everything very tricky because I don’t care that my state picks up the tab for less productive states. But Germans are extremely apprehensive about being the state which shoulders the productive and potentially the higher tax burden that could come with a full United States of Europe.
Redistribution is often thought of as a dirty word, but the reality is that redistrubtion is the only thing that will make Europe a workable currency union going forward. There is simply no choice going forward aside from a break-up of some sort which could have devastating consequences. And the interesting thing is that Germany is probably better off in the long-run given the geographical interdependence in Europe because it’s in their best interests for their neighbors to have stronger economies. This is why, to a large degree, the USA has come out of the Great Recession in much better financial shape than Europe has. Full federal integration has helped to raise all ships.
So here we are once again talking about a solvency issue where there really need not be one. The instant Greece was admitted into the EMU the inevitable endgame was full integration. Unfortunately, history and politics are continuing to cause turmoil, depression and lots of uncertainty. Here’s to hoping Europe can overcome politics and history in favor of the well-being of all involved.
¹The Red and Black Ink, The Economist, August, 2011
The US Government isn’t Going Bankrupt, Pragmatic Capitalism, July 2012
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.