x Abu Dhabi, UAE Thursday 20 July 2017

Euro under the cosh but can it survive?

European Central Bank and state financial learders now face a renewed currency crisis and fiscal discipline alone may not be enough.

European powers and the leaders of the central bank must now face the harsh winds of a renewed crisis. Hannelore Foerster / Bloomberg
European powers and the leaders of the central bank must now face the harsh winds of a renewed crisis. Hannelore Foerster / Bloomberg

The European Central Bank (ECB), guardian of the euro, describes its mandate as maintaining the purchasing power of the currency and price stability in the euro area.

In the months since the crisis in Greece, it appeared that the patchwork bailout might achieve these goals. Recent events in Ireland, however, have revealed that the crisis in the euro zone is not over and has started fresh speculation about which profligate nation will be the site of the next crisis.

Continued erosion of faith in the common currency has mixed with a palpable fear to even mention economies such as Spain and Italy that are "too big to fail".

Having hidden their heads in the sand for six months, various European powers and the leaders of the central bank must now face the harsh winds of renewed crisis.

While talk of public sector layoffs and spending cuts dominate the consensus of how to proceed, the case of Ireland seems to call this rhetoric into question. Ireland can be interpreted as a clear demonstration that fiscal discipline alone, even to the point of incredibly harsh economic austerity, cannot solve the problems.

In times of crisis, bailouts assure euro-based investors that even in the event of defaults on corporate or sovereign debt, they will not lose all of their money.

The austerity that follows demonstrates the penance of debtor countries; public spending cuts show that these nations have learnt that their deficit spending cannot continue.

The short-term improvements in projected cash flows and symbolic value, however, do not capture the full effect of these cuts. People know, at least implicitly, that reducing expenditure on public services such as education, health care and infrastructure are likely to have long-term effects on the productivity of a nation.

Despite undergoing one of the most wrenching fiscal reductions ever conducted in a modern economy, investment and business have not returned to Ireland. Austerity has failed to restore trust in Ireland or the euro zone.

At the NATO summit in Lisbon on November 21, William Hague, the British foreign minister, was asked if the crisis in Ireland might cause the collapse of the euro; his two-word reply, "who knows?" caused a diplomatic furore.

So what can be done to make it clearer that the euro will survive?

First, purely economic responses cannot restore faith in the euro. Greece earlier this year and now Ireland have highlighted what was true since the common currency came into being more than a decade ago: the participating states have fiscal policy independence but total interdependence in terms of monetary policy.

If one country issues more debt than others and requires a bailout or causes a crisis, this will erode confidence in the euro and in euro zone economies, regardless of how responsibly other countries may behave.

With such intrinsically linked economies, austerity, or any other fiscal policy in a single country, is insufficient for restoring trust and confidence following a crisis.

The faith that the independent euro zone fiscal policies would somehow work themselves out has been shattered. This is now a political crisis, not purely an economic crisis.

Given the current state of the political economy of the euro zone, what other solutions can be proposed to restore trust in the future of the common currency?

The ECB and European powers now need to demonstrate they are going to co-ordinate fiscal policy. To make this happen one myth that needs to be debunked is that tinkering with fiscal policies in individual countries will be sufficient to reintroduce trust into the market. Thus, the recent decisions to provide €85 billion (Dh413.57bn) to rescue Ireland and create a permanent fund to replace the temporary fund for bailouts are insufficient to stem the loss of trust and confidence.

In addition, the politicians need to take some decisive steps that are more proactive and less reactive.

The spectacle of euro zone finance ministers and the prime minister of Ireland denying there would be a bailout in the days before it occurred did little to restore faith in the political will of the euro zone to fix itself.

Slamming the media and denouncing speculators does not advance the agenda of creating policies that achieve actual fiscal co-ordination across the countries that share the euro.

Finally, and with most difficulty, the political and institutional leaders of the euro zone need to act, not just speak.

Governments, along with the leaders of the ECB, need to develop fiscal guidelines with real enforcement power among member states. Without a co-ordinated set of well-enforced policies for fiscal unity among member states, the euro zone countries will continue to stagger from crisis to crisis; each one will be more expensive and damaging to the trust that needs to be restored.

The sooner the relevant parties begin to make progress on this agenda, the better it will be for them. It is worth clarifying they do not necessarily have to sit down, hash out a comprehensive set of policies to which they all agree, and then announce and enforce them.

A far easier way to proceed might be to start with a few general fiscal guidelines to which they can all sign up, have member states act to demonstrate the intent to comply, and then measure the impact on the market.

Towards that end, work by researchers at two Chicago area business schools, who have put together a website offering a continuous measure of trust in financial markets,could prove quite useful. With sufficient attention to trust as the key measure whether policies are a success, the euro can be saved.

Without decisive, unified action by euro zone leaders, William Hague may be proved right in his assessment of the future of the euro: who knows?


Stephen Mezias is the Abu Dhabi Commercial Bank chair of international business and academic director of the Insead Abu Dhabi campus