It is difficult to overestimate the political and economic significance of the very real prospect of the Euro's eventual unraveling. For not only would the Euro's unraveling mark a major reversal in Europe's post-war movement towards greater economic and political integration. It would also have enormous global economic and political consequences.
Since the end of the second world-war, Europe has been engaged in the boldest of experiments aimed at forging closer economic and political co-operation among its member states. This experiment is widely perceived to have under-pinned Europe's remarkable economic prosperity over the past sixty years and to have kept Europe at peace among its member countries.
From the formation of a modest Coal and Steel Community among six member states in 1956, the European Union has blossomed into the world's largest trading bloc comprised of 27 member states. In 1999, the process of closer European economic integration took a quantum leap forward with the launching of the Euro as a single currency for 16 members of the Union.
At the time of the Euro's launch, Milton Friedman famously warned that the Euro would not survive Europe's first major economic recession. He based his grave misgivings largely on the fact that Europe lacked the wage flexibility and the labor market mobility that are the necessary conditions for a successfully functioning monetary union. Since in such a union, currency devaluation can no longer be used to restore competitiveness or to boost export growth.
Aware of the intrinsic structural weaknesses to which Friedman alluded, European leaders realized that strict budget and public debt limits were fundamental to the successful functioning of the Euro. They also recognized the dangers of different rates of inflation among member countries. To that end, the Euro-zone's members agreed upon an Economic Growth and Stability Pact that was intended to require member countries to keep their budget deficits below 3 percent of GDP and to limit their public debt to no more than 60 percent of GDP.
The fundamental cause of the Euro-zone's present sovereign debt crisis is that countries like Greece, Portugal, Spain, and Ireland have all been flagrantly in breach of the Economic and Stability Pact's limits. Budget deficits for these countries are all in excess of 10 percent of GDP, which is placing these countries' public debt levels on a path to soon well exceed 100 percent of GDP. In addition, these countries have generally lost in excess of 20 percent in international competitiveness.
The essence of the Club-Med countries' present predicament is that, stuck within the Euro-zone, they cannot resort to currency devaluation to restore international competitiveness. Nor can they devalue their currency to boost exports as a cushion to offset the highly negative impact on their economy from the major fiscal retrenchment that the IMF and the EU are requiring as a condition for financial support.
In the particular case of Greece, one must expect that the savage budget cuts now being prescribed by the IMF to reduce Greece's budget deficit from its present level of 14 percent of GDP to 3 percent of GDP by 2012 will lead to the sort of economic collapse now being experienced by Latvia and Ireland. Those two countries, which are one or two years ahead of Greece in trying similar hair shirt fiscal austerity programs without the benefit of a currency devaluation, have seen their economies contract by between 10 and 20 percent.
Yet a collapse of the Greek economy will make it difficult for Greece to meet its budget targets and will cause Greece's debt to GDP ratio to rise toward 175 per cent. It is little wonder then that markets consider that Greece has a solvency problem that is not being addressed by the massive IMF-EU financial support.
The deep economic problems in Greece, Spain, Portugal, and Ireland constitute the most serious of risks to the European banking system. And judging by Moody's recent downgrading of Greek debt to junk status and by the acute difficulties now being experienced by the Spanish banks in the interbank market, it would seem that European sovereign risk is now intensifying.
The European banks have already been enfeebled by the 2008-2009 global economic crisis and they now could sustain major losses on their very large sovereign debt holdings. An eventual write down of these countries' cumulative US$2 trillion in sovereign debt by 30 cents on the dollar would constitute as large a shock to the European banking system as that which it experienced in 2008. This would almost certainly tip the overall European economy, and not simply the Club Med countries, back into recession.
Any further deepening in the Euro-zone crisis would also heighten the risks of a double dip US economic recession in 2011. It would do so through a further depreciation of the Euro and through a marked increase in global risk aversion that would raise borrowing costs for US households and corporations. And it would do so at precisely the time when the support to US GDP growth from the fiscal stimulus is fading.
With the clearest of signs that a European tsunami is about to hit the global economy, it is difficult to understand the most recent G-20 call for a move away from fiscal stimulus to generalized budget consolidation. But then again it was these same policymakers who grossly underestimated the fallout from the bursting of the US housing market bubble on the global economy.
Desmond Lachman is a resident fellow at AEI.