2011 was a landmark year. Villains were captured and killed, dictators were overthrown, and the initial step was taken in releasing an HIV vaccine. But the financial story of the year was, and continues to be, Europe’s financial crisis. It is viewed more as an inconvenience than a global cultural change. However, the world may be watching the failure of an extremely bold globalization experiment called the Euro.
The world has entered an age of austerity. Governments fund their spending through two ways – taxation or debt. In 2011, the bond markets notified governments that they had reached their credit limits. Of the seventeen nations that use and support the Euro currency, several have reached their credit limits. To put this into perspective, you have a better credit rating with your local bank than nations like Portugal, Italy, Ireland, Greece and Spain (endearingly referred to as: PIIGS). Your credit line or mortgage has a lower interest rate than the governments of these countries.
The Euro experiment is a little over a decade old. The currency unit is now facing the most difficult test it will ever endure, as bond markets around the world are extremely shaky. Bond markets hold up the value of currencies and provide market accountability over government actions. Make no mistake; we are one defaulting nation away from repeating the panic of 2008.
But despite serious credit issues with PIIGS nations, the Euro’s value is being held steady due to the strength of the German and French economies. The union represents stability in the value of the currency unit. Amidst all the turmoil in the bond markets, the Euro continues to hold its worth (battling inflation). This was one of the major reasons for the creation of the Euro in the first place.
Symbolically, the Euro represented an effort to maximize efficiency in trade among nations that were already heavily engaged in trading with each other. Economic theory says that a single united currency protects individual nations from inflation. Price differences between European nations diminish so everyone pays the same amount for goods and services. Exchange rate risk is completely eliminated, which removes the transaction costs associated with constantly converting currency. Overall, the Euro facilitates commerce and investment across the Euro zone.
The other part of this currency union was that each participating nation had to comply with rules over its own fiscal affairs. Each country was limited to an annual deficit of no more than 3% of its GDP and total debt of no more than 60% of GDP. If these covenants were violated, the currency union was supposed to kick that nation out.
That didn’t happen. Despite all the benefits, the experiment doesn’t really work if several governments are fiscally irresponsible. As the world is learning now, politicians have a serious problem when it comes to raising taxes or cutting spending because they lose all popularity. That makes debt the most attractive option because it has the least political consequences – voters tend to be indifferent toward increased national debt, whereas they are extremely sensitive when it comes to tax hikes or spending cuts. Of course, borrowing through debt has consequences too. The bond markets have made it increasingly difficult and expensive for PIIGS to obtain more debt because they have overextended themselves.
But can currency be greater than country? For example, had Greece not been part of the Euro but instead continued to used Drachmas, its currency would have been severely devalued by this point. That would mean you, as a Canadian, could purchase Drachmas on the cheap. Automatically you could travel to Greece, spend months there and your Canadian Dollars would last longer because of this currency devaluation. Greece would win as well. It is currently mired in recession. You staying at hotels, purchasing goods and services would employ people there.
Slowly, as people around the world took advantage of cheap Drachmas, the demand for its currency would increase, the value of Drachmas would rise, employment would be restored in Greece, and slowly Greece would get out of its recession. Unfortunately, because of the price stability provided by the Euro – this cannot happen. Greece suffers, not only because of it was fiscally irresponsible, but because its currency is greater than its country.
This has brought upon a significant question about globalization. For a long time the conventional theory has been to unify global efforts and facilitate free exchange of information, goods and services. Forget the Euro, people were suggesting a single global currency. Now, the largest unification experiment in history has been met with a very simple and serious problem – we can’t rely on politicians of sovereign nations to follow the rules of globalization.
Some experts argue that the European Union simply needs to be stricter over applying the rules. Don’t allow PIIGS to violate their covenants. But the reality is no sovereign nation is prepared to give up control over its fiscal policy simply to facilitate globalization. Who would want to lead a country that has been handcuffed in how it can tax and spend? How can a democratic society hold its leader accountable when the rest of the world has control over what the nation can or can’t do?
The European crisis has provided a valuable lesson. Voters keep governments accountable for their taxation and spending while bond markets provide a final check that a government’s policies are sustainable. Each nation’s independent currency is how the world keeps that nation accountable for its system of money and economy. We should never compromise accountability for the sake of efficiency. Unless a system of accountability supplants democracy, we should expect the Euro’s slow and painful demise as a natural end to the experiment.
Umar Saeed is an accomplished professional in finance and accounting. On his website (www.umarsaeed.ca), where this post originally appeared, he writes essays to explain the elaborate connections between people and money, without making your head hurt. You can follow him on Twitter @UmarSaeedCA. Or you can read the rest of his posts at The Little Red Umbrella here.