Beyond Greece: The Euro's Fundamental Flaw

Rodney Johnson |

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I have a sister who is two years older than me. We fought from time to time growing up. I distinctly remember this one time when I was 11 and our dad forced us to make up by putting our arms around each other’s shoulders. I don’t remember what the fight was about, but I do remember that the outcome wasn’t pleasant!

This is sort of what’s going on in Europe as the crisis with Greece comes to a head.

The European Union consists of 28 countries. It allows for the free transfer of goods, people, and capital across national borders. The euro zone takes it a bit further, with 19 countries sharing a single currency, allowing for even easier trading.

But the point of creating these organizations wasn’t just to facilitate trade. The member states wanted something more: an end to the hostilities on the continent that had ripped their nations apart for centuries.

Whether it was England, France, Germany, Prussia, Italy, or some other actor, Europe has a long history of being at war.

As technology advanced, the wars became more devastating. This culminated in the mass destruction of World War I, followed by World War II. By forging closer economic ties among the nations, the architects of the EU hoped to derail any growing animosity that might arise between or among nations.

So far, this has worked pretty well, but not everything has gone according to plan. Greece is Exhibit A of things gone wrong.

To join the euro zone, nations must commit to fiscal responsibility and promise never to leave. In exchange, these members let a single institution, the European Central Bank (ECB), oversee their central banking functions.

Essentially, member nations hand over the sovereignty of their currency to a board of administrators over which they have no control, and still have to balance their budgets, keep tax revenue flowing, and manage their expenses. Therein lies the problem: euro zone members kept their fiscal responsibilities, but gave up their monetary powers. In doing so, they surrendered two of the main monetary tools used in tough economic times – interest rates and control over the money supply.

When an economy slows down, government can try to prod it higher with lower interest rates. That, in theory, results in more borrowing and spending. The second option is to print money to drive down the value of its currency, which lowers the cost of exports.

Without control over monetary policy, both of these options are off the table. That leaves a much less attractive one – reducing the costs of the country through deflation by lowering prices and lowering wages.

This approach goes by another name: austerity.

An Austere Greek Tragedy

Greece is in the throes of this today, and it’s not pretty. The country grew in the 2000s based on poor risk control (lending too much) and a building boom fueled by speculators. After the financial bubble burst, many borrowers defaulted, leaving Greek banks with bad debt. Economic activity dropped dramatically. Today, Greek GDP is 25% lower than it was before the financial crisis.

Without the ability to change its monetary policy, Greece was left with the unenviable task of deflating its economy to a sustainable level. This meant lowering prices, cutting wages and benefits, and a host of other unpleasant things.

Leaders of the euro zone recognize the issue, and have offered a long-term solution – give the ECB control over fiscal as well as monetary policy.

Member nations would submit their annual budgets for approval. The ECB would then monitor them for success or failure. At some threshold, euro zone leaders would dictate fiscal policy to national governments. Such decisions would include things like pension payments and employment law.

Keep in mind that these nations were at war with each other less than 100 years ago, and most of them don’t speak the same language or have the same backgrounds. How is that supposed to work?

Every nation I’ve ever visited or read about has pride in the period when their country was on top.

The Canadians talk about repelling the Americans during the War of 1812.

The Italians reminisce about the Roman Empire.

The Greeks discuss the cradle of democracy.

And the Brits are quick to remind us that they ruled the world from a tiny island.

When things get tough, it’s hard to see how any nation will choose to give up more of who they are to a governing body in a distant country.

The euro zone appears to be an experiment that went too far. Sharing a currency is a great idea if everything goes well…but that never happens.

Economic Disaster Might Actually be a Small Price to Pay

The current situation with Greece is far from the only problem that will arise. When the Greek euro tragedy finally comes to an end, another tale of woe in the euro zone will rise to the top and take its place. I think the euro will always be hobbled by such issues.

But there is a caveat to the problems with the common currency: Europe has not had a military conflict since its inception. That’s an awfully big bright spot at an otherwise bleak time.

From that point of view, choosing to fight over who prints money or who sets interest rates is better than waving goodbye as your sons and daughters head off to war.

As for investors, we’ve been pointing out the problems in Europe for years. The showdown with Greece is on full display at the moment, but the outcome isn’t clear. While we still think a deal will emerge to keep Greece in the euro, there could be a lot of financial pain on the path to recovery. Stay long the US dollar, and avoid European equities.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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