The Eurozone in Perspective

collapse. The €750 billion European bailout fund announced in early May will remain available to any nation needing assistance until mid-2013. As of today, the facility has hardly been utilized. Furthermore, European leaders have drawn heavily on political capital to support the unpopular Greek and Irish bailouts. The inability to save the currency after all this effort would be a huge political blow felt across the Continent—and you can bet politicians won't stand idly by should the situation worsen.  

In the long term, the likelihood of a changing country composition or even outright end to the euro rises. If the eurozone wishes to maintain its current form, it will require a concerted effort towards federalism. This may prove too costly for some members, and the euro could conceivably dissolve. For member states with centuries of national identity, subjugating sovereignty to save the single currency is a tough pill to swallow. But importantly, dissolution of the euro is a very different concept from a true euro collapse. Ending the euro does not have to be traumatic to the global economy if conducted in an orderly manner over time, giving market participants time to adjust. If Europe decides to end the euro experiment, an organized wind-down is quite possible. In much the same way as euro integration occurred, a well-executed, multi-year plan would allow markets to properly digest scenarios and adjust prices accordingly. Conversely, a sudden collapse could indeed have significant ramifications for markets and the global economy. 

But to Europe's credit, leaders appear committed to making the necessary changes for long-term euro viability. Though contradictory to free market tenets, plans are already underway to create a permanent bailout mechanism to assist struggling members teetering on default, which is critical for confidence in the currency. The same mechanism, however, will require bondholders of those strained nations to take haircuts, which reintroduces the idea of country risk to eurozone sovereign yields in a way that was not present during the euro's first decade (but in our view is the way it ought to be). Some countries will face higher costs in deficit funding, but debt will be more appropriately priced to prevent living beyond means. For example, Greek government bond yields during much of the 2000s were equivalent to German yields, a stunning notion in retrospect given their differing risk profiles, and a big reason Greece overspent. 

Stricter budget oversight is also expected, but the stringency of such measures has yet to be decided. The initial limits for deficits and debt were 3% and 60% of GDP respectively, but were nearly universally broken. Clearly needing more teeth, Germany is pushing for caps on government spending within national budgets to prevent excessive deficits before they start. Penalties for noncompliance may entail fines or even suspension of voting rights on EU matters. From a wage standpoint, internal devaluations by way of public sector pay cuts will help the struggling peripheral economies become competitive on the global stage. Most difficult to address will be how to narrow growth rate differentials. Core Europe is clearly outpacing the weaker periphery and monetary policy is difficult to apply to both regions. For now, the European Central Bank is prudent to be accommodative, but if the stronger nations face inflation while the weaker parts of Europe still struggle for growth, the eurozone will find itself in a difficult quandary that has yet to be properly addressed. 

Imbalances within the eurozone haven't disappeared and long-term challenges to the euro are numerous, but the single currency can remain viable if member countries are willing to move towards stronger federalism. Recent steps are a good start, but it may require rigid budgetary controls. A serious federalist effort would be bolstered by a new European watchdog monitoring national spending plans. Perhaps increased taxation on a federal level (in lieu of national taxation, not in addition) would help create a unified entity cultivating greater investor comfort. But changes of this kind take time. The concept of the European Union was created after World War II in an attempt to foster unity and prevent further warfare. While more work is to be done, the idea of "one Europe" has a come a very long way since then, and the euro is another step along that course. But the currency is certainly at a crossroads, and the old Continent must either tie itself together more tightly or end the euro altogether.