When the Euro was set up some commentators warned that the economies needed to be brought into line with each other before binding them in with a single currency. The creators of the currency appreciated that they needed internal discipline. If countries came in with too large a stock of debt they could free ride on the backs of the more prudent countries. They could refinance their debts at lower average interest rates which reflected the credit worthiness of the zone as a whole. They decided to let this happen up to a generous upper limit.
They also understood that if a country started to run a high annual deficit for any period they too would be free riding on the better financial disciplines of the area as a whole. Their conduct would tend to raise the average interest rate for all a little, but reduce their rate by rather more. If a group of countries persisted in borrowing too much, the effects would be more marked.
In order to combat this problem the founders put in place rules which said that any individual country was not to borrow more than 3% of its National Income in any given year. They also left the markets believing that each individual country was still responsible for its own credit worthiness within the system. There was no automatic guarantee to lend money to a country in trouble at the average Euro government rate, nor was there any promise that if a country could no longer pay the interest or the repayments on its debt the other states would definitely foot the bill. Instead there was studied ambiguity, giving the zone the power to intervene, to lend or grant money to countries in trouble if the others thought that a good idea.
We are now into the second serious crisis of the Euro. The first was their share of the world banking crisis, which on the whole they handled better than the US and UK. The second revolves around the deteriorating credit rating of several Euro members on the periphery of the Euro area. The Euro zone so far has shown a firm touch with Ireland, which obligingly and correctly cut its spending sharply to reassure markets, and weakly with Greece, which so far has failed to do enough to reassure markets. The Euro zone masters have failed to insist that Greece does cut its deficit, whilst also failing so far to come up with subsidies and loans to let them off the hook for the time being.
Most of the countries in the Eurozone have large public sectors. Many have stretched the national credit during the downturn. Markets are already worrying about Portugal and Spain before the Greek issues are settled. The Eurozone is going to discover that they can only make a continuing success of their currency if they are strict about the discipline. If they had enforced the 3% budget deficit limit – maybe with a cyclical adjustment for the world slump – they would not be in this awkward position now. If they told Greece more firmly that there is no money for them and they have to repair their own credit rating on world markets to carry on borrowing, that would help sure up the currency and would send a strong message to other overspending Euro states that they had better take earlier action with their budgets before the markets upset them.
The Euro authorities may of course want to see the Euro fall a bit more. Germany is finding it difficult to export against the current world trade headwinds and in the face of Chinese competition. They are going about engineering a devaluation in the right way by appearing to dither over whether to support ill discipline in their ranks or not. We do not expect the zone to so misjudge it that the zone itself falls apart, but the pressures are building up in markets.
Meanwhile all real asset prices are under some pressure, as world liquidity is being squeezed by the sharp corrective action in China and the cessation of new quantitative easing in the US and UK. We remain concerned about prospects in highly borrowed countries, avoiding sovereign debt in them and preferring claims on real assets in parts of the world that can still grow at good rates despite the general sluggishness of the recovery.