This ADVENTURE CAPITALIST column by U. Mahesh Prabhu was first published by Business Goa.
While the international media is busy covering the apparent migrant crisis in Europe; there’s even worse crisis that’s brewing quietly with no credible solution at hand.
European history has been replete with feuds, rebellions and intra-national rivalry for centuries. Doing business across borders was difficult and each time there was a huge cost incurred on “exchange fees” alone. This of course was a great impediment to the continent’s economic growth. Post World War II the businesses and governments felt the desire for a unified Europe.
Eventually, in 1993, 27 European nations signed the Maastricht Treaty and created the European Union (EU). This made business across borders easier but there was one more major constraint – different currencies. The Euro was thus eventually launched in January 1, 1999 as the currency for the entire region.
Countries adopting Euro – called Euro Area – discontinued their own currencies, some of which had existed for centuries. They even discontinued their Monitory Policies (MP) giving more powers to ECB (European Central Bank). Yet they had many Fiscal Policies; a key reason for current debt crisis.
MP controls money supply in the economy. It also determines interest rates for borrowing money. Fiscal Policy (FP) controls how much money government collects in taxes and how much it spends. The government can spend only as much as it can collect taxes. Anything above that amount has to be borrowed – this is called Deficit Spending.
Before the Euro in countries like Greece, people had to pay higher interest rates to borrow and they could borrow only certain amounts. But when they became part of EU the money they could borrow sky rocketed. Interest rates dropped from 18% to paltry 3%. There was a general and highly misplaced belief that if countries like Greece defaulted, the money could be recollected from Germany, which remained economically prosperous. This was because they were bound by common currency.
Greece like countries incurred huge debts and for some time even promptly re-payed this money with more borrowed money. As far as borrowing continued so did the spending. Such countries also continued expensive welfare and social service payments to their citizens, but now paid for with borrowed money.
Credit flowed debt accumulated and economies in Europe became tightly intertwined, with borrowed money being confused with actual assets or real profit. Companies began opening new factories across Europe. German banks provided the lending for French companies. French banks provided the lending the Spanish companies and so on and so forth. Debt was transferred as if it were an asset from one country to another.
This made doing business incredibly efficient and easy. Things continued the way as long as credit was available. Credit was available until 2008, when it became clear such credit had no real financial assets to support or sustain it.
As the biggest and strongest Economy in Europe, Germany reluctantly decided to bailout the debt ridden EU countries. But Germany agreed to repay the bills only if other countries would agree to strict “Austerity Measures”. This was to make sure that the problem won’t ever happen again.
Austerity measures meant coming more under control of EU and German banks and never making any more debt driven spending. Austerity measures meant cutting government spending, particularly on social benefits. Since by far government is the largest spender in any economy when government stops spending it can hurt many of its citizen’s income. People lose jobs, they get angry and they riot in the streets. Since government collects taxes based on people’s earnings, when earnings are reduced the government collects less in taxes. So they can only less repay their debts.
Yet there does not seem to be an easy alternative to austerity as continued spending based upon borrowing from other countries does not lead to a healthy economy either. In short, the financial quagmire created does not seem to have an easy or even perhaps a real solution, unless there is some radical change in how business is done.
There are a lot of cultural differences between Germany and other debt ridden EU nations. Germans are financially responsible. After terrible hyperinflation Germans experienced during World War I, the nation has been very inflation averse and careful about spending and borrowing. In simple terms: Germans work hard and expect little in retirement benefits and they meticulously pay their taxes.
Many Greeks, on the other hand, like other Europeans who live in countries with strong welfare states, expect generous state benefits and don’t pay taxes. Greece has never collected majority of its taxes it has imposed on its citizens. The Germany disagrees with Greece on this attitude. Germany’s argument is “If you want our money you’d need to follow our morals.”
As debt ridden countries are headed towards default, the whole continent of Europe is in danger as all these economies are intertwined. Even though economies of these debt driven countries are relatively small it is posing a great challenge since European financial system is so interconnected – precisely because of the Euro.
The problem is: even if debtor nations adopt austerity measures, and bailout from Germany and other nations pay their debts and avert the crisis there’s no system in place to prevent this from happening again.
Ultimately the Euro Area will require a fiscal union to match its monetary union or neither. This means there needs to be in place a political authority to impose fiscal policy across Euro area. It must have the power to cut spending, raise taxes and even set laws. A fiscal union may also prevent excessive borrowing and spending.
However, this is an enormously complicated as well as unpopular notion. This means surrendering sovereignty to higher powers. In essence United States of Europe. Who or what country would be the prime power in such a situation. Likely Germany; owing to its financial strength, but few European countries would like to come under German fiscal domination particularly given the two world wars of the last century. Yet even without such a union, Germany remains the dominant country in Europe.
What is needed to be seen is as to whether Europe can take necessary steps to create a fiscal union alongside the monetary union or will the monetary union breakup thereby making Euro disappear.