A crack in a support beam of a bridge can jeopardize the entire structure, as people in the Louisville area can attest to. The same principle applies to currency regimes. The crack in the euro system threatens the Eurozone economy and the financial bridges that link global markets, including those in Indiana.
The euro was designed to pave the way for closer integration of European economies and cultures. It was a feat of economic and political engineering in its replacement of 17 currencies. Its engineers required countries to lower inflation rates and follow sound monetary policies prior to entry.
Once within the euro system, the European Central Bank set the interest rates, removing any possibility of aberrant monetary behavior. Limits on deficit and public debt-to-GDP limits also were imposed.
However, countries retained sovereignty over their fiscal policies. Therein lies the structural flaw—the temptation to use fiscal policy to counteract constraints imposed by an inflation-conscious central bank.
Greece’s failure to enact fiscal discipline, with its high-budget deficits and a public debt-to-GDP nearing 190 percent, is the crack that exposed this design flaw.
Why have markets reacted so adversely? First, with the price of Greek debt falling, banks holding this debt could become insolvent. The bigger global issue is that 65 percent of Greece’s debt is held outside Greece.
The International Monetary Fund projects 2012 debt-to-GDP ratios above 100 percent for Italy, Ireland and Portugal. As market values of debt from these countries fall, European banks with large holdings of such debt risk their capital levels falling below regulatory limits.
Recapitalization will have to occur. While some suggest this burden should be on the banks, it’s unlikely they could raise sufficient capital. The governments could recapitalize the banks, but doing so would stretch budgets. Intervention also could transfer taxpayer funds from prudent to imprudent countries and deepen the government’s hand in bank affairs.
Finally, the ECB could buy the sovereign bonds, infusing capital into the banking system and keeping a floor on sovereign debt prices; however, there is concern this would amount to monetizing the fiscal debt.
U.S. financial markets, along with investors and companies in Indiana, have felt the weight of this uncertainty. Inaction to recapitalize the banks in Europe risks the collapse of major European banks and a downward spiraling effect throughout world financial markets.
Economic growth in Europe could turn negative. Given a recent report by the Indiana University Kelley School of Business’ Indiana Business Research Center showing the European Union buys more than 25 percent of Indiana’s exports, a significant downturn in the European economy would mean lower sales for Indiana companies. A depreciation of the euro against the dollar also becomes likely, making Indiana products relatively more expensive and reducing export revenue.
The scenario for Indiana companies and investors may be somewhat brighter in the short term if action is taken to deal with solvency problems. However, these actions carry long-term risks.
The recapitalization of banks by governments would amount to nationalizing many banks in Europe, which would have implications for capital allocation and ultimately economic growth. An infusion of capital from the ECB raises the risk of European inflation, and will put downward pressure on the euro’s value.
Furthermore, such intervention without restrictions only reinforces the “too big to fail” problem. Finally, none of these actions will fix the fundamental flaw of the euro system, which is the lack of fiscal policy coordination and means by which to hold countries accountable for their actions.
Patching a bridge will not solve the structural problem—and in Europe, a new load beam is needed.•
Bonser-Neal is an associate professor of finance at the Indiana University Kelley School of Business at Indianapolis.