The Euro Crisis: Why Greece is broke but Germany won’t do anything about it

Source: Dirk Vorderstraße

Anyone reading the news lately would’ve surely caught on that something is amiss in Europe: The so called ‘PIGS’ (Portugal, Ireland, Greece and Spain), and especially the Greeks have been on the edge of default for months, causing  rumours that the Euro may be headed to the scrap heap.  If any of you still remember, the Euro was introduced with great fanfare nearly ten years ago which was supposed to promote closer ties both politically and economically for the EU members in the Euro-zone (The sub-group in the EU that uses the Euro as their currency).  So why then, has the Euro’s health deteriorated to such a sickly state?

To grasp the full scope of the underlying problem we should examine what the Euro actually is. Having a single currency across independent sovereign states means that in effect, it is a fixed exchange rate policy enacted by its participants. A caveat is that Euro-zone nations surrender their ability print money meaning that countries surrender the ability to adjust monetary policy independently, which is instead set at a EU wide level by the European Central Bank (ECB). This distinction is key to understanding why the Euro is slowly breaking up the EU.

On the surface the benefits of having a unified currency is straightforward:  cross border exchange of goods and services is allowed to grow freely, improving the integration of the member state’s economy with each other. This vastly reduces costs of doing business in Europe, doing away with the need to change currencies between countries. With reduced exchange rate risk and transaction costs, in the good times businesses get, well, more business, and more investment activity happens in the Eurozone,.

The problem with fixed currency is that the Euro is undervalued in some countries and overvalued in others. Germany is an example where because it does a disproportionate share of production in the Euro-zone, the Euro is undervalued in Germany and German firms are able to take advantage of this since they can easily sell their goods, thanks to the fixed currency. On the flip side Greece can import cheaply, so when the economy is booming no one complains, and this trading arrangement leads to what is perceived as high levels of economic activity in the EU.

In reality though, what’s happening is that the countries who rely on the Euro to import cheaply is running up a huge trade deficit. The countries that use the Euro can borrow money cheaply compared to be before by piggybacking onto the low rates paid by Germany and France. After all, if one Euro in Germany is the same as one Euro in Greece, that implies that it is not possible for one country to default without the other failing too as long as they use the Euro.

But this is precisely what is happening at the moment: the governments of Greece, Spain, Ireland and Portugal over-expanded debt to fund spending and imports (from countries like Germany) during the boom years. But now that the economy is headed for a bust, people have realised that the Greeks may not, in fact mostly likely will not, be able to repay what they borrowed during the boom years. Part of the problem is that they can’t just print more money to first, meet their obligations and second, devalue the currency, which would have helped them increase exports and possibly boost their sclerotic economy.

Further exacerbating the problem is the fact that each EU member state is an independent political entity. The heads of state are voted in by their respective citizens and thus have no incentive to put the good of the whole union before the state. Again in the current situation, it means that countries like Germany will keep doing what they doing best: making and selling stuff to other countries taking advantage of their devalued currency in order to keep their economy from sliding into recession, even if it’s making the problem worse for the countries with huge deficits.

Now troubled Euro-zone members find they are tackling a problem with one arm tied behind their back because they can’t manipulate monetary policy to pull out of a recession. This is why Greece has resorted to raising taxes and imposing strict austerity measures in an economic downturn, which has been very unpopular. A default in Greece is not being allowed because it would result in Greece’s exit from the Euro-zone, an admission of failure of the Euro, the very thought deemed blasphemous to the ones who championed its cause, no prizes for guessing which countries in particular.

It seems that the leaders of a decade ago did not foresee the scale of the very real disaster that the Euro now faces very, very shortly. The question now is not whether the Euro was a good idea, but whether it will survive. If it is to survive,  how can we avoid a tragedy of this scale in the future?