Sum constrasts the Euro Zone problems with countries who pursue an independent monetary policy and suggest a possible solution to the present Euro Sovereign Crisis.
The Europe problem has been getting complex by the day. It started with Greece and inevitably everyone knew it is destined to spread to PIIGS (Portugal, Italy, Ireland, Greece and Spain) sooner than later. So here we are witnessing history in the making yet again. Europe, a union of nations formed to exploit synergies by forming a common understanding and policy framework on different subjects is falling like a pack of cards.
Complex and difficult situations demand serious path breaking efforts on the part of stakeholders to overcome the difficulty. The regulators and lawmakers in European Union are working their guts out to provide a temporary relief to the nations who found themselves underwater due to excessive spending and faulty policies. Once the bloodshed is controlled by temporary measures, efforts would then made to address the structural issues.
I have gone back and forth to the drawing board many a times trying to deconstruct the Europe Sovereign Crisis and start all over again in finding the missing link by studying the structural framework of Euro.
My recent efforts are aimed at contrasting the PIIGS with some other sovereign nations having independent currencies and monetary policies (i.e. having independent Central Banks). So I started with a comparison of Spain (Euro zone) with Britain (Independent currency and central bank). Both Spain and Spain have similar debts, deficits and inflation (in percentage terms). Spain, as a part of European Union has embraced the Euro and thus has given up its independent monetary policy in favour of a common European Central Bank. Britain, on the other hand Britain has an independent currency and has a central bank that pursues an independent monetary policy.
Let’s suppose that both Spain and Britain face a Sovereign Debt Crisis. The crisis is caused by excessive spending resulting in high fiscal deficit which is financed by foreign and domestic debt investments. As the debt repayment becomes due both the countries are overstretched with their finances and unless their debt is refinanced the creditors face a possible Sovereign Default. In the absence of any other source of refinance, the countries would only be able to refinance at steeply increased rates. Thus borrowing at high yields will increase the risk of a sovereign default by these countries in the future even higher.
If Britain is unable to roll over its debt at acceptable yield levels it will force its central bank to buy the bonds and in the process devalue its currency. Thus a liquidity crisis is averted by a devaluation of currency. In the case of Spain, refinance at acceptable rates is not possible because it does not have an independent central bank which can be forced to refinance the debt. Thus a liquidity crisis is highly likely in case of Spain if yield on refinancing of debt spikes higher.
One possible solution to this problem could be a consistent effort by the European Central Bank wherein it can give a guarantee to stand by its member countries in times of distress particularly when they face a liquidity crisis (or refinancing problems). For example if Spain needs to refinance its debt and it is unable to do so at reasonable rates, ECB should step in as a lender of last resort and buy the bonds. The value of Euro should thus be made up of weighted average of the respective members states economic parameters. Monte Carlo Simulations and Black Scholes Options Pricing Model can be reconfigured to accommodate financial parameters of member’s states. These parameters can be weighted in accordance with weights (which can be calculated using another set of economic parameters) to derive the targeted value of Euro. ECB should then balance inflation targeting with managing exchange rate expectations thorugh its monetary and fiscal policy.
At any stage the value of Euro should reflect the financial and economic strengths and weaknesses of its members. If PIIGS are refinanced by ECB, the relative devaluation of Euro in accordance with the weight PIIGS in Euro should be undertaken, so as to bring its value to a realistic level. It would not doubt be detrimental to the disciplined and hard working members who have instilled fiscal prudence and best practices in their respective states. A weaker currency would hurt the imports. A weaker currency however would be welcome across the board, especially by the exporters.
The downside to this solution is that bond purchases by central bank expand the money supply, potentially leading to inflation. A hyperinflationary economy may develop as a result of monetising budget deficits. Thus the reluctance of ECB to lend to governments is understandable. Germany is in particular still in the awe of hyperinflation in had to experience during 1920-24 due to monetizing its budget deficit. It’s opposition to such a plan is thus understandable, but as they say tough situations and circumstances demand tough solutions. So Germany pave way for a representative Euro, pay way for maintain order in the union your fondly formed.
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