If the global economy could be described as a three ring circus, then the center ring attraction would definitely be the currency and debt exchanges between the United States and China. But for the past month the world’s attention has been distracted by an entertaining sideshow in which Greece and the European Union are jostling over a potential bailout for Greek debt and whether the European Union, and the euro itself, will exist for much longer. I believe the short-term problems in Europe are being overblown and the potential demise of the euro highly exaggerated. For those who can connect the dots however, the drama throws some much needed light on the far more daunting problems unfolding within our own fiscal house.
The scenario that is eliciting the greatest fears is that resentment from the more solvent EU members will prevent a bailout for Greece. If the Greek government then fails to adopt austerity measures that will bring it back in line with EU debt requirements, then an expulsion, or withdrawal, from the Union becomes a possibility. This could set off a domino effect that will bring down larger European political or monetary union. On the other hand, if Greece does receive a bailout, a moral hazard will be created that will encourage other indebted countries (Portugal, Spain, etc.) to press for equal benefits. Both scenarios would destroy confidence in the euro, remove the biggest rival of the U.S. dollar, and give a shot in the arm to the dollar’s global status.
However, there is a third more likely alternative that few are considering. My gut is that Greek politicians will find the prospect of being forced out of the union and re-creating their own currency, formerly called the drachma, even more unpalatable then swallowing the bitter pill of fiscal austerity. Even if defying the EU might seem like good politics now for Greek leaders, the risks associated with economic independence could be so daunting that politicians will refuse to roll the dice. Their better political choice would be to talk tough against draconian spending cuts but vote for them anyway. By playing the role of callous bullies, politicians in Berlin, Paris, and Brussels can provide Greek politicians with the political cover necessary for them to make the unpopular decisions. That way Greek politicians could have their cake and eat it too.
The best case for Europe would be a solution that is all stick and no carrot. This would mean that Greece would have to get its fiscal house in order with no help from the EU. However, even a solution that involved some help from Brussels, but still forced real reforms in Athens, would be seen as a positive for the euro.
Rather than being the beginning of the end for the euro, the Greek drama may well become the euro’s first major victory. If the EU forces Greek politicians to act more responsibly, the Union will show that it cares about the value of its currency and that it has the political will to keep its members in line.
On the other hand, the negative consequences for the EU, and the euro, of an outright Greek bailout would be devastating. Central to the euro’s viability is the limit it places on the ability of member nations to run deficits. The moral hazard associated with a Greek bailout would create a situation that would actually encourage all EU nations to run larger deficits because the costs of doing so would be borne by the more responsible members.
While I still have my doubts about the long-term viability of the euro, I feel that there will be many short-term successes before the experiment ultimately fails. In the meantime, if the euro can survive its current trial, its health could be bad news for the dollar. A battle tested euro, backed by a disciplined union, will have greater credibility as the currency capable of dethroning the dollar. This will eventually refocus attention back on the United States and will highlight the significant distinctions between the two economic powers.
First, while the European Union may have several member nations with fiscal problems, the same situation exists in the U.S. where many of our most populous States are currently navigating similarly dire financial straits. Like Greece, California cannot print money. So if leaders in Sacramento can’t find the will to raise taxes or cut spending, absent federal bailouts, default will be their only option.
However, my guess is that the political pressure in the U.S. to bailout State governments, or to avoid the huge cuts in State spending that would be required to avoid default, will be too great to resist. While Germans are vehemently opposed to bailing out Greeks, I do not foresee the same level of opposition on the part of New Yorkers to bailing out Californians, especially since New York will likely need its own bailout in the not too distant future.
This is especially true since most voters will not be asked to pay higher federal taxes to finance State bailouts. We will simply “pay” for State bailouts the same way we “pay” for all the others, we will borrow from abroad or print money.
As a result, none of the States will be forced to make the necessary spending cuts, and many will actually increase spending even faster, even as their tax bases continue to shrink. Those States that may have otherwise acted responsibility will likewise be incentivized to run large deficits themselves to get their fair slice of the bailout pie.
Of course, on a Federal level, there will be no one to force Uncle Sam’s hand, because unlike Greece, our government can print money. Since printing money is far more politically popular than cutting spending, raising taxes on the middle class, or honest default, it is the most likely option our leaders will choose.
If these two scenarios unfold, the EU holding the line on Greece and Washington caving to California, creditor nations will be presented with a clear message as to where to hold their currency reserves. The stampede out of the dollar will begin, and the greenback’s tenure as the world’s reserve currency will enter its final act. Such an outcome would also throw light on the solvency of the United States itself, which has its own debt issues which in many ways are far more daunting than those faced by the European Union. The real tragedy will play out not in Greece, but in America.
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