The Euro, of which much was expected and which once was touted as an alternate global currency to the beleagured US Dollar, is in serious trouble. How did it go wrong so terribly for the Eurozone economy?
When the Europen Union was formed in the 1990's, followed by monetary union, there was much inequality in the region. The Berlin wall had come down only 1989 and the integration with the erstwhile east european economy with that of the more developed west europe had not gathered sufficient momentum. While the first was essentially an agrarian economy with lower living standards and wages, the latter was starting to decline as an Industrial economy, and moving towards services economy. Formation of Euro led to Capital flow into the under developed East European countries since the manufacturers wanted to avail the cost advantage of low wages prevalent in the area. The idea was to industrialize the East Europe with the more affluent Western part consuming it, and the money remains within the economy. Smaller countries like Greece joined Euro in 2002 and suddenly found that they can raise sovereign debt at low interest rates, not due to the strength of their economy, but on the artificial strength of the other members of the Union, as the debt givers valued the risk against euro. Then Greece went on a spending spree, including the 2004 Athens Olympics, that is a financial disaster in the short term. The EU countries, especially the weaker ones, had easy money, higher leverage, poor regulation and still worse accounting. They borrowed much more than their capability with hardly any supervision from the EU parliament on controlling countrys deficit. The ideal recipe for disaster.
And no one factored in the competition from China. They were bigger, had a tremendous cost advantage and as a nation adopted Low Cost Strategy to grow, with remarkable success. The European manufacturing became unsustainable. The customer preference also changed - from higher quality, higher priced, longer PLC products for which Europe was famous for to lower quality, lower price, shorter PLC products, the latter being the hallmark of Chinese goods. Thus over a period of time Europe lost its industrialization momentum, agriculture had to be subsidised heavily and they ignored the services sector, other than the financial services. Purchase of Chinese goods meant there was as monetary outflow. This led to lower GDP growth as the profits could not be reinvested and the existing investments did not produce sufficient returns.
Meanwhile the various Countries that joined the monetary union, threw fiscal prudence to the winds and started spending indiscriminately, running up huge fiscal deficits. In the pre-monetary union days, they were able to either print notes or devalue their currency to meet the deficit. The fallacy of having a single currency, without a single economic policy and a single budgetary control has been exposed. The smaller countries like Greece, Spain, Portugal and even Italy were living on debt, with more debt raised to pay off the existing debt - a situation similar to India in late 1980s. This was more like the ponzi scheme - the countries thought they are immune to the financial market rules since the debt was sovereign in nature and hence the debt provider not likely to be worried. Once this bubble burst, triggered by the Global Financial Crisis, there was no place to hide.
For now, the richer countries of the Union has bailed them out. But that was not out of love for the PIGS (Portugal, Italy, Greece and Spain), but more out of self interest. They cannot afford Euro to suffer a crisis of confidence. The region will have to pay a heavy price during the next 4-5 years, with slower GDP growth, lower investments and higher unemployment on the anvil.There are also strong rumours that a few big hedge funds have ganged up to create this crisis, which could be true.
The current financial crisis has more to do with investor confidence. The Government Treasury bonds were considered to be the most trust worthy and risk free investment - a reason why governments used to pay pittance as interest to the bond holders. This was followed by savings in the Banks as debt instruments like Fixed deposits. The last two years have destroyed the investors faith in Banks, and now the Euro crisis has reinforced the apprehension of many sceptics that Sovereign Debt too cannot be trusted any more.
Is there any wonder, Gold prices are soaring high?
