06/01/2020 No. 156
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Two Factors Determine that the Euro Is Bound to Collapse
By Pierre A. Hanson (Heyuan Han) Translator Sheng-Wei Wang
May 1, 2012

G20 finance ministers gathered in Mexico City in late February to discuss the world economic affairs and the debt crisis in Europe was the first hot topic. In fact, this became clear as early as late January 2012 during the 2012 annual meeting of the Davos World Economic Forum held in Davos - Klosters. At that time although there were more than 200 issues proposed by the Forum, Chen Xingdong, chief China economist and the Board Director and Managing Director at BNP Paribus, expressed his emotion on t.qq.com: "The economic theme of this year's Winter Davos Forum can only be the debt crisis in Europe.” The trend of the debt crisis in Europe and the positions of the relevant leaders and financial people stood as the focus of this annual meeting.


What will be the future of the euro? The participants in these two meetings clearly held a cautiously optimistic attitude. What they were optimistic about was the long-term future of the euro, and what they were cautious about was the current European response. As a result, the meeting of the G20 finance ministers delivered the message that the euro area must first “help itself.” The implication was that euro could be saved, but the premise was that Europe must first help itself.


But my view is just the opposite; in the long term, the euro is bound to collapse, but in the near term, I actually have a cautious optimism. So, what factors have doomed the euro to collapse? I think the following two elements are crucial.


National Financial Requirements Are Not Compatible with the Unified Monetary Policy


The debt of Europe and the debt of the United States have very different formation mechanisms. Of course the debt of the United States has growth factors in social welfare spending, but the cost of war and the maintenance cost as world's policeman are also big factors; Europe, on the other hand, is different. The formation of the European debt turns out to be different from the U.S.’s, and comes more from welfare spending. Europe has long considered itself as a "lifestyle superpower." French President Nicolas Sarkozy and German Chancellor Angela Merkel have also repeatedly mentioned "Europe that provides protection;” namely, the European Union (EU) sets itself the task of protecting Europe's unique way of life. However, for the protection of this unique way of life, the cost is also expensive. This is the debt crisis in recent years that has repeatedly stirred the nerves of the European economy.


The EU public social expenditures climbed from 16% of the GDP in 1980 to 21% in 2005 (U.S. was only 15.9%). France's public spending has reached 31%, the highest in Europe, of which the government pension accounts for more than 44%. The current French retirement age is 60 with generous pensions (civil servants will receive 75% of their last- six-month salary as a pension). [1]


According to media reports, during the current crisis the debt of Greece alone has reached 294 billion euros. Calculations based on the Greek population of about 11 million would give a per capita debt of about 26,700 euros. [2] Such a high debt comes from the outrageous Greek social welfare. Data show that half of the EU fiscal expenditures are for social welfare. A high welfare system has decreased the flow of the financial expenditures and increased labor costs. At the same time the monetary integration, as the important outcome of the European integration, has had a huge impact on the traditional model of the European welfare states.


But the European Monetary Union has made the Member States comply with the convergence criteria as a condition to join the eurozone and has created a tightening effect on their public finances so that they have to reduce the fiscal deficit. Under the populist politics, in order to obtain votes, politicians were apparently afraid of welfare reform. Undoubtedly, this will compress the economic spending of the European countries, which in turn causes a negative impact on the country's economic growth.


As we know, the eurozone economy has its own specialty. This particularity on the one hand is reflected in the common monetary policy, but on the other hand there is a lack of unified fiscal policy. In fact, since the launch of the euro in 1999, which in 2002 completely replaced the sovereign currencies of the eurozone members, the Member States have lost the independence in issuing and controlling their currencies while the control over fiscal policy remains in the hands of the member governments. Since monetary policies are formulated and unified by the European Central Bank, if the member countries encounter internal or external economic shocks, the only macroeconomic adjustment tool they can use is the fiscal policy.


But, at the same time, the healthy operation of the monetary union depends on Member States complying with the strict financial discipline. Because the fiscal deficits of the Member States of the monetary union have a higher solvency risk, if a sovereign national government abuses budget deficit policy without restraint, this will result in increasing continuously the amount of bonds issued. The long-term accumulation of public debt will inevitably face the question of solvency risk. If the public debt burden is too heavy and the government is unwilling or cannot be financed by higher taxes, it has to find ways to renege on the debt. Under the general situation, the government is more willing to use indirect ways to default the debt to reduce the burden, because directly walking away from the debt will lead to political instability. However, after a country joins the monetary union, it loses control of the money supply, namely, the means of indirectly walking away from the debt. So the possibility of directly reneging on the debt increases. As a monetary union, the impact of a country reneging on a debt is clearly not only confined to that country, but affects the entire monetary union. We have seen it very clearly with the debt crisis of Greece.


In order to avoid serious political influence due to directly walking away from the debt by a government, the European Central Bank will be pressured to provide relief to the Member States in trouble, that is to provide loans to or to purchase bonds of that government. Then, the monetary policy of the European Central Bank will be subject to the interference of the financial problems of the Member States, thus losing its rightful independence.


In addition, if a Member State were to adopt an expansionary fiscal policy, it would undoubtedly increase the total demand of money supply. Under the condition of the established money supply, the market interest rate of the monetary union would be affected and tend to rise. Rising interest rates not only increase the debt burden of the worsening financial situation of the member governments, but also have a tremendous impact on investment. In this way, these Member States are likely to exert pressure to the European Central Bank to loosen its monetary policy in order to lower interest rates by increasing the money supply. So the monetary policy of the European Central Bank may be interfered by the fiscal policy of the Member States.


Due to the above-mentioned two external impacts of the fiscal policies of the Member States, the Maastricht Treaty has developed strict fiscal rules for the Member States. And the Stability and Growth Pact has further strengthened the supervision of the financial situation of the Member States as well as the sanction mechanism for breaching the financial disciplines by them. At the beginning of launching the euro, the 12-country eurozone made financial commitments based on these two treaties: the public sector debt of a country cannot exceed 60% and the budget deficit cannot exceed 3% of its GDP [3]; the Member States committed to reach the target of fiscal balance in 2004.


However, the commitment of the Member States to the fiscal disciplines results in two conflicts:


First of all, after a Member State lost their monetary sovereignty, fiscal policy has become the only macro-control tool to promote national economic growth. But the financial constraints imposed on the Member States have greatly reduced the operational space of their national fiscal policies. It is difficult to fulfill the function of promoting economic growth.


Secondly, most European countries are high welfare states. The high social welfare spending has often pushed the national budget toward over-spending, especially when the economic growth appears to show sign of recession. The rise of the total payments for unemployment protection brought about by the high unemployment will further increase the financial burden; should the fiscal rules in the euro area be strictly carried out, they are bound to generate pressure to cut welfare spending. But in the current situation of populist politics, it is almost impossible to achieve a fundamental reform of the welfare system. Therefore, the target of fiscal balance is also unlikely to be achieved.


In this regard, some scholars such as Emma Frankel, Barry Eichengreen and Rudiger Dornbusch have long been thinking that if Europe continues to maintain the existing social welfare system, the European Monetary Union is bound to fail. In other words, the regional monetary integration is incompatible with the European welfare system. The major internal reason is the financial crunch caused by the operation of the single currency, which has created pressure on the economic growth and welfare system of the member countries.


Of course, the member countries of the eurozone have never observed strict compliance with the required financial discipline. Taking the eurozone's second largest economy France as an example, its 2003 public deficit accounted for 4.1% of the GDP [4], exceeding by more than 1 percentage point of the 3% set by the EU Stability and Growth Pact.


Especially in the current financial crisis, due to existing economic structural disadvantages, Greece and other countries in the eurozone faced declining competitiveness and their governments could not make the financial ends meet. On the other hand, in order to prevent a full economic depression, their governments did not let the fragile and highly leveraged investment banks and enterprises fall in order to achieve "creative destruction." The governments tried hard to intervene and rescue them, thus turned them into walking corpses like “zombie banks, zombie businesses” that relied on endless government assistance. In this process, the private loss was socialized: the government budget deficit resulted into a large-scale increase in public debt and became the greatest burden of government and society. After the economic downturn had been curbed, spending had to be expanded to stimulate economic growth. The European Commission accepted quietly the heavy-borrowing behavior of the Member States of the eurozone and this has planted a hidden danger to the crisis. In addition, because the main form of the response taken by the European Central Bank to the 2008 financial crisis was to cut interest rates, this has also induced serious "moral hazard." In the context of relatively low financing costs, some countries lack prudence in fiscal expenditure and spend money profligately. This will no doubt further deteriorate the already very difficult debt problems. In 2009, the fiscal deficit and public debt of the Greek government that ignited the European debt crisis accounted for 12.7% and 113% of the GDP, respectively. [5]


It is in this environment that cumulating welfare spending, inverse circulation, counter-cyclical operating cost and moral cost contributed to today’s debt crisis in Europe. If the Stability and Growth Pact cannot effectively restrict the EU budget deficit to rise, then this Pact may eventually become invalid. The resulting vicious circle is the decline of the euro credibility and frequent fluctuations in the euro exchange rate, thus further dragging down the economic recovery in Europe. Therefore the reform of this Pact is desperately needed. Among the reformers, Germany’s voice is the loudest and its attitude is the toughest. German Chancellor Angela Merkel has repeatedly called for a comprehensive reform of the EU Stability and Growth Pact with the most stringent requirements to regulate the behaviors of the Member States to avoid the recurrence of a similar crisis of the Greek debt problems. But other Member States feel that this is a bit extreme. All Member States are only looking after their own interests and simply cannot reach a consensus. Their meetings are still filled with constant noise.


Strong Euro Is Not Compatible with the U.S. Interests


It is this endless noise that determines the inevitable collapse of the euro, because the euro cannot not afford to gamble. In January 2010, the renowned Harvard University Professor Niall Ferguson warned that the European sovereign debt crisis was not over, and would continue to spread and erupt in Japan and the United States. The reasons given by him were: the United States controlled the dollar, it could issue a large number of dollars to reduce its debt, but in the euro area, Greece and other countries could not follow suit, so the cost of debt of these countries would rise. [6]


Niall Ferguson is right. The problems faced by the United States are actually not less serious than those in Europe. Under the premise of carrying a huge debt, in order to maintain the normal operation of the state, the government must have the appropriate debt resources. In the United States, what it needs is to consolidate this advantage it currently has. But with the birth of the euro, this U.S. status is increasingly being threatened. In just a few years, the euro has rapidly grown into the second largest international currency after the U.S. dollar.


First of all, the euro has weakened the status of the U.S. dollar as an international trade settlement currency. For emerging market countries, the euro provides an alternative to the dollar as a settlement currency. Since the range of main export commodities of the eurozone is competitive with the United States’, the increase in the volume of euro clearing will inevitably lead to the decline of the U.S. dollar clearing. The settlement amount is the pricing power.  The decline in the proportion of the U.S. dollar clearing implies a loss of pricing power of the United States in the international market.


Second, the euro has impacted the status of the dollar as a reserve currency. After the birth of the euro, its share of total global foreign exchange reserves continued to rise, whereas the dollar continued to fall. According to official statistics by the International Monetary Fund (IMF) on foreign exchange reserves, from 1996 to 2009, the U.S. dollar in the international reserves position experienced an "inverted U" type trend. Before the euro was formally established and in the early years after it was born, the status of the U.S. dollar as an international reserve continued to rise and the proportion of its share of world reserves rose from 59% in 1995 to 71.5% by the end of 2001. However, since 2001, the proportion of the dollar began its continuous decline, and slipped to 62.1% as of 2010.


Former Fed Chairman Alan Greenspan has also confirmed this point. On December 11, 2006, Greenspan delivered a speech at a business conference in Tel Aviv, Israel, in which he said that the dollar may continue to decline, unless the deficit situation of the U.S. current account was changed. An important reason for this conclusion was that: "There is already evidence that the Organization of the Petroleum Exporting Countries (OPEC) are beginning to convert their foreign exchange reserves from the U.S. dollar into the euro, the yen and other currencies." [7]


And no matter whether it is international trade settlement currency or international reserve currency, the root lies in the debt resources. Under the borrowing "dependent" system, the long-term U.S. international trade deficit and current account deficits can be maintained with the uninterrupted cycle and revolving movement of the U.S. dollar as insurance. And to guarantee the uninterrupted cycle and revolving movement of the US dollar, the United States is bound to rely on the merchandise exports of other countries in exchange for the dollar. Then, other countries again use exchanged U.S. dollars to buy U.S. bonds to invest in the United States so that the dollar has returned to the United States to service its debt financing.


That is to say, the euro has weakened the U.S. dollar hegemony in the international monetary system and made the international monetary system show a pattern of two strong powers. Obviously, this situation is not what the United States wants to see, because money dominance often determines debt resources. If the euro is allowed to become stronger, for the United States, first of all, there will be fewer and fewer buyers of US bonds. After all, European countries are like the United States, they are basically "debt-dependent countries." According to the IMF data, the ten countries that issue the largest number of external debts include the U.S., seven European countries, Japan in Asia and Australia. The external bonds issued by the ten countries account for 83.8% of the world’s bonds; the total bond market of the eurozone accounts for 45% of the world’s bonds, which is more than the US share of around 32%. [8] This is undoubtedly the biggest challenge to the U.S. debt-dependent system. The more troublesome matter is the bargaining power of buyers in the bond trading. On the basis of the selection availability, their bargaining power will also become stronger. This is absolutely in conflict with the interests of the United States.


In order to protect the debt resources, the United States must continue the "structural power" conferred by its financial and monetary hegemony and hold on to the dominance of the international monetary system. In this context, as the most powerful potential competitor that is capable of an overall challenge to the dollar hegemony, the euro’s fate is obvious. This is also why, for the United States, the collapse of the euro is in line with the US interests.


The United States may resort to, from time to time or on a regular basis, a manufacture of the euro debt crisis by taking turns to attack the European debt to create unrest, and then hit the euro in order to create more rotten European bonds than the U.S. Treasury bonds. Only this way will enable the financial market to make a better choice. The dollar can then take advantage of being a hedging tool and its fluctuation to attract a strong capital flow back to the United States. To a certain extent this explains why, during the debt crisis in Europe, dollar assets including the U.S. treasury bonds, stocks and other corporate bonds have been heavily sought after. Although the current U.S. national debt has exceeded the debt ceiling, the 10-year U.S. Treasury yields and the 30-year U.S. Treasury yields have hit a five-month low; the U.S. Treasury bonds are over-subscribed and debt financing can proceed smoothly.


Over time, the inevitable result will be that the U.S. can continue to borrow more new debts to pay for the old debts to avoid a payment crisis. On the contrary, Europe, due to debt resources being snatched away by the United States and the maturity of the debts, cannot borrow enough new debts to pay for the old debts that reach maturity. This may cause a solvency crisis at any time.


Some maintained that the euro would have collapsed last year and others even gave a concrete time table. For example the Hong Yuan Securities chief economist Fang Sihai has repeatedly expressed on his microblog that the euro would crash on September 20, 2011. My attitude then was far less pessimistic; in fact, I am no different now. According to my microblogging response to his remarks, is there still a way around the euro crisis? Yes, there is. Then, where will the money come from?


Roughly speaking, there are four sources: the first is the national finance, the second is the European Financial Stability Facility (EFSF), the third is a joint European bond, and the fourth is the European Central Bank. But among these four, the challenges would not be small either:


First, concerning the domestic finance, simply relying on each Member State alone is clearly impossible. As we can see, the European national welfare spending in these countries is heavily indebted. More troublesome is the long-standing tradition that has made the Europeans accustomed to waiting for national unemployment relief but not willing to work. According to the data published by the Eurostat in November last year, in September 2011 the unemployment rate of the eurozone countries reached 10.2%, setting a new high of 11 months. The unemployment rate throughout the EU region rose to 9.7% in that month from 9.6% in the same period of 2010. Spain and Greece had the highest unemployment rates, 22.6% and 17.6%, respectively. Of more concern is that the EU unemployment rate of youth under age 25 reached 21.4%. The youth unemployment rate in the eurozone also reached 21.2%. The highest rates occurred in Spain and Greece; they even reached 48.0% and 43.5%, respectively. Can there be harvest without sowing? Can there be wealth without hard work?


The second is the EFSF. In fact the EU in June 2010 agreed to set up an EFSF of 440 billion euros. However, the actual financing capacity is still a question mark. The warranty dispute arising around the "Finland" rules will bring about further uncertainty and it is needless to mention about expanding the EFSF. The two rounds of aid by the eurozone to Greece already spent 240 billion euros. The more important thing is that Greece also needs more large-scale relief funds in the future. The critical matter is that countries ridden by the debt crisis are not Greece alone; they include Spain and Italy that have larger total economies, being the eurozone's third and fourth largest economies. Once the debt crisis breaks out, the impact on the market would be far greater than Greece’s. By the same token, if the two rounds of rescue for Greece spent 240 billion euros, similar rescues for Spain or Italy would by no means be a mere 240 billion euros.


The third is a joint European bond. Germany and France have publicly opposed such a bond issue which lacks a unified financial condition. Based on the road map of these two core nations, at least there should be an advance on the basis of a unified corporate tax system for the Member States. This is clearly not attainable in the short term.


So, what would be the best option? Last year, my view was: learn the good example of the Fed and let the European Central Bank print money. Sure enough, the European Central Bank broke the single goal of a stable currency that it has consistently adhered to: twice in August last year it bought 36.3 billion euros in bonds issued by the Member States. In November last year, it even unexpectedly cut the interest rate by 0.25 percentage points.


But what we must realize is that the European Central Bank is not the US Federal Reserve. Namely, under a monetary system with 17 independent Treasury Departments, the European Central Bank has more limitations on releasing liquidity than the Fed of a single country.


Based on this, we believe the possibility of the eventual dissolution of the euro in the long run is valid. In short, we are not optimistic about the long-term future of the euro. After all, its shortcomings are objectively present: the unified euro is incompatible with welfarism; the financial requirements of the Member States are incompatible with the common monetary policy; the prosperity of the euro is not compatible with the operation of the U.S. economic system; the European debt needs are not compatible with the interests of the United States.


References are listed in the Chinese version of this article.

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Pierre A. Hanson (Heyuan Han) is a guest researcher at the Beijing Ruiku Research Institute of Social Sciences, Senior Fellow of the Guangdong Research Association of Productivity Development, and chief economist on macroscopic research of an asset management company. He has also worked for U.S.-owned investment companies and economic research institutes as their chief economist and senior economist. Since 2001 his research has focused on monetary and economic cycles. He has successfully used the model of Mises - Hayek money supply and economic cycle to warn in advance the global financial crisis in 2008. His related publications are as follows: 1) “Global Economic Crisis in the Making - Bequest from Greenspan” (September 2006, 《酝酿中的全球经济危机——格林斯潘给我们的遗产》): http://www.chinavalue.net/Finance/Article/2006-10-1/44872.html; 2) “Interest Rate Cut Will Not Help the U.S. Economy” (March 2007, 《降息无助于美国经济》): http://www.p5w.net/ news/xwpl/200703/t854533.htm; and 3) “Zero Interest Rates and Four Trillion Cannot Save China's Economy” (December 2008, 《零利率和4万亿救不了中国经济》): http://www.cqvip.com/QK/83722X/200901/29299094.html
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