Dec 3, 2011

Euro : The Curious Case of Profligate family member

Someone asked me a few days back about whats happening over the Eurozone crisis. It took a while for me to explain. However, i've been thinking about the correct way to explain it in a simpler language. Here it goes

Imagine a big joint family ( i.e, European Union), whose members are practicing different professions . Each has their own pet concerns, but supports each others in times of need .Suppose a profligate member of the family starts spending beyond his means. To meet his expenses, he starts approaching money lenders or banks. The lenders, because of the fact that he's from a reputed family initially starts lending to him at lower interest rates or without guarantees. This puts additional fillip to the spending person and his income expenditure gap widens. Gradually, lenders tend to doubt his capacity for repayment and reduces loans to the all members of the family. This creates difficulties even for the well performing members of the family . The knee-jerk reaction is to try to bail out the spendthrift. But even after bailing out couple of times, if he goes back to this overspending mode, what will you do ? You have two choices 1) kick him out of the family (2) make him follow an austere path somehow.

This is precisely the question that European Union is facing now. And the exacerbating fact is that the profligate member is no longer a fringe nation like Iceland. They are major economies like Italy. Few years back in my introductory MacroEconomics course at IIMK, professor Nandakumar explained the pitfalls of getting into a monetary union without making a fiscal & political union. Such a union is inherently unstable . Europe could have never achieved a political or fiscal union as cultures are totally different from one side of continent to other and they require different kinds of political policies. Maastricht treaty which established the concept of Euro was fundamentally flawed in that angle. It was an attempt to put up a strong front which would combine the bests of different factors of production , or rather efficiencies prevalent in different parts of Europe . It was a political stroke without working out necessary economic fundamentals. Given the quagmire that Europe is in now, the costs of pulling out of Euro is far higher for even the strong economies like France & Germany. Hence, I think in the short run, these powerhouses will force the rogue member states like Greece & Italy to follow good fiscal discipline. But in the long run, the associated loss of freedom ( both economic and political ) will be too much for these nations to bear. A decade down the lane, i won't be surprised if Euro nations are just the well performing economies of Germany, Netherlands, France etc.