Sa nakalipas na taon, punong punong puno ng balita ang international news tungkol sa "Euro crisis", "sovereign debt crisis" at "Greek and Irish bailout". (Initial reaction: Ano ba talaga lahat ng iyan… at ano ba ang pakialam ko diyan???) Sa totoo lang, ang trade at finance at kahit anong paksang may numero ang mga iniiwasan ko sa pagrerebyu dahil wala akong maintindihan. Pero noong kinuha ko ang FSE Written Exam ngayong 2010, marami sa mga tanong ay tungkol sa trade atbp. (Nayari ako dun.)
Mahalaga sa Pinoy na pag-aralan ang Euro at ang European Monetary Union dahil isa itong posibilidad para sa atin sa hinaharap. Noong 1997 Asian Financial Crisis, nagbuklod ang mga kalahok ng ASEAN (kung saan miyembro ang Pilipinas) upang pag-usapan ang mga maaaring gawin nito upang hindi na muling maulit ang krisis—at isa sa mga solusyong nakita ng ASEAN ay ang pagbuo ng ASEAN Monetary Union. Ayon sa mga pag-aaral, maraming makukuhang aral mula sa kalakasan at kahinaan ng Euro, lalo na sa sa nakaraang 2 taon kung saan binibigyan solusyon ngayon ng European Union ang mga mabibigat na problema dala ng mga miyembrong-estado nito tulad ng Greece at Ireland.
Susubukang sagutin ng talang ito ang mga sumusunod na tanong: Ano ang monetary union at paano ito binubuo sa konteksto ng Eurozone? Ano ang mga kabutihan at kahinaang maidudulot ng pagbuo at pakikilahok sa isang monetary Union? Sa gitna ng krisis na nagaganap sa Eurozone ngayon, tama ba ang desisyon ng Estonia upang makilahok bilang miyembro?
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New Year's Day marks the first day of Estonia's effective membership newest member of the Eurozone—a group of states in Europe that had formed an economic and monetary union that uses the currency named the "Euro". And the question is: has Estonia made a wise move pushing through with its membership despite the crisis and setbacks that has hit the currency?
In 2008, the Euro entered into a recession (which means it has had negative growth for three consecutive quarters) as an effect of the global financial crisis caused by the failure of the U.S. housing market. While urrencies have dipped and even failed before, like that of Argentina peso in the 90's and the German papiermark during the post-Versailles Treaty Weimar Republic. But the problem is by far larger because the Euro is not just used by one state—it's used by 17 member countries and directly affects the economy of 26 member states of the European Union.
The Euro: the Whats and the Whys
To begin with, forming an economic and monetary union like the Euro has a lot to do with increasing trade between two states. Remember, that the basis for forming the European Union back in the '60s was to facilitate the trade of steel and coal between member states (which prevented further war from happening among them). It's good to trade because of the obvious reasons—there are bigger markets for businesses to tap into, wider access to goods lessen opportunity cost (or let countries become more efficient with resources by allowing them to specialize in goods they're good at making) and also make the transfer of technology, people, among other things possible.
Let's go into a bit of theory on this. Adam Smith's laissez faire concept says that an invisible force guides markets to become more efficient, to produce the best goods and in the end allow everyone a prosperous life. What Smith is also saying here is that the economy should be left alone by government because it would work out in the most ideal way possible. This theory supports the Theory of the First Best—which basically says a particular market (or one within the borders of a state) will become the best it can be when left alone.
But the experience of markets reveal the reality of distortions, or things that prevent a market from attaining Smith's economic nirvana. A monopoly, for example will mean unfair competition among business players. This leads us to the Theory of the Second Best—which basically says that a state economy can turn to trade in order to correct the distortions within its own borders. And that's why it's advantageous for states to trade between themselves, which is also called economic integration.
When two or more states go into economic integration, they have to agree upon the lowering of their tariffs and trade duties—or what it costs to import or export goods between borders. On the small scale, you've got preferential trade agreements; then free trade agreements as more trade concessions are given by both parties.
Then you have the more advanced economic integration like the economic union, which creates a single market between the partners (no more tariffs and trade between participants), and also the monetary/currency union that allows the trade partners to share the same currency. These last two examples combined—an economic and monetary union—is what the Euro is.
The Euro creates among all its partners
- A common market. Because trade and tariff barriers are eliminated between members, you can have goods, services, capital and labor flowing easily across borders. Think about it as the removal of fences between houses in a neighborhood.
- A customs union. Only members will enjoy the full advantages of a common market, while non-members will be outside what is called the trade bloc. Think about the abovementioned neighborhood fencing themselves off from outsiders using fencing material they all agree upon. The customs union is charged with setting up the details of an trade and tariff barriers agreed upon by all the members.
- A monetary union. A single currency means a single central bank that will manage monetary policy, like the printing and distribution of notes and coins.
So there are perks and benefits in joining something like the Euro, so why isn't all the states in Europe joining in? It'll be useful to look at another theory by Robert Mundell to help us understand what the disadvantages are, and can provide a background to why the Euro is going through a crisis now.
Mundell came up with the theory named the "optimal currency area theory", which basically says that the major cost of joining a monetary union is a loss of independent monetary policy. State use monetary policies during times of crisis and shocks to keep their economy stable.
Exchange rate control is an example of a monetary policy. A state that is undergoing problems with their balance of trade (they are, for example importing more than they are exporting) can use their exchange rate controls to limit the amount of foreign currencies that can be exchanged with domestic currencies—because too much exchange can make the economy unstable.
Another point Mundell raises with his theory is that the monetary union will be more effective if there was a means for the budgetary process to be centralized and monetary transfers between budget surplus countries to budget deficit countries can be established. Take note of these two important points raised by Mundell, because they can be applied to our discussion of Euro history and issues later on.
Forming the Euro Basketball Team: A Short History
The precursor of the European Union—the European Coal and Steel Community—already had the idea of forming a monetary union along the way. But the desire to join economies in a single currency could be seen in events happening after World War II.
After the war, the international community saw the formation of new states, which contributed to the currencies and foreign markets becoming unstable or volatile. Because states had to look after their own interests the practice of "beggar-thy-neighbor" policies became popular. These are fiscal and monetary policies that improve a state's balance of trade at the expense of its trading partners. One example would be for State A to devalue one's own currency to boost exports (making products in state A cheaper than that of state B's) and discourage imports (because buyers in state A will find foreign goods too expensive).
The international community put their heads together to come up with a system that will prevent this kind of exploitation among states—such as a peg that would limit the evaluation and devaluation of world currencies. The Bretton-Woods system and the gold standard pegged currencies to the dollar, but it would fail later on because of the Nixon shock in the 70's. For the EU, then known as the European Community (EC), this highlighted the need for a monetary union.
In 1988, the European Monetary Union was formed in a 3-step process. Remember what Mundell said about the price to pay for joining a monetary union? That's exactly what this new system exacted from its members—each had to give up exchange controls, which made sense since they wanted to do away with the old beggar-thy-neighbor system among them. This led to the capital liberalization—a relaxation of restrictions, more freedom for businesses and individuals to invest in goods beyond their borders, a healthy flow of money—among the member state's markets, which led to more competitiveness, better efficiency and productivity. What comes to mind here is the image of 10 goldfish in 10 separate fishbowls all dumped into this huge tank—allowing fish more swimming space, oxygen and greater interaction with fellow fish.
In 1993, 12 out of 15 member states of the EU signed the Maastricht Treaty, which basically meant that the signing states were politically committed to the sharing one currency. This also sanctioned the creation of the independent body, the European Monetary Institute, which would later become the European Central Bank, which manages the euro today.
One of the issues that needed to be addressed by the group is who would be able to participate in the monetary union. After all, when you share currencies, you share risks. In insurance terms, you have an underwriting system that screens membership; you've got to be choosy because high-risk members endanger your investment. In even simpler terms, there's a reason why the weakest, scrawniest student gets picked last in school basketball teams—no team wants a poor player slowing down the efforts of the team. Likewise, the monetary union wanted to ensure that all of their members are good players that can help boost the team effort, with each member committing to being a good player after getting picked. (Would a football analogy be more appropriate?)
That's why the group decided to adopt the Stability and Growth Pact (1997) which established the criteria which states needed to meet before they can become members. Let's take a look at some of them:
- It looked at the spending practices of the state governments in question—budget deficits should only be at 3% of the GDP (in other words, it shouldn't be spending more money than it has);
- And foreign debt should be less than 60% of GDP (apart from practical reasons, this also has a lot to do with the reputation of the state to investors among other things)
Based on the criteria, only 11 member states made it into the "varsity team". Greece—among those initially rejected—made the cut in 2001 (in time for the formal launch of the currency as physical notes and coins in the Eurozone) after allegedly faking its deficit figures—which would come back to haunt the euro when the global financial crisis struck in 2008.
From The Crib To Crisis
When the euro was launched in 2002, growth started slow. But it would steadily increase in strength as the years passed, rivaling the US dollar as a reserve currency. Eurozone member states began enjoying the advantages of a single currency and market. If you've traveled between countries before, you'll understand how advantageous it is not to have to convert your cash between currencies. The advantage translates also to the flow of goods, services and labor etc., across borders. A bigger market without trade barriers also means that buyers will now have access to cheaper products across state borders, encouraging competition among businesses, which increases their efficiency and productivity. Investors are always looking for huge markets with a lot of growth ahead, and that's what the Eurozone represented. In short, the basketball team, who has the strong backing of the school funding, is performing well because it's being trained and fed well.
One of the biggest advantages the Eurozone enjoys is the European Central Bank (ECB). Because it is an independent body exists to serve the needs of all Eurozone members, it's insulated from political influence of one state (although a lot of sectors will contest this). One thing's for sure, it is less politicized than a central bank embedded in a state.
The disadvantages of the being part of the Eurozone became stark during the bursting of the housing bond market bubble in the US, leading to the close of banks that made the mistake of investing in these bonds that turned out to be worthless. This led to a domino effect that caused banks—particularly in the US and Europe—to stop lending to businesses and private individuals in order to hold on to their capital and improve their solvency (or their ability to meet their long-term responsibilities). And with little money to go around, consumers became cautious about spending, which meant losses for businesses with customers who were no longer willing to buy as vigorously as before. The effect caused world economies to go into recession.
The Eurozone had more reason to get worried than other states with their own independent currencies. While other states could employ exchange control strategies to protect their currency, Eurozone members states—by virtue of the Maastricht Treaty—no longer had that option. Because their economies are all tied together under a common market and one currency, they are in danger of contagion. Returning to the goldfish analogy used above, if one of the fish in the tank has a disease, it threatens the safety of the rest of the system. The Eurozone then had to help out its members who were in trouble, because otherwise, they'd all float belly-up themselves. After the crisis hit, Eurozone states bought into banks, infusing it with 500 million euro worth of capital to encourage interbank lending. But the euro was in for more trouble—particularly when Greece happened.
Greece entered into a sovereign debt crisis. Think of your average worker who spent more than what he's making in his day job—going for extravagant shopping sprees, splurging on food, loaning to buy a car or a house. To be able to afford all these, he's got to borrow money from friends, family—or anyone for that matter. Sooner or later, reality will catch up—our man will have a reputation for bad credit, he'll file for bankruptcy and get thrown into jail. But unlike a person or a company, a state cannot file for bankruptcy or get thrown in jail. A state has to go on; it only has the option of telling its investors that it can't pay on time, or that it can't pay the full amount anymore.
During the fat years of growth that happened before the crisis, and with investors confidently putting their money into the Eurozone, Greece gets access to cheap debt. Instead of putting all this money into good use, Greece mismanaged its economy by continuing its deficit spending (spending beyond its revenues). It just kept on borrowing and borrowing. Investors and creditors, unsure of whether they're getting paid in the long run, raised their interest rates as this borrowing goes on, making it more difficult for Greece to come up with money to spend in the long run. By April 2010 credit rating agencies (the guys who determine whether or not it's wise to invest in anything or not, like Moody's or Standard & Poors) have deemed Greek bonds as "junk bonds"—investments that will most likely result to a loss.
Most of these junk bonds have ended up in French and German banks—and to protect themselves, these banks have stopped lending not only to Greece but to everyone in general, in order to consolidate their capital. You've got less money going around, which halts economic activity all over the Eurozone, the effect of contagion. Last November 2010, Ireland came next, a member of PIIGS (Portugal, Ireland, Italy, Greece, Spain)—Eurozone states with increasingly compromised economies.
It's important to note that the global financial crisis is not the direct cause for why the euro is in trouble now. Nor should the blame be placed solely on Greece, or the rest of PIIGS for mismanaging their economies. The euro is in crisis because the measures initially undertaken to prevent Eurozone member states from having bad economic practices—particularly the Stability & Growth Pact—was not enforced. In fact, a lot of member states were in violation of at least one of the criteria of the Pact!
Going back to the basketball team analogy, there was no effective coach that ensured that every team member got trained hard, ate healthy and exercised daily to prepare for the upcoming competition. Naturally, some team members, lagging behind in performance, would cause the entire team's games to suffer.
Conclusion: Did Estonia Draft Itself Into a Losing Team?
It's now time to answer the question: was it wise for Estonia to join the Eurozone at this point?
The euro may be undergoing difficult times at this point, but it still remains to be seen whether or not the contagion will be controlled or not. What's more important is to look at how the Eurozone responded to the crisis. On one end you've got Greece and Ireland realizing they have dug a hole for themselves—with no way to raise more money or isolate themselves from partners that are considering them a liability to the euro, they are now subject to a lot of demands from lenders. On the other, you've got creditor states being brought down by the weaker economies… and looking at burdening their taxpayers just to bail these economies out. There are two ways member-states could respond, the options almost equally choices because they're both expensive and will inevitably lead to clashes with their partners:
- Disband the euro; or for states to get out of it. From a realist perspective (where you have states looking after their own interests), Eurozone member-states could just cut their losses and bolt from the system. I've heard my mother threaten us many times when we were behaving very poorly at home: magkaniya-kaniya nalang tayo. Now that their economies and that of their partners are doing bad, it makes sense to give up their membership to the trading bloc and relinquish control of their independent monetary policy. This option has its disadvantages. Things are bound to get better in the coming years, and the loss of trading partners in those years may not be worth it. Add to that, if a state gives up its use of the euro, it'll have to come up with its own independent currency, something that can be very expensive.
- Help each other out. Liberalists (or those who think cooperation among states result to better gains for all) will support what's happening today—a pricey bailout by the strong economies (particularly Germany who answers for almost a third of package) to help out the weaker economies. This is consistent with Mundell's theory that an effective monetary union requires a centralized budgetary system where funds from states with a balance of trade (BOT) surplus can be smoothly transferred to states with a BOT deficits.
It's good to to see that Germany et al are stepping up and taking charge to fight for the euro. It's a tricky situation however to come up with a fair deal that would leverage reforms from the weak economies. We hear the phrase "austerity measures" a lot, and it looks like the message is clear: if you want this money that we've bled from our own purses, don't spend beyond your means.
The Eurozone is learning a lot of lessons from the crisis. We're seeing a strengthening of EU institutions that govern the rules across borders—they will need to have more teeth in order to keep member-states in line. All the states are now reforming their fiscal policies to meet Pact standards—having the need to cut costs, create a sound budget and scrupulous investment policies. Last month, we saw students rally across Europe because of tuition fee hikes that states have put into effect to raise revenue; and this effect is being felt by a lot of sectors.
Uncertain outcomes lead to more questions. Will the bailout make a difference? Will contagion be contained? Isn't it unfair for states who have kept their house in order spend their own money to save bad economies? Will it be right for taxpayers to invest in more bad debts? From Germany's end, Prime Minister Angela Merkel's government has become unpopular to the constituents.
But the course is set. Instead of letting things go awry and break apart what they've worked on for years, Eurozone leaders have decided to take charge and fight to save the euro together. The problem may seem impossible and overwhelming, but it revealed that the Eurozone has the political unity—and backbone—to follow through with their vision of a unified economy.
And it is in that value—being part of this strong-willed political bloc that has held together especially in time of crisis—that Estonia's decision to join the Eurozone becomes sound. Having strong trading partners is not as important as having partners who will stand up for you and help you out when the going gets tough. Fears of the challenges and an uncertain future of the euro are far outweighed by the political leadership, the resolve and the swiftness of action of the Eurozone that revealed the strength of this unique model of economic and monetary union.
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Ending this article leads to a lot more questions that I'll try to answer in succeeding posts. Such as, how far along is the ASEAN in terms of regional economic integration? And, based on the EU model, how close is it to achieving political unity? Should there come to be an ASEAN economic and monetary union, how advantageous is it for the Philippines to become a member of such a trade bloc?
Anyway, I came across a Stanford University study that answers some of these questions, which you might be interested in. http://publicpolicy.stanford.edu/group/siepr/cgi-bin/pubpol/?q=system/files/shared/documents/Mittal.pdf
Officially the first post for this blog and for the year, I find the article a good start for understanding the world economy, albeit a bit expansive (shall keep the next articles shorter next time!). I'll welcome comments and arguments—discussion can help enrich our knowledge! I hope to see you again, fellow citizen of the world :)
