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Eurozone recovery: is breaking up the euro the best solution?

The “Economic and Financial indicators” section of the latest issues of The Economist have brought some hope for the EU’s economic recovery. The Eurozone’s GDP grew by 2.7% in the last quarter of 2017 against lower expectations, with both France and Germany’s growth picking up by the end of the year. Yet, the durability of this recovery is questionable. The Eurozone still faces structural weaknesses that will prevent such countries from achieving the highest economic growth possible and improvements in living standards. It also puts Eurozone countries at risk to future shocks.

Stagnation, fall in productivity and severe unemployment for a decade across the Eurozone, particularly in Greece and Spain, provided grounds for many economists to question the effectiveness of the single European currency, established under the Maastricht Treaty in 1992. Joseph E. Stiglitz argued in ‘The Euro’ (2016) that the single currency exacerbated the effects of the 2008 Financial Crisis and prolonged the economies' downturn. Although a break up of the single currency would erase the limitations of a lack of economic sovereignty for such countries, enabling them to adopt individually-suited policies to recover; this essay will argue that a far better solution would be increased economic and political integration between the countries.

Potential benefits of breaking up the euro

(Source: CNN)

Allowing each member of the EU to bring back its own currency will enable them to set its own interest rate, different to the current 0% set by the European Central Bank. Obtaining this vital monetary instrument back will allow individual macroeconomic objectives to be achieved for easily. For example, the new targets for Italy would most likely focus on reducing severe unemployment in the medium term, thereby reducing high inefficiency. Currently, under the euro, the interest rate that is set will never satisfy each Eurozone member’s need as their economies have diverged since its establishment.

More importantly, it will allow countries to set their own exchange rates, which was completely taken away by the introduction of the euro. They will also be able to manage its economic recovery, through devaluating or appreciating their currency. Greece could use measures to lower the value of its currency to make its beaches, hotels and restaurants cheaper for tourists. Making tourism more price competitive would boost the tourism sector in Greece, leading to higher revenues and GDP growth, given that demand for tourism is elastic. Creation of jobs to facilitate the increased demand would lead to lower levels of unemployment, which again will help with economic recovery.

The better solution

However, breaking up the Eurozone now could have severe economic and political implications. It will require careful agreements and cooperation between all member states. With Brexit negotiations still incomplete, the abolishment of the euro will put politicians under excessive pressure, thus leading to possible irrational and rushed decisions.

Another way to ensure durable economic recovery of the Eurozone is a removal of sources of divergence - i.e. things that make some countries within the EU grow and others stagnate - through reforms of the financial system, as proposed by Stiglitz. Reversing the flight of capital from weaker states to ones with stronger economic performances is key to the economic recovery of the EU as a whole. The current flow of capital in the unwanted direction is caused by the potential inability of banks in the economically weaker countries to be bailed out in a crisis, and by the bank’s dependency on the value of its country’s bonds.

In fact, the EU has already moved towards “breaking the doom loop”. To reduce banks' reliance on domestic bonds, sovereign bond-backed securities will be introduced. This will allow banks to issue different countries’ bonds jointly. Suppose Greece’s economic situation does not improve, and the value of its bonds is still low. Greek banks will no longer suffer the consequences of depreciated Greek bonds and will be able to increase lending and boost confidence in the economy.

However, far more can be done. For example, more funds could be made available for bailouts. One of the causes of the undesired direction of the movement of capital in the Eurozone is because consumers and firms in countries with weaker economies fear that in the case of banks failing, they would lose their money due to the government’s inability to bail them out. This incentivises individuals to use financial services in neighbouring, more economically successful Eurozone countries. Larger funds available for the financial help for banks will boost consumers’ and firm’s confidence in their own banks, hence making the banking sector stronger and allowing it to be drive of economic recovery. A risk of this measure, however, is that it could encourage banks to engage in risky behaviour due to moral hazard, which could lead to another financial crisis.

To conclude, breaking up the euro at this stage could have a catastrophic effect on Europe, especially if only certain countries decide to leave the Eurozone. In such a case the euro could become subject to speculative attacks, which would weaken economies further. A better way forward for Europe, where the single market principle will be able to deliver positive economic impacts, would be for the countries to work together for bigger political and economic integration, through reforming the financial sector. Although this is the most rational solution from an economic perspective, such cooperation will be challenging to achieve, especially considering the current popularity of anti-EU and protectionist sentiments.

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