BY CHARLES CALOMIRIS--
Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo. At this point, several European countries will likely be forced to abandon the euro within the next year or two.
European leaders tell us that this is impossible. There is no legal mechanism, they say, for exiting the euro. But the collapse of the euro is simple arithmetic:
Once a country's debt-to-GDP ratio gets high enough, it becomes impossible for it to generate enough future taxes to repay its existing debt and interest costs. This week, Portugal became the latest country to threaten the integrity of the eurozone when it saw the yield on its Treasury bills soar, based on investors' fears that it would be unable to pay its debt.
The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency. Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing.
The countries currently teetering on the precipice include "peripheral" countries -- such as Greece, Ireland, and Portugal -- as well as large countries, such as Spain, Italy, and France. It is extremely unlikely that all of these countries will still be members of the eurozone by the time revelers gather to ring in New Year's 2013. The most likely scenario is that the next two years will witness the departure of more than one peripheral country and at least one of the large countries.
Greece is at the top of that list. The country will soon have a sovereign debt-to GDP ratio of more than 150 percent and an economy that contracted approximately 4 percent in the past year. It has long suffered from the worst corruption and largest shadow economy in Europe, while also possessing some of the lowest labor participation rates, most generous pension systems, and highest consumption rates among its European peers. It is true that the Greeks have made heroic efforts in the past six months to cut spending and raise taxes, but it won't be enough to reverse the explosive costs of covering its debts. And yet, the story goes, Greece will somehow repay what it owes.
Following closely on Greece's heels is Ireland. During the so-called "Irish miracle," the country experienced a housing boom that saw twice the appreciation as did the United States. When this bubble popped, Ireland's banking system suffered a massive loss. The government's bank bailouts have added more than 20 percent of GDP to its budget deficit in the past year and will add a similar additional amount to its deficits in the near future.
The Irish case also shows the perils of EU intervention. Ireland was forced by its self-serving European partners to guarantee massive bank debts -- in order to forestall debilitating losses to German, Belgian, Danish, and British banks, among others -- as a condition for receiving emergency EU assistance. This Irish policy mistake has raised its debt to stratospheric levels, which the government will be hard-pressed to bring down. Thus, in effect, some of the largest EU countries proved their willingness to throw Ireland under the bus to postpone dealing with their own financial institutions' problems.
Now Spain is being pushed by those same European partners into making the same deadly mistake as Ireland. Spain's housing boom was similar to that of Ireland and was similarly financed by large external borrowings. The good news in Spain, however, is that most of the country's largest financial institutions appear to be solvent. If Spain shuts down its insolvent savings banks and allows closed banks to default on their external bond debts held by other EU countries' banks, Spanish sovereign solvency can be preserved.
A number of other European countries face similarly daunting fiscal challenges. Italy, for example, is running a debt-to-GDP ratio in excess of 125 percent. Although serious and immediate fiscal spending cuts could give Italy a reasonable chance of repaying its debts, the country seems so politically broken that it is unlikely to make the deep spending cuts that would permit it to stay in the euro. Its meager cuts this past year are an indication of how difficult it is for Italy's political system to confront its challenges.
FP
http://www.foreignpolicy.com/articles/2011/01/06/the_euro_is_dead
