The sovereign debt crisis in the European Union raises a fundamental question, one that Europe and the rest of the world will be debating for months and possibly years to come: What would the cost of a dissolution of Europe be for the continent and the world?
The E.U. was created to promote cooperation and prosperity in the region. It began with the goal of fostering free trade among member countries and gradually evolved into an economic and monetary union (E.M.U.) in which members share the same currency, the euro. This kind of economic integration enables its participants to capture the benefits of specialization through mobility of goods and services, and to enjoy greater monetary efficiency gains. The E.U. currently has 27 members, 17 of which are also in the E.M.U.
Many different measures and initiatives have been launched in attempts to solve the debt crisis and to stop it from spreading from stricken countries to healthier ones. Unfortunately, these efforts have had little success. As of press time, financial markets seem to still not have faith in the ability of policy-makers to save the euro, and Greece is teetering on the brink of bankruptcy.
So, what is the future of the E.U.? Possible outcomes include a complete breakup of the union, a partial dissolution into a core group of nations and a more peripheral group, and the exit of some debt-stricken countries such as Greece and Italy. Some even speculate Germany might leave the union altogether to avoid having to bail out an increasing number of troubled states.
If any of the above happens, it will have a catastrophic impact on all parties involved. If the E.U. disintegrates or if a weaker euro-zone nation leaves the E.M.U., either voluntarily or involuntarily, the worldwide banking sector will be the first to feel the impact. The flight to safety in the region, which is already underway, would be exacerbated. Nations that no longer use the euro will have to reintroduce their own currencies, and the currencies in weaker countries would have to trade at a discount against the euro and other major currencies. Those who own assets in those countries would find their wealth significantly diminished overnight.
To avoid potential losses, depositors and investors will withdraw funds from these economies and move them to stronger ones. They will do this very quickly, which will put banks everywhere under tremendous pressure. Banks always encounter the problem of maturity mismatch—that is, holding long-term assets while having short-term liabilities. Mass withdrawals would rapidly trigger a liquidity crisis and may cause weaker banks to become insolvent. There are signs that this has already started. Some European banks are experiencing larger-than-normal withdrawals, while others are making fewer loans to boost their holdings of liquid assets in case of sudden, gargantuan withdrawals.
Banks perform the critical function of financial intermediation, which helps promote economic growth. If European banks are unwilling or unable to make loans, as we saw in the U.S. in 2008, the economy will suffer severely. Firms will find it more costly to finance their daily operations and undertake new investment, while households will find it more expensive to finance the purchase of homes and durable goods. The inevitable result will be a lower demand for goods—and economic recession.
Furthermore, governments with low credit ratings will have to offer higher interest on their bonds, which will make it more difficult for them to service their debts and might force them to run larger deficits. This increases the likelihood of a default, further weakening market confidence and deepening the ongoing crisis.
The E.U. is the world’s largest economy. Bad news there brings bad news everywhere. Should the E.U. fail, either in whole or in part, it will jeopardize the entire international financial system. Banks around the world will suffer huge losses due to their exposure to the E.U., via holdings of government bonds issued by debt-stricken countries, lending to European banks and corporations, and many other channels. If this scenario unfolds, the vicious cycle of financial Armageddon that began in 2008 will accelerate. Some, like billionaire investor George Soros, warn that the collapse of the euro will be costlier to the world economy than the financial crisis of 2008–2009.
Given what is at stake, policy-makers will no doubt try to keep the euro zone intact. However, time is running out. Policy-makers in the E.U. have to put forward a concrete plan to solve the crisis and restore market confidence. The longer the delay, the larger the damage done and the harder it gets to fix the problem.
While the benefits of remaining part of the E.U. may be difficult these days for member states to realize, with the crisis at such an advanced stage, the alternatives are surely much worse. The only silver lining is that we now have a great opportunity to rethink national, regional and international fiscal policies, and reconsider what it truly means for a group of disparate nations to climb into financial bed with one another.
Iris Au is a senior lecturer in economics in the department of management at UTSC.