16.12.2010.

Virus Therapy or Lessons Learned from the Latest Developments in the Euro Area and US

Recent developments in the global economy may be compared to an acute viral disease affecting a sick person; without effectively dealing with the infection, the virus builds upon itself developing side effects and complicating recovery. Keeping both public and private expenditure and income balanced is like boosting the immune system, which is the best preventive measure against any type of viruses in both the body and the economy. Similar to improving ones health, a change in the economy is not attainable in a jiffy: you must "exercise" on a regular basis! The comparison may be extended by describing the behaviour of states and people when attempting to avoid problems: taking medications or living on credit today, with payment liabilities postponed to a later time, is easier and more convenient.

The latest economic developments confirm that such unhealthy lifestyle has a snowball effect. A large share of countries (including some in the euro area) financed their budget deficits with borrowed money, thus building up the sovereign debt. For instance, the European Commission has estimated Greece's total budget deficit for this year to stand above 140% of GDP! Taking into account the overall value of international loans, debt servicing costs are rising. Ireland paid 2.5 billion euro or 8% of country's all tax revenue in interest on debt in 2009, with around 20% to be paid in 2014, which means depriving the public needs budget of an enormous amount of financing. Another evil phenomenon is gradually building up: financial markets that extend loans or finance sovereign debt rapidly lose confidence in the ability of many a country to reduce their debt levels effectively, and concerns about creditworthiness of these countries increase automatically finding their reflection in rising interest rates. While at the beginning of this year the interest rate on the Irish government's 10-year bonds was 2.5%, at present it already exceeds 9%! It suggests that in the eyes of investors the risk has increased several times.

These dramatic examples notwithstanding, the statements about alleged willingness of a number of countries to step out of the monetary union should be looked upon as speculation, not reality. An objective assessment of a country's exit from the euro area suggests that such solution would not be pragmatic either for the problem country or the EU in general. Such a decision would have irreversible political, economic and social consequences.  If such a scenario is accepted theoretically, the economy of Portugal or Greece would most likely plunge into the black hole of economic crisis while the global heavyweight Germany would bring destruction to its exporting sector. With a country stepping out of the euro area, fleeing investors would destroy its economy, fluctuations of the national currency (to be introduced anew)  would go out of control, the single European market would not function  as effectively as before, global financial markets would be hit, and chaos would substantially spill over to other countries in the region. It is hard to believe that any country in the European Union, instead of bringing order to and undertaking reforms needed for its economy, would endeavour to face such challenges.

Similar to medical tests performed to aid in the diagnosis of disease, the convergence criteria aid in measuring stability in the euro area: they are economic criteria for any country to strive for building up their economy. Having introduced the single euro currency, many countries in the euro area relaxed and neglected a number of reforms in support of economic sustainability, verifying the awareness of the state of its future income, amount and purpose of expenditure, and spending priorities.

The implications of relaxing are well seen in Ireland, Portugal, Greece and Spain. Instead of taking advantage of the euro changeover as a new reference point for boosting competitiveness, these countries dared to handle essential economic problems with so much laxity and neglect. In fact, economies in these countries had not been truly healthy already prior to the euro changeover, and the economic overheating was artificially reduced to meet the criteria. This vividly shows that the euro changeover alone, if not supported by reforms prior and after it, is not a panacea for maintaining competitiveness of the economy.

Are there any alternatives to budget consolidation and structural reforms? There are records on a variety of attempts, yet the potential of manoeuvring depends on the scope of national economy. Thus, for instance, the US Federal Reserve System  consistently with its monetary policy of quantitative easing injected 600 billion US dollars into the economy and bought long-term government bonds for this amount from the market. Economists refer to this policy as "therapy of last resort". On the backdrop of initial euphoria, it took around one week for the financial markets to realise that without expenditure cuts new capital inflows only enhance instability. The effects of this policy are to be assessed in a longer timeframe, yet at this junction deep concerns rule the markets. Initially such a stance may support avoiding deflation; later, however, inflationary pressures will rebound and the long-term effects may be destructive.

Meanwhile, Germany has proved in practice that well-timed economic adjustment is a guaranty for swift recovery in a crisis situation. In 2010, GDP in Germany is expected to increase even by 3.7% (after a 4.7% drop in 2009). As a result of  historical orientation toward economic sustainability (including collective bargaining about wage freeze in the middle of the 1990s and in 2002, the absence of real estate and lending bubble partly due to it, and timely implementation of structural reforms), the economy in Germany is resilient and business environment steady even in this complex post-crisis situation.  Even though German trade volumes were seriously affected by the crisis, this year the country's export indicators have rebounded to the pre-crisis levels. The so called Mittelständler or medium-sized companies like Kärcher, Faber – Castell, Koenig & Bauer, etc. that produce and export globally recognised innovative output with high value added are still the cornerstone of the German economic competitiveness.

Is it still worth it to strive for the introduction of the euro in Latvia? First, it is not the euro and the euro area we are speaking about. The developments taking place elsewhere in the world notwithstanding, our objectives are to adjust our own economy, to strike a balance between the available financing and the needs of the country, not to live beyond means, and not waste public funding on debt servicing! Second, the Maastricht criteria the EU countries have agreed on capture the economic regularities and in no way are a whim or will of a higher power. A recovery consistently with these criteria will result in a healthy economic structure, provision of goods and services with high value added, and an optimal utilisation of available resources. Third, the euro is not an end in itself for Latvia: it is an essential means for bringing order to its economy and achieving competitiveness within the vast single market of Europe. These are the advantages that many countries have failed to value appropriately. With a view to a healthy domestic economy, it is the people that can take timely adjustment decisions or lead a life expecting for a miracle to happen. In regard to criticism about Estonia's decision to join the euro area, let us compare Latvia's and Estonia's accomplishments in 20 years, and let us be objective in our assessment!

APA: Kravalis, J. (2020, 20. sep.). Virus Therapy or Lessons Learned from the Latest Developments in the Euro Area and US. Taken from https://www.macroeconomics.lv/node/1831
MLA: Kravalis, Juris. "Virus Therapy or Lessons Learned from the Latest Developments in the Euro Area and US" www.macroeconomics.lv. Tīmeklis. 20.09.2020. <https://www.macroeconomics.lv/node/1831>.

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