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Euro-zoned Out

By / 2.11.2010

Things in Europe are looking grimmer than my chances of getting a taxi in blizzard-slammed New York City.

Today’s announcement that Germany and France are going to provide financial aid to Greece — with stringent IMF oversight — caps off weeks of speculation that the EU would have to bail out the Hellenic Republic. The newly elected left-wing government in Greece has come clean with what the previous conservative government had been hiding — Greece’s budget deficit for last year was a whopping almost 14 percent of GDP, and this year’s is looking not better. The new government, in a bid to reassure the markets — and the other members of the Eurozone that have all sworn to adhere to the deficit limits of the founding Maastricht Treaty — has promised to get government deficits down to three percent of GDP by 2012. Seeing the coming of severe austerity measures in the wake of what wags have been desperately trying to tag the “ouzo crisis,” Greek civil servants have unsurprisingly gone on strike.

The news is no better outside the Eurozone, where, to take the most latest example, Latvia is putting up numbers that are even grimmer. The Latvian economy shrank by 18 percent the past year, and it’s not likely to rebound anytime soon. (To put that in perspective, U.S. GDP fell by 30 percent over four years at the start of the Great Depression.) Latvia has pegged its currency, the Lat, to the Euro through the Exchange Rate Mechanism (ERM), in hopes of joining the Eurozone like Slovakia did last year, and like its neighbor to the north, Estonia, might do as soon as this July. The Baltic countries want to join the Euro, as adopting a strong currency is a surefire way to control inflation and make it easier for the government to borrow on the international markets (this is why several small economies have unilaterally adopted the Euro or the U.S. Dollar as their currency).

These two cases are emblematic of the issues facing several European countries. Greece has been lumped in with Portugal, Italy, and Spain to form the “PIGS,” southern Europe’s sluggish economies (Ireland is occasionally added to the group as a second “I”: “PIIGS”). Latvia’s problems are similar to those seen all over Eastern Europe, with Lithuania, Poland, the Czech Republic, and Hungary all facing similar — if less dire — straits. But while it looks difficult all over the EU, if I were a small business owner (or finance minister), I’d rather be in Latvia than in Greece.

Why? Because it could be a lot easier for Latvia to get out of its situation than Greece’s. Latvia has been facing a choice: aim for the Eurozone or faster recovery. While the benefits of a small country joining the monetary union make sense over the long term, when faced with a recession a currency devaluation might make more sense. This would immediately make domestic products — now cheaper to make — more competitive, stoking exports and, with them, job and GDP growth. Leaving the ERM would postpone joining the Euro for several years, which could make inflation a problem, but other countries, notably the UK, have been forced to leave the ERM before, and in the UK’s case it helped fuel a strong decade of growth in the 1990s.

The alternative to devaluation is deflation, a painful process where you ratchet down the prices of everything in your economy, from raw materials to salaries, to the point where they become competitive. This is the prospect that Greece is facing. In the Eurozone, Greece cannot lower it’s exchange rate against the markets it exports to — they all use the Euro. Devaluation also makes local currency-denominated debt much easier to pay. And this is where Greece is also getting hammered. As it looks increasingly unlikely to be able to pay its obligations, the yield on Greek debt has jumped. Greek debt is trading for less in the secondary market because investors are less sure that the government will be able to meet it’s obligations. As Greek banks hold significant amounts of Greek government debt, they are teetering on the edge of bankruptcy.

In the end, why should these issues in Europe be a concern to the U.S.? Surely problems in Athens will have limited impact on the largest economy in the world. Well, it’s worth remembering that the bankrupcty of Creditanstalt in Austria following the crash of 1929 was one of the sparks that turned a recession into the Great Depression.