How to avoid a eurozone breakup: solve two key problems.

• Author: Koo, Richard C.

It has been said that the eurozone needs a new idea to avoid an eventual breakup. With Irish fiscal consolidation efforts resulting in larger budget deficits, smaller GDE higher bond yields, and more onerous credit default swap spreads, it is obvious that orthodox, single-minded efforts to reduce budget deficits are not the solution to the problem. The fact that the European Union had to offer financial support to Greece instead of collecting fines from the country for going over the 3 percent Maastricht limit on budget deficits also suggests that the current rules are not working.

The eurozone is an artificially created currency zone. In putting this grand scheme together, its founding fathers had to impose conditions on members so they would not take actions that could undermine the credibility of the common currency. In particular, they wanted to make sure that member countries would not run profligate fiscal policies by taking advantage of the ease in attracting foreign funds in a single currency arrangement. This concern led to the limit on budget deficits of 3 percent of GDP. Recent events in Greece and Ireland, however, have proven that this limit not only failed to prevent problems from happening, but is also making the situation worse for many countries. As a result, the European Central Bank and European Union are now forced to fight economic fires in one country after another, week after week, and talk of eventual breakup is growing louder by the day. Is there a way out of this mess?

Yes, if we go back to the basics. Actually two separate problems must be solved, only one of which was anticipated by the founding fathers. In the current crisis and contagion, the two problems are intertwined to the point where the solution must address both problems together.

The problem that was anticipated was the problem of profligate fiscal policy financed by foreigners. This is the problem Greece has created for itself.

The problem that was not anticipated was the problem of fighting balance-sheet recessions triggered by massive private sector deleveraging following the bursting of debt-financed bubbles. This is the problem Ireland and Spain are facing now, together with the United States and the United Kingdom. During this type of recession, the collapse in asset prices forces the private sector to minimize liabilities in order to repair its battered balance sheets. That makes monetary policy largely powerless, because those with balance sheets underwater are not interested in increasing borrowing at any interest rate, and not many will want to lend, either, especially when the lenders themselves have balance-sheet problems.

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