Global Financial Challenges: The Real Issues In Europe

By M. Isi Eromosele

The well publicized financial troubles of the Eurozone are merely a microcosm of the rest of the world. Thus to consider a resolution to Europe’s problems, it should be treated as a global problem that is not the fault of any single party but where there is a prevailing understanding further fiscal instability brings with it an increasing risk over time.

A major contributory factor to the heightened volatility of capital flows internationally in recent years has been the build up globally of current account imbalances - primarily driven by countries’ balance of trade deficits.

The existence of a single nation’s currency acting as the reserve currency in addition to the existence of exchange rates of various countries of increasing global importance that are not fully flexible are the key factors in perpetuating these imbalances.

Non-floating exchange rates are at the heart of the problem since the ‘deficit’ nations tend to have floating currencies whilst the ‘surplus’ nations tend to have fixed or quasi-fixed exchange rates. This prevents market forces doing their work properly as the currencies of the former group should fall in value whilst the latter group’s rise.

This would cause a rebalance of trade such that both surpluses and deficits narrow. Unfortunately, many emerging economies are pursuing policies domestically to suppress their currency to the detriment of global stability. Their artificially rapid accumulation of foreign currency reserves thus ‘forces’ the U.S. to shoulder increasing current account deficits.

Its status as the owner of the world’s reserve currency enables the U.S. to continue on this path for longer than others can but as the debtor nations in the Eurozone are currently finding out, ultimately these things come home to roost and sooner or later (probably later), the US Dollar will lose its luster.

China is the dominant holder of U.S. Dollar assets and in the absence of real change this will only increase to the point where it potentially has a quasi-veto over US economic policy. Already, China has chided the US over ‘weak dollar’ policies such as quantitative easing that inflict paper losses on China’s U.S. Dollar assets even though their own suppression of the Yuan essentially demands such policies.

The increasing size of emerging economies is the primary reason for the accelerated increase in FX reserves and plans need to be formulated to address this as a matter of urgency.

The countries with large deficits are being pressured by the so-called ‘bond market vigilantes’ to tackle them through increased taxation and reduced public expenditure. In the absence of a boost in exports or very flexible monetary policies, these are the perfect ingredients for a full-blown depression.

The European Central Bank is still ideologically constrained by the German Bundesbank’s hyper-inflation ghost of the 1920s which prevents them from replicating the dramatic interventionist actions of the Federal Reserve in the US and the Bank of England in the UK. Regrettably, this suggests that significant falls in wages are the only remedy though it is one that could easily ‘kill’ the patient so this isn’t really the desired course.

Strong economic growth, not driven by increased leverage, would be the best solution all round but this seems unlikely. With developed market consumers generally increasing savings rates and governments under pressure to reduce borrowing, this is simply rather difficult without a dramatic change in domestic policy in China and elsewhere in emerging economies.

One not widely discussed approach that could help those countries not in quite such a terrible state as Greece would be a clever approach to taxation. If Eurozone members cannot benefit from a depreciating currency to boost exports and reduce imports, and large drops in wages are undesirable, then there is an unconventional third way.

What is needed is something, other than a currency move, that makes a country more competitive and should improve their trade balance. One way to achieve this would be to lower business costs by slashing payroll taxes, which would make exports more competitive. To replenish the lost taxes, VAT is significantly increased. Domestic producers could use the lower costs to cushion the VAT rise whilst imported goods would see no benefit from payroll tax cuts but would be hit by the VAT rise.

Without such measures, it seems that the only viable plan involves some kind of debt restructuring including extension of principal, lower interest costs and/or reduction of principal. Italy is the biggest problem but also potentially the easier solution as their issue is one more inspired by liquidity than solvency.

For the time being, many of the government bond auctions look only to be possible with the buying support of the European Central Bank. There are some that take comfort from this and it is indeed preferable to the alternative of failed bond auctions.

However, until the Eurozone can stand on its own and its nations can fund themselves in the usual manner, the area remain firmly in the danger zone where the situation can escalate at short notice. While that remains the case, one needs to be mindful that any further unexpected stresses could be the final straw for the Eurozone.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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