Eurozone’s self-fulling cycle to nowhere

Below is a flow chart which explains the problem that indebted eurozone countries have in trying to improve their fiscal position – it becomes a self-fulfilling cycle. Higher interest rates are needed to attract investors but this puts more pressure on government fiscal stability which leads to greater unease amongst investors.

Although investors focused on small countries like Ireland and Portugal, Italy and Spain were experiencing significant problems with regard to fiscal discipline. These two economies are among the biggest in the eurozone and a default by one of them will have serious consequences – Spanish and Italian government debt is held worldwide. However the belief that the crisis was initiated by fiscal neglect is not totally correct. Before the financial crisis of 2008/09 Italy’s debt had been falling as proportion of GDP. Furthermore Ireland and Spain were being used as model countries with their low debt and low government deficits.

Problems of one currency in getting out of the mess
With all Eurozone countries sharing the same currency (the Euro) one of the main instruments in the pre-eurozone environment has become invalid. When a country has their own currency imbalances such as differing labour costs between countries would be offset by a typical revaluation of their respective currencies. In pre-eurozone, if there was a rise in labour costs in Italy this would lead to a fall in the Italian currency (the Lira) and thereby restoring some of Italy’s lost competitiveness against other trading nations. However under the euro these balances cannot be corrected by currency revaluation. Therefore the result for Italy is that the euro is too strong (strong currency makes exports less competitive) and too weak for exporting countries like Germany. Therefore, strong increases in the unit labour costs of the peripheral European nations have left them burdened with significant competitive disadvantages.

What does this mean for New Zealand? 

European policymakers will do enough to avert disorderly financial disruption – though it could be that only a dramatic turn for the worse prompts decisive rather than 
incremental action.  So what are the implications for New Zealand?

– The likelihood is we will have another year of volatility in global financial markets. 
– ‘What if’ risks to the downside will linger, so scenario planning may be beneficial for  businesses. 
– The crisis emphasises that New Zealand needs to work hard to integrate into Asia and 
focus strongly on the trade opportunities there. 

Source: ASB Bank

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