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ECONOMY-EUROPE: Fear of Mediterranean Contagion Grows

Analysis by Julio Godoy

BERLIN, Feb 17 2010 (IPS) - The deep economic, fiscal, and trade crises of several Mediterranean countries in the euro zone that is threatening monetary stability in Europe with the possibility of contagion spreading to developing countries, say studies.

The economic crisis is affecting Greece, Spain, Portugal, and Italy in the Mediterranean and also Ireland. These countries are members of the European monetary union (EMU) that gave up their national currencies in January 2001 in favour of the euro.

The four Euro-Mediterranean countries are confronting deep recession as a result of the global economic crisis and risky real estate speculation.

Large fiscal and trade deficits have exacerbated the problem. Greece, which has a fiscal deficit of 12.7 percent of the country’s gross national product (GNP) and state debts of 120 percent of the GNP, was forced on Feb. 11 by European Union (EU) to adopt austerity measures.

As a consequence of the Greek crisis, the euro’s exchange rate at the currency markets has been falling steadily since the beginning of the year, from some 1.50 US dollars per euro to 1.35 US dollars per euro today. Compared to its peak exchange rate of July 2008 at some 1.60 US dollars per euro, the devaluation reaches 15 percent.

This devaluation of the euro has confirmed warnings that fiscal crisis in several EMU members would debilitate the euro. The devaluation is also affecting emerging and other developing countries that have strong trade ties with Europe, through deterioration in the competitiveness of exports.

The EU is likely to impose similar austerity programmes upon Portugal and Spain. These countries are also facing extremely high fiscal deficits (eight and 10.1 percent of GNP respectively) and high state debts (84.6 and 66.3 percent of GNP).

Ireland is mired in higher fiscal and state debts and has already launched an austerity programme on its own.

Such austerity programmes could lead to a further squeeze on aggregate demand – already reduced by the global crisis – and to a deepening of recession in the Mediterranean countries, triggering further unemployment, with explosive social consequences.

Even without resorting to austerity programmes, the economies of Greece, Portugal, and Spain are facing a further shrinking of their GNP this year by some three percent.

According to figures released by the Organisation for Economic Cooperation and Development (OECD), Spain is currently facing an unemployment rate of well over 18 percent – the highest in the EU. Eurostat, the EU statistics office, said last summer that Spain’s youth unemployment rate had hit 39.2 percent in August 2009.

Under normal circumstances, countries facing such fiscal and state debt crises could counter the austerity programme’s recessive effects by devaluating their national currencies. A strong devaluation would trigger a boom in exports and a shrinking of imports, thus leading to a surplus in the national current account – that is, to a positive balance of trade in goods and services.

Such a boom in exports would stimulate production, employment, and also improve the fiscal situation of the countries. A good example of such an effect was the sharp devaluation of the Swedish krona and the Finnish markka late 1992, in the aftermath of a wave of currency speculation against the then functioning ecu and its European Exchange Rate Mechanism (ERM), the precursor of the euro.

After having tried to defend their currencies’ foreign value, and maintaining them within the ERM, the Swedish and Finnish central banks let them devaluate. In Sweden, the krona’s exchange rate fell by 25 percent within days. Since then, the Swedish share of exports related to the country’s GNP rose from about 27 percent in 1992 to well over 50 percent today.

It is conventional wisdom among economists that the devaluation of the krona boosted Swedish competitiveness among the export industries – electronics, heavy engineering, cars and trucks, and forestry products.

As a result, the Swedish economy grew strongly throughout the mid and late 1990s until 2008. According to the World Economic Forum 2008 competitiveness index, Sweden ranked then the fourth most competitive country of the world.

As Lars Jonung, a former research adviser for the European Commission and one of Sweden’s most respected economists, put it, in a paper published in 2006, “Once the two countries abandoned the defence of the fixed exchange rate and allowed floating rates in the fall of 1992, the economy’s downward slide was halted. The floating of the currency caused a sharp depreciation of the markka and the krona, which soon revived the export sector.”

The problem for Greece, Portugal, Spain, and Ireland is that they no longer have one national currency to devaluate. An unlikely alternative could be for these countries to leave the euro zone and return to their national currencies.

This proposal was made by a group of conservative German economists on Feb. 11, immediately after the EU promised to financially support Greece’s austerity measures. In the paper, titled ‘The EU applies the axe against the Euro’, the economists urged the European government to respect article 125 of the treaty on the functioning of the EU.

The article in question says that the EU “shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any member state, without prejudice to mutual financial guarantees for the joint execution of a specific project.”

The article goes on: “A member state shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another member state, without prejudice to mutual financial guarantees for the joint execution of a specific project.”

In the paper, the German economists say that the “answer to the Greek debt crisis and to the feared contagion must be, for Greece and for all the other high indebted countries to balance immediately their state budgets, through an austerity programme, and eventually through higher taxes.”

“If the Greek government is not able to implement a sustainable fiscal and financial policy, then, as last option, there is the possibility for Greece of quitting the monetary union,” the economists pointed out.

Otherwise, they added, a rescue package for Greece would be a bad example for the other highly indebted countries, which would see in such a package an easy way out of their crisis and a reward for their fiscal recklessness.

The contagion risk is indeed big. According to the new misery index by the financial ratings agency Moody’s, Spain faces the worst crisis. The compounded dangers of the extreme high fiscal deficit and unemployment make the Spanish economy the most fragile and susceptible to a total collapse in the industrialised world.