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Euro under pressure

Nicole MacAdam/Globe and Mail

As far as big, stupid housing projects go, Residencial Francisco Hernando is hard to beat.

Located in the bleak flatlands in Sesena, a semi-industrial suburb some 35 kilometres south of Madrid, the development is a monument to construction gone mad. Close to a dozen enormous apartment blocks, each containing 300 units, sit fully built but entirely empty, their green shutters drawn.

There is no sign of life anywhere - not a tree, not a blade of grass - save a bored security guard, Angel Fernandez, fiddling with the radio in his yellow Jeep. "It's all empty," he said. "With the crisis, people don't buy."

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About half a kilometre away, another housing development surrounded by nothing is using low prices to lure customers. New apartments can be rented for €450 ($630) a month. Alberto Ordonez, an industrial painter, bought a big place there a few months ago for €163,000. He had to trade down because full-time work has proved elusive for two years. "I live here because it's not expensive," he said.

Sesena and the hapless Mr. Ordonez represent everything that's wrong with the Spanish economy - a collapsed housing market, a persistent recession, an unemployment rate of almost 20 per cent, the European Union's highest.

But Spain is not just the dark symbol of the burst housing bubble. It, along with Greece, Portugal, Ireland, and to a lesser extent Italy, also represent the economic and political risk associated with the euro, the common currency of 16 of the 27 EU countries.

The euro, introduced 11 years ago as drachmas, liras, francs, pesetas and deutschmarks were tossed overboard, initially proved a godsend to the EU countries - mostly the small ones - weary of the endless devaluations, exchange-rate risk and high interest rates associated with fringe currencies in perennially struggling economies. Economic growth rates rose smartly, disguising the inner rot in the same way a freshly painted old car belies its clunky engine.

The rot came from reckless spending, fuelled by the low interest rates that came with the euro. The open-chequebook approach for housing, infrastructure, wages, Olympic games, defence, social safety nets and other areas sent national debt and budget-deficit levels of the weaker, undisciplined countries through the roof.

At least one of them - Greece - is now in danger of defaulting on its sovereign debt and may yet require a bailout from its EU colleagues or the International Monetary Fund. The need to rescue Greece, and possibly other struggling members of the union, poses the most critical test faced by Europe since the creation of a single currency more than a decade ago.

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"This is a major challenge, and it's something that the EU has to work through," said Amy Verdun, co-author of a new book on the euro zone, Ruling Europe: The Politics of the Stability and Growth Pact , being published this month, and chair of political science at University of Victoria. "It's not Greece as such, but what Greece stands for."

If Greece is left to go bankrupt, does it mean the euro area cannot look after its member states? And conversely, if it's bailed out, does that mean the detailed rules set up to protect the euro area "are just in vain and there is no responsibility for governments to live up to their commitments?"

Few economists and politicians predict the demise of the euro, which in turn would rip the heart out of the EU. But there is no doubt the currency union is under is first serious threat as the economies of the PIGS - Portugal, Ireland, Greece, Spain - unravel, exposing both the EU's soft underbelly and the flaws in the one-currency-fits-all design.

The euro is an odd beast. It is a common currency in a common market without political and fiscal union. Countries retain control over their national accounts even though they face EU-mandated constraints, notably the rule - widely ignored - that budget deficits not exceed 3 per cent of gross domestic product (GDP).

In other words, EU countries can live beyond their means and not suffer the ultimate penalty - ejection from the currency. But how long might that luxury last? "The historical fact [is]that no monetary union has survived without fiscal union," Russell Jones, a strategist with Royal Bank of Canada's investment arm in London, said in a recent note.

When the euro zone was launched with great fanfare, such vocal critics as famed U.S. monetarist Milton Friedman voiced many of these concerns. How, they wondered, could a single currency possibly work, when all the governments maintained their own separate fiscal policies and when there were such huge economic disparities between the wealthier power centres and the small, weaker countries on the periphery?

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But the idea of the euro was compelling for economic, political and investment reasons. The single currency would be the cornerstone of a vast, new common market of 500 million consumers, giving it enough clout to compete with the United States. Foreign investors, from Canadian pension funds keen on infrastructure plays to Japanese car makers, would find the market irresistible.

Integrated economies would be less likely to invade one another, for the simple reason that it makes no sense to start a war in a country that buys your products and services. The currency, coupled with the reduction of tariffs and other trade barriers, would stimulate pan-European competition, giving poor countries like Greece and Portugal the opportunity to modernize their economies and raise their standards of living.

Much of this dream scenario became reality. But much did not. The euro raised costs and inflation rates in many of the small countries, making them less competitive against powerhouses like Germany and France. Fiscal discipline was largely absent in these same countries, pushing deficits into dangerous territory.

As long as growth was strong, governments could ignore these faults. Thanks to a long period of benign economic and financial conditions, a strong dose of fiscal discipline swallowed by most of the member nations and the cost-cutting benefits of globalization, the euro soon won entrance into the exclusive club of the world's most-trusted currencies.

Then the financial crisis and recession came and the downside of the euro suddenly became apparent. Costs were wildly out of control and devaluations could not come to the rescue. The boom turned into a bust virtually overnight. The financial monster created by the subprime mortgage market in the United States had stomped over to Europe and ultimately clamped the euro zone in its jaws.

RBC's Mr. Jones won't go so far as to predict the end of the euro. But others will. One is Nouriel Roubini, "Doctor Doom" himself, the New York University professor who predicted the 2008 financial crisis. "The euro zone could drift essentially with bifurcation, with a strong centre and a weaker periphery and eventually some countries might exit the monetary union," he said in a recent Bloomberg Radio interview.

Another skeptic is Paul Krugman, Nobel laureate economist and New York Times columnist. He has predicted years of pain ahead as the common currency drags down uncompetitive countries.

Even those who believe the euro's demise is unthinkable and unwise agree that the currency faces a rough ride unless the member countries even out their economies and become more transparent about their financial health.

Germany, Europe's export machine, would have to raise domestic consumption; the PIGS would have to spend less. Labour costs and flexibility would have to converge. Policing of national accounts would have to become tougher to prevent countries from fudging their deficit figures, as Greece did for years. Some sort of standby bailout package would have to be put in place to rescue the countries hit hardest by a financial crisis.

The worst may - just may - be over for Greece, whose spending clampdown was applauded this week by the European Central Bank. On Thursday, the day after the cutbacks, which included pension freezes and cuts to bonuses for civil servants, were announced, Greece saw strong demand for its €5-billion bond issue (though the debt had to offer a hefty 6.25-per-cent interest rate to attract buyers).

Jean-Claude Trichet, the central bank's president, was quick to praise the handling of the Greek crisis as a demonstration of the success of the euro zone, not the opposite. Some economists were equally quick to disagree. The euro zone "still needs to demonstrate that it can enforce fiscal discipline while generating strong and sustainable growth," said Marco Annunziata, economist in London with Italy's UniCredit bank.

Spain showed no fiscal discipline and is in grave danger of showing no strong and sustainable growth. Its progress, or lack thereof, is being watched closely by Brussels, central bankers and investors. Spain's economy is at least five times bigger than Greece's. If Greece implodes and pulls out of, or gets turfed from, the euro, the EU and the common currency might just survive. If Spain goes under, all bets are off.

The Spanish economy has suffered from relatively high unemployment and inflation rates, and has lurched from one industrial crisis to another, for decades. In the 1980s it cleaned up its heavy industries, like shipbuilding, and went big into tourism, turning its Mediterranean coast into a playground for sun-starved northern Europeans. Growth accelerated, but the best was yet to come.

The real party began when Spain joined the euro club in 1999. Interest rates, which historically had been in the mid-teens, plunged. Cheap and easy credit flowed into the economy and Spain went on an epic spending spree, dominated by real estate. At one point in the middle of the last decade, construction spending represented 16 per cent of GDP - two to three times its normal level - and 12 per cent of employment. Speculative projects like those in Sesena were thrown up like tents.

The housing boom - propelled by tax rules that allowed owners to deduct both interest and mortgage payments - allowed Spain to create fully half of all EU jobs in the first half of the decade. Spain sucked in capital from the rest of Europe to finance the breakneck growth in general, and the building bonanza in particular, swelling the country's current account deficit to a fat 10 per cent in 2007 (the figure refers to the difference between the payments Spain received for selling exports and the payments made to purchase imports).

"In 2006, Spain built more homes than France, Italy and Germany combined," said Angel Estrada Garcia, director-general of macroeconomic analysis for Spain's economy and finance ministry.

Spain's finances, meanwhile, began to deteriorate even as growth barrelled ahead. Spending on endless infrastructure projects proved costly. Wages soared, driven by agreements that gave workers covered by collective bargaining agreements pay increases that matched or exceeded the inflation rate. In 2008, the crash year, wages went up 3.9 per cent. By last year, the budget deficit had reached 11.4 per cent of GDP - nearly Greek levels. "Now it's payback time," said Jose Manuel Amor Alameda, a partner at AFI, an independent economic and financial consulting firm in Madrid.

The financial crisis ended the housing boom overnight. Since 2008, a million Spanish workers have lost their jobs, nearly half of them in construction. Spain was slow to grasp the severity of its problems, economists said. The Greek debt crisis changed that in a hurry. Investors dumped the bonds of any EU country with shaky finances, including Portugal and Spain. Spanish bond prices plummeted, sending the interest yield in the opposite direction. "What scared us was the reaction in the debt markets," the finance ministry's Mr. Estrada said.

Fearful of being labelled the next Greece, the socialist government of Prime Minister Jose Luis Rodriquez Zapatero is suddenly in a hurry to clean up Spain's financial act, knowing it cannot rely on currency devaluations to make the economy more competitive. Consumption taxes are rising, the tax-driven housing incentives are disappearing and only one in 10 retiring civil servants will be replaced.

An Investor's Guide to Understanding the Economy:

  • Part 1: How the money in the economy is managed
  • Part 2: How inflation works
  • Part 3: Avoiding the deflationary spiral
  • Part 4: How much money is too much money?
  • Part 5: How markets and currencies work
  • Part 6: How interest rates affect your investments

But the cutbacks may not be enough. Gayle Allard, economics professor and labour expert at Madrid's IE Business School, said "there is no plan for labour reform," suggesting that unemployment rates will remain high because of the lack of job flexibility. AFI's Mr. Amor said the government's recovery plan depends in good part on economic growth forecasts he considers "overly optimistic." He also expects a massive restructuring of the dozens of smaller banks that had pinned their fortunes on an endlessly rising housing market and now face years of zero to low growth.

Will the pain get so intense that Spain will ditch the euro? It's not even under contemplation, according to Mr. Amor, Mr. Estrada and most European economists. But Spain, Mr. Estrada said, will require "discipline" to get its deficits down. So will Greece, Portugal and the other EU debt miscreants, a process that could take many years and possible trigger social turmoil, as it already has in Greece. "The jury is still out, and the euro zone is not out of the woods yet," said Mr. Annunziata, the UniCredit economist.

With files from Brian Milner in Toronto

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