Eastern crisis that could wreck the eurozone

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By Wolfgang Münchau

Published: February 22 2009 19:48 | Last updated: February 22 2009 19:48

The crisis started in the US, but Europe is where it might turn into catastrophe.

A senior policymaker told me last week that the present situation reminded him of the 1992 crisis of Europe's exchange rate mechanism, when one country after another became subject to speculative attacks – leading to the expulsion of the UK and Italy from the system. In a monetary union, you can no longer bet on exchange rates. But thanks to credit default swaps, you can place convenient bets on the break-up of the eurozone. Last week, speculators bet on an Irish default, and these bets make it more expensive for Ireland to refinance its debt, thus threatening to turn into a self-fulfilling prophecy.(MP: Milton Friedman rikal, ze se Eurozona rozpadne do roku 2013, mozna to je verozvest. Myslim, ze kvuli Irsku se nikdy nerozpadne, ale jakmile se zhorsi situace v Italii (jih/sever) nebo v Nemecku(vychod/zapad), popripade v bidnem Recku, svet se muze zmenit. Euro ma na(ne)stesti obrovskou politickou podporu).

But Ireland is not the biggest danger for the eurozone. If the country goes down, the eurozone will bail it out. Even the Germans accept this now. A far more imminent danger lurks in central and eastern Europe. The possibility of a financial collapse there is the most urgent policy issue the European Union must confront at this point. If mishandled, it could bring down the eurozone.

The crisis has hit central and eastern Europeans so disproportionately hard because of two policy errors by their governments. The first was to encourage households to obtain mortgages in foreign currencies. In Hungary, almost every mortgage is a foreign currency mortgage, mostly denominated in Swiss francs. The choice of Swiss francs is plainly ludicrous – testimony to economic illiteracy. I could just about understand foreign currency borrowings in euros, since Hungary will eventually join the eurozone. But Hungary will presumably not join the Swiss Federation. The money that Hungarian households saved on cheap Swiss interest rates has been more than wiped out by the rise in the Swiss franc.

The second policy error is directly related to the first. The new EU members treated eurozone membership as a voluntary policy choice. This is a misinterpretation of their own accession treaties. When they signed up to EU membership, they signed up to the euro as well.

Only the UK and Denmark have a legal opt-out. Of course, as newly industrialised economies, they were not under an obligation to join immediately, but they were under an obligation to conduct policies consistent with eventual membership. If they had pursued such policies, they would almost all be members by now. Slovenia and Slovakia have demonstrated that, given the right policies, it was possible to enter the eurozone early on. Both these countries are now safe. (MP: Really? And for how long? Daji se najit studie, ktere rikaji, ze: The macroeconomic situationsin Hungary, Iceland, or Belgium have shown that countries and their financial markets have been suffering from crisis no matter whether they are a member of the Euro zone or not: http://www.cnb.cz/m2export/sites/www.cnb.cz/en/public/media_service/conferences/speeches/download/tomsik_20081125_new_issues.pdf ..plati to stale?)

For the others, the decision to procrastinate turned out to be a financial stability disaster. If confronted with a crisis such as this, you do not want to be a small open economy, on the fringes of the eurozone, with an irrelevant currency and lots of Swiss franc mortgages.

But the central and eastern Europeans got one thing right. They made sure their banks were owned by foreigners. Austrian banks are among the most active. Their exposure to eastern Europe is about 80 per cent of Austria's gross domestic product. If Hungarian households default, it is not Hungary that will go down, but Austria (MP: !!!. Snad nas nasi rakousti bratri nenechaji padnout. At zije Rakousko-Uhersko)

Italy and Sweden are also exposed. A central and east European crisis is therefore a systemic event for the eurozone as well. One should not therefore treat this as someone else's problem – because it is not.

What are the policy options? Naturally, the EU could provide financial help – through the International Monetary Fund – but it is not clear that this would stop a contagious balance-of-payments crisis in the region. If exchange rates were to drop further, household defaults could rise dramatically. Would we bail out those households as well?

In my view, the smartest answer to the prospect of meltdown is the adoption of the euro as quickly as possible. There is no need to switch over tomorrow. All we need tomorrow is a credible and firm accession strategy – one for each country – which would include a firm membership date and a conversion rate, backed up by credible policies.(MP: Nedovedu si predstavit, ze bychom ted vstoupili do ERM II, o Maastrichtu si letos taky muzeme zdat. Jak rikal Singer: Nebyl-li duvod vstoupit v minulych letech, neni duvod vstoupit ani ted. Navic buhvi, co bude s eurozonou, kdyz uz tam neplati zadna pravidla)

Obviously, this would require the long overdue abandonment of the eurozone's defunct entry criteria. Of those, the most nonsensical is the reference rate for inflation, calculated as the average of the lowest three national rates. Soon, this will be a deflation rate (MP: Myslim, ze se myli, pocitaji se jen nedeflacni zeme). So an aspiring member state would be in the absurd position of having to deflate as a precondition for euro entry.

The inflation criterion is not only insane, it is also in conflict with other parts of European law. Since price stability counts as an important overriding goal of EU economic policy, enforcing a deflation criterion would be a clear breach of this objective. The same goes for the exchange rate criterion. Forcing a country into a two-year sentence of membership of the exchange rate mechanism – in which its currency would fluctuate against the euro in a fixed band – is an open invitation to speculators and would risk further instability. The accession criteria are inconsistent with basic stability rules. They should be declared invalid and certainly not be abused as a bureaucratic hurdle to prevaricate in a dangerous crisis.

If calamity strikes, the EU will pay up. This is laudable, but will probably not solve the problem, especially if the crisis spreads. Granting financial aid without a firm commitment to euro membership would be irresponsible. Euroisation is the way to go.

Z clanku je trosku poznat, ze to pise Nemec. Spis nez Euro nam pomuze, kdyz si Nemci udelaji doma poradek a zacnou kupovat "nase" skodovky. Nejaky rozumny clanek o realne situaci v Cesku ve FT by taky nebyl od veci.