Will the Eurozone survive?

                                                              di Andrea Fasolini


Part I
 

During the last European campaign, we discussed much about the Union, and not enough about the Euro. Despite the results, which confirm the PPE and the PES as the main parties of the European parliament, the Euro’s problems are far to be solved. 

Thanks to the relatively low interest rates and to the global economic recovery, everyone in Europe seems forgetting about the 2011 financial crisis that involved the Eurozone. 

Unfortunately, the euro is still a huge problem for the recovery of the European economy and for the world trade in general. Let us try to understand why. A currency is nothing too different from a common consumption good: it has a price, which is driven by the law of demand and supply. So, if you want to buy American goods, for example, you have to buy dollars, in exchange for euros. In this case, you are demanding dollars and offering euros.

If many people acted like you, the price of the dollars would rise (demand exceeds supply). Simply, you will need more euros to buy the same amount of dollars. This process is called appreciation. The reversal process is the depreciation. 

These mechanisms are essential to preserve an economic equilibrium between different countries.   

In fact, if we bought too many goods and services from the USA, we would buy less in Italy and our unemployment rate would rise. A flexible exchange rate is crucial in the modern economy for another reason. When different countries have heterogeneous growth rates, their inflation grows differently. 

Inflation is an increase of costs. Let us see what happen with a fixed exchange rate.

Image two countries: country A and country B. Those countries are identical: same institutions, history, economy etc. In some moment, country A starts to grow faster thanks to rich oil reserves just discovered. While country B, grows at the same rate.

 

Let us assume that the inflation gap is only 0.7. Since the inflation growth is calculated by this formula Pt-1(1+It), after 15 years the inflation gap would be of 10%. If you take a look at the graph, you can easily see the gap between the two countries. 

This gap is completely due to a different growth rate. 

Basically, after 15 years the product prices of country A are 10% higher than the ones of country B. 

The effect? Everybody will buy less goods and services fabricated in country A. This is what happen with a fixed exchange rate. Let us assume that county A decided to depreciate its currency in order to way out of this problem. 

As you can see, thanks to the depreciation, its costs are now equal to those of country B.

 

Depreciations are common in the world. Except made for The Eurozone. 

Basically, the Euro is a fixed exchange rateDuring the last decade, countries, such as Greece and Spain, have grown faster than country such as Germany. 

Growing rapidly, those countries have created more inflation than the others. The graph well explained the results. Greek’s costs are now almost 50% higher than German’s ones. What are the implications? We will discuss about that in the next paper.