Carlin Financial

 Depending on the day, the Eu­ropean Monetary Union is either heading for a cataclysmic break up or crafting a grand solution to its contagious sovereign debt crisis. This scrum started nearly two years ago when Greece disclosed a budget situation much more dire than previ­ously admitted. At the time we noted that this was but “the first major call­ing of a question at the heart of the EMU project: How does a common currency handle very divergent fiscal stresses among member countries?”

The rolling crisis has continued to illuminate certain genetic flaws in the common currency scheme. For starters, there is no real lender of last resort positioned to stop a sustained run on the financial and payments system itself. European banks are primarily governed by and closely associated with their respective home governments. Yet their key role in commercial lending and their signifi­cant holdings in cross-country, euro-denominated debt create systemic risk across the continent.

Although today’s biggest con­cerns are focused on the likes of Greece, Portugal, Spain, and Italy, it was France and Germany who first violated the fiscal guidelines in the Stability and Growth Pact under which the currency union was launched in the 1990s. The EU Com­mission has not been inclined, then or now, to impose censure and/or sanctions on members of the club.

The EMU has sometimes been characterized as a “United States of Europe,” with some of its more fis­cally impaired countries compared to states with high profile budget and debt challenges (e.g., Califor­nia, New Jersey, Illinois, et al). But there are key differences. In the U.S. the federal government can tax the residents of all states and borrow on their full faith and credit. Many states are precluded from sustained deficit spending by their respective constitutions. Perhaps most importantly, in a fully integrated national economy with a common language, American taxpayers and businesses can much more easily abandon a state whose fiscal profligacy leads to onerous levels of taxation or an unacceptable decline in public services.

At this writing the euro zone’s largest players are struggling to pull together a consensus plan that can overcome its genetic defects while respecting the sovereignty of member countries. All eyes are on Germany, justifiably proud of its global com­petitiveness due in part to its own painful labor and economic reforms of a decade ago. But as it touts the virtues of reform and fiscal rectitude, Germany knows that its economy draws heavily on the viability of its euro zone neighbors. Pressing for a level of austerity that ends up tanking the region’s growth prospects would be a Pyrrhic victory indeed. That’s the circle they hope to square.