The one-size fits all problem in the EMU

Europe represents a well integrated trading zone. While there are language and regulatory barriers across the EMU countries, most of their trade is intra-regional. Having a single currency makes sense. Having a single regulatory body to codify rules and standards in the region makes sense. Having a one-size-fits-all system during a fiscal crisis is a problem.

There is a EMU fiscal problem and it is affecting the EUR. Greece is on the brink of a fiscal crisis which they cannot solve through creating inflation. Default is one of the few options. If course, it would be in the form of a restructuring of payments. Given they have lost one degree of freedom through not being able to control their money supply, they will have to either increase taxes or cut significantly expenditures. Fiscal crises do not just occur at extreme debt to GDP levels. Most actually occur at levels of less than 60%.

The impact of fiscal problems in Greece will spillover to all EMU capital markets. Note that earlier this month the EUR was declining while many emerging markets were seeing currency appreciation. We have been watching CDS spreads but they have been giving mixed signals. What is clear is that more investors have concerns that the EMU is riskier that 3 months ago. There may not be a bail-out, but the greater fear is that ECB will react to this problem. The reaction will not come as direct support but a slower response to overall EMU growth. Rates will stay low and there will higher potential for inflation in other parts of the EU. This will be EUR negative.

At the very least, markets abhor uncertainty. There is now more uncertainty on the potential policy reaction regardless of what policy-makers may say. There certainly is a renewed interest in sovereign risk. The markets should not be surprised that with aggressive fiscal deficit policies sovereign risk would increase. During the height of the credit crisis the focus was only on stimulus and not on how all of this stimulus would be financed. Now the focus of markets has changed to ask questions on how deficits will be sustained.