THE E.U. CHEAP CREDIT BUBBLE, now popping before our very eyes.

THE E.U. CHEAP CREDIT BUBBLE, now popping before our very eyes.

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The State Of The European Monetary Union

By Thomas Mayer, on December 14th, 2011

[This article was originally published by Deutsche Bank Group. It explores likely outcomes of the EMU.— Ed.]

Summary

Although failing to meet the criteria for an optimal currency union EMU worked fairly smoothly during the first decade of its existence. In our view the reason for this was cheap credit, which substituted for fiscal transfers to economically weaker countries.

With the disappearance of cheap credit EMU 1.0 lacked an essential element compensating for its deficiencies as an optimal currency area. In principle, cheap credit from the markets could be replaced by government transfers from stronger to weaker EMU countries or ample central bank credit. However, we would consider a “transfer union” or an “inflation union” not as stable states of EMU.

This leaves in our view only two options for EMU 2.0: A hardening of EMU or a redrawing of the boundaries of EMU such that only countries meeting the real economy criteria for a currency union are members.

We expect EU governments and institution to do everything possible to retain an EMU with a large group of countries. This requires credible and irreversible adjustment in the countries in financial difficulties and an improved economic governance structure in EMU. Most likely, it also requires start-up funding from the EU level, including from the ECB as other facilities (e.g. IMF and EFSF) lack the necessary financial fire-power.