"With yields on Spanish and Italian 10 year government debt now above 6% this is now the moment of truth for the Euro. Neither the Spanish nor the Italian economies can sustain these rates of interest and their economies are too big to be "rescued" by bail-out funds.
"If, like in the UK, the Spanish and Italians had their own currency, it would devalue boosting short-term competitiveness and economic growth. Their central banks would also be able to erode the value of debt through printing more money via quantitative easing in the same way as the Bank of England has done in the UK. Their membership of the single currency currently precludes this.
"The strict monetary policy of the European Central Bank and the strength of the Euro reflects the robust economic growth in Germany, the Euro-zone's largest economy. The only way for the Spanish and Italian economies to cope with being shoehorned into Germany's monetary policy would be if it were accompanied by fiscal stimulus. As their solvency is already being questioned, this stimulus must come from an external source, the most obvious being Germany.
"The folly of a currency union without large scale fiscal transfers has been known ever since the single currency was conceived. Events of the last few months suggest that financial markets are no longer prepared to tolerate this illogic indefinitely. To survive in its current form the Euro-zone must evolve into a transfer union where the taxpayers of the booming economies subsidise those that are struggling. This will be a tough sell for politicians, particularly in Germany, where electorates have little sympathy for their profligate Southern European neighbours.
"If it turns out that the German electorate has no stomach for fiscal union then the German government should accept the logic that their continued membership of the single currency is destabilizing for many of its other members. If Germany left the Euro, the value of the Euro would fall, providing a short-term boost to its remaining members and monetary policy set to provide appropriate stimulus. At the same time, the value of the new German currency would appreciate, providing a boost to German consumers.
"For the periphery, leaving the Euro is not an option. Their governments and their banks would still owe Euros, but would own something less valuable. Germany leaving is the only way in which the single currency can be broken up without it causing a second banking crisis, or a sovereign default. Germany must show political leadership now or face responsibility for the consequences."
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