It?s become imperative for a management student not only to understand global events but also think ahead and analytically weigh various possibilities as they form the economic environment in which her business functions. Let?s take possible ways out of the euro crisis, and repercussions on Indian economy. Europe is caught between the devil and the deep blue sea. If stringent austerity measures are forced, European countries will get deeper into recession, causing bigger unemployment and even riots. If allowed to undertake expansionary policies to stimulate their economies, the already bad debt-to-GDP ratios will get worse. And, under a common central bank, different monetary policies for different countries are not possible.
It?s not the time to ponder over whether common currency was a good idea in the first place, but it?s time to think about ways to save the euro with minimal adverse effects. Before that, let?s consider the suggested break-up of the euro. The minute euro breaks up and the 17 countries go back to their own currencies and central banks, we shall see all of them devaluing to reduce the debt burden, but thereby nullifying each other?s currency advantage. We will see a currency war within Europe, which will bring things back to square one, and the currency break-up will lose its advantage. Besides, all of them would adopt expansionary monetary policies to repay the debt, which will spike up prices.
In order to save the euro, a couple of countries may be allowed to default, which will force several banks to take a big beating, or even go under. Another option is to let a couple of countries go on ?euro holiday?, meaning thereby they leave the euro for a stipulated period of time, have their own currencies and central banks, devalue, liberalise and stimulate their economies out of recession and then adopt stringent austerity measures to eventually meet the requirements to join the euro back again.
Another interesting option suggested is seigniorage: printing currency to cover deficits. Since the need of the hour is trillions in euro liquidity which can save the euro as well as the individual countries, the mints printing the euro should be run 24 by 7. Let?s consider the impact of printing almost-infinite amount of currency. One impact is inflation. But inflation can be handled later if the economies are put back on firm growth trajectory. And money supply, if reduced, can harm the real economy, but if raised, it causes inflation that reduces the value of money, but can stimulate the economy in the interim. Second impact of huge seigniorage will be the euro?s depreciation against the dollar, which will be beneficial since it will give the European countries an export-advantage outside the eurozone while curtailing costlier imports. This will likely correct their BoP deficits, the same benefit sought from breaking away from the euro and devaluing. Thirdly, greater money supply would reduce the interest rates which will encourage consumption and investment borrowing, thus stimulating the European economies. Fourth impact will be rewarding the ?culprits? by providing them the required money while penalising the ?behaving? countries by making them cross-subsidise the ?bad boys?. But this can be avoided by putting strict conditionalities on countries accessing more euros, as per the country?s situation and economic requirement, the way India was forced when we borrowed heavily from the IMF in the 1991 BoP crisis by pledging our gold.
The required liquidity could be provided by, say, the BRICS, by deploying their forex reserves, but it?s doubtful if they would oblige. America is recovering from its own crisis and may not be in a mood to bail out Europe. Japan?s own debt-to-GDP ratio is over 300% and has moved into negative growth rate after the unfortunate tsunami. So, money is required in Europe, and lots of it, and it?s not likely to come from outside the eurozone. The European Central Bank and IMF will have to jointly take a call on this.
There are worries about excessive and rising money supply causing harm to the real economies by creating price bubbles leading to crises. But it?s unregulated leverage more than liquidity that?s harmful as was evident from the US subprime crisis wherein the leverage had reached 30. It?s the money-multiplier, or M2, M3 and the highly leveraged derivatives that can be source of trouble rather than M1. In fact, rising M1 with a firm check on derivatives would reduce the leverage ratio. So, despite all the ill-effects of excessive money-supply, when there is no other option, money-supply must be raised with a plan to reduce it gradually later and monitored by linking it to the forex reserves.
If the world goes into monetary expansion, RBI can?t afford to stick to its tightening stance any longer. Inflation has started moderating, despite rising policy rates. Given the time lag in monetary policy, it?s high time RBI started reducing repo rates to encourage investment and get the economy out of the slowdown. A stitch in time will save nine. Liquidity can always be sucked out by raising CRR and/or SLR as well as exchange rate management. It will be worth deploying a part of our huge forex reserves to support the rupee around 51 levels with RBI intervention in forex markets by selling dollars and buying rupees. This will also suck away rupee liquidity from the system while reducing import bill and imported oil prices. It?s necessary for management students to understand this ?big picture? and draw lessons so as to be ever-ready to face any eventuality globally and locally.
The author is director, Indus Business School, Pune
shubhadasabade@hotmail.com