Friday, 17 December 2010

Goodbye Euro?

The unthinkable suddenly appears possible: the politicians, popular media and the European public at large are openly discussing the possibility of abandoning the euro. How has it come to this?

The end of the euro is being discussed in the context of the bailouts of peripheral members of the Eurozone. Greece and Ireland have already received assistance. Portugal, Spain and perhaps even Belgium can be next in line. Some speculate about Italy being close to the brink too. The immediate cause for these countries’ troubles is the same: high stock of government debt and unsustainable deficit made the financial markets doubt their ability to repay their debts in full. Consequently, they are increasingly finding it difficult to sell new bonds.

The Eurozone’s response, so far, has been to prop them up with vast amounts of cash. They are not doing this only out of solidarity and altruism: allowing a sovereign default of one country would produce contagion effects: if one is allowed to go bust, the market would expect the remaining countries to meet a similar fate. Pulling the plug on one would thus hasten the downfall of others in a manner of a self-fulfilling prophecy.

So far so good: the bailouts of Greece and Ireland, while politically controversial, were agreed upon by the Eurozone members (with the notable exception of Slovakia, the most recent and poorest euro member, which refused to pay for Greece’s past mistakes). It is, however, widely assumed that Spain will be too big to save. In that case, the earlier bailouts may only serve to postpone the euro’s downfall, without preventing it.

If the Eurozone breaks up, would the euro disappear altogether or would only certain countries leave the common currency (or be expelled)? As many have pointed out (including a recent article in The Economist), a complete break up would be very costly, destabilizing as well as practically very complicated (replacing all currency in circulation in 16 countries is no trivial matter and certainly it could not be pulled off at a short notice).

A more likely scenario would see a few of the crisis-stricken countries leave, with the euro live and kicking in a shrunk Eurozone. The trick is to do this before it is widely expected. If, for example, Greece is expected to abandon the euro, both international investors and Greeks themselves would have a strong incentive to move their funds out of Greece and into a safe haven such as Germany (or hide it under their mattresses). In fact, they would probably want to take out a large loan and stash that money safely away too, in order to make a handy profit after their country dumps the euro and the new currency depreciates. This would lead to a modified Gresham’s Law: one would want to hold assets in a strong Eurozone country and liabilities in a weak one.

The advantages of this would be non-negligible. The countries leaving the Eurozone will be able to devalue their new currencies and thus to improve their competitiveness and revitalize their economies. If they stay in the Eurozone, they can only achieve a similar effect by real depreciation driven by falling prices and wages. The resulting growth acceleration would allow them to lower the deficit without as drastic tax rises and spending cuts as would be required otherwise. Their debt, as long as it is subject to their national law, would be redenominated into the new currency. The domestic lenders would not be hurt by this but the foreign ones would effectively receive a ‘haircut’ equivalent to the size of the subsequent devaluation, without the country formally defaulting on its debt.

The background of the current troubles of the Eurozone can be understood quite well in the light of Robert Mundell’s Theory of Optimum Currency Areas (American Economic Review, 1961). Mundell argued that common currency is optimal for regions or countries that either encounter symmetric shocks (or, put differently, whose business cycles are synchronized) or that possess effective mechanisms for absorbing the adverse effects of asymmetric shocks. The core Eurozone economies are closely integrated and therefore broadly meet this definition: the shocks that affect them tend to be similar and/or spillover easily through flows of trade, capital and, to a lesser extent, migration. The same cannot be said about the peripheral countries. For a while, these countries seemed to thrive with Eurozone membership as it allowed them to enjoy low interest rates: monetary policy was driven by economic conditions in the core countries which used to be much more sluggish than the periphery until recently. Eventually, however, this backfired: low interest rates encouraged reckless public spending in Greece and fuelled housing-market bubbles in Ireland and Spain.

What about the adjustment mechanisms that are the second part of the optimum currency area definition? Mundell’s article emphasized labor mobility which is known to be low in Europe, especially across national borders. Another solution is fiscal transfers: the EU thus may need to turn into a transfer union, a term which has been giving the Germans sleepless nights lately. The contrast between the EU and the US is striking: not only are Americans much more mobile than Europeans, the US Federal government wields fiscal tools that allow it to intervene fiscally in any State; even more importantly, no one questions the preparedness of the Federal government to do so in times of crisis.

Besides international comparisons, history provides helpful lessons as well. The EMU is not the first European attempt at monetary integration: its predecessors include the Latin Monetary Union (formed by Belgium, France, Italy and Switzerland in 1865) and the Scandinavian Monetary Union (Sweden, Denmark and Norway, from 1873 onwards). Both of these ultimately failed in the late 1920s or early 1930s. Benjamin Cohen (“Beyond EMU: Problem of Sustainability, Economics and Politics,” 1993), analyzed these previous cases. He concludes that economics matters when determining the stability of monetary unions but international politics matters even more: the two previous attempts at monetary unification failed because the participating countries did not to share a feeling of common destiny. And this is where my discussion completes a full circle: as long as some countries in the Eurozone are willing even to contemplate throwing in the towel on other countries, no matter how deserved it would be to do so, the Eurozone is doomed.