Members of the eurozone are suffering from a severe bout of buyers’ remorse. Many would like to disassemble the kit they bought almost 20 years ago and put together in the late 1990s and 2000s. But they can only break it, together with the entire structure of European co-operation. Meanwhile, the world looks on in horror at the possibility that the eurozone is about to unleash a wave of sovereign debt and banking crises. If so, it would not be the first time that European folly has brought ruin on the world.
The idealism that drove the project has vanished. But self-interest is proving an insufficient replacement. The fumblings of national politicians, answerable to frustrated electorates, are making things worse. Jacques Cailloux, chief European economist of Royal Bank of Scotland, stresses the errors in a recent paper. Eurozone leaders have, he charges, failed to understand the scale and nature of the crisis, played heedlessly to domestic galleries and focused on putting malefactors in the dock, even though bad lending is as culpable as bad borrowing. He is right. Now, he adds, two new elements have entered: first, German opinion is turning against their central bank; and, second, a number of politicians, including Mark Rutte, Dutch prime minister, are suggesting the possibility of forced exit.
Yet the point of the currency union was that it was irrevocable. The supposed benefits depended on that. Any talk of exit reintroduces currency risk. Moreover, argues the RBS paper, “we cannot see any policy announcement ... that could successfully reduce the risk premium on exit back to negligible levels”. Now investors confront sovereign debt, financial and exit risks. The results will include runs on sovereign and bank debt, and even the disintegration of the capital market into national components.
Yet, once the taboo has been broken, the possibility of exit must be examined. So is it possible, or even desirable? Any such discussion has to start with Greece. Nouriel Roubini of the Stern School, New York University, has argued in the Financial Times this week that Greece should both default and exit. I have no difficulty in accepting the first proposition. Few can still believe that a huge reduction in the country’s public debt can be avoided. It is a question of when, not if.
Yet would that mean forced exit from the eurozone? The answer is: no. This is a point made by Willem Buiter and Ebrahim Rahbari of Citi in another interesting paper. Exit would indeed happen if nothing were done by the rest of the eurozone, including the European Central Bank, to recapitalise and reliquify Greek banks. The creation of a new currency would then become inevitable. But Greece’s partners could well prevent such an outcome.
Should Greece actively seek an exit, in its own interests? Here economists are at odds. Mr Buiter thinks a currency devaluation useless, arguing that it would be eroded by inflation. Mr Roubini thinks it essential. I am with Mr Roubini. Greece has both a huge current account deficit and a depressed economy. A big real depreciation is required. It is far easier to achieve this via currency depreciation than cost deflation.
Yet the idea of exit is also vastly difficult to implement. Legally, it would require the country to leave the European Union. Would the latter then take the trouble of inviting the malefactor back in? Unlikely. The country would, as a result, probably be excluded from the single market, too. Moreover, it would find it impossible to exit quickly and cleanly. As the story broke, there would be a run on all its liabilities. The government would have to limit withdrawals from banks, if not close them outright. It would also need to impose capital controls, in violation of treaty obligations. It can redenominate debt contracted domestically. But it cannot do so for debt contracted abroad. Many corporations would then go bankrupt. A report from UBS estimates the total economic cost in the first year at 40-50 per cent of gross domestic product.
Contagion would also be inevitable. Presumably, an effort would be made to build a firewall between the exiting country and other vulnerable countries. But it would be tested to destruction. Much Greek debt is held abroad (see chart). Moreover, once one country has exited, currency risk would be even more real for every other vulnerable country, including even Italy and Spain. Neither governments nor corporates in such countries could easily sell their debts. Banks would experience runs. The ECB would be forced to lend without limit. The global interconnections of banks would appear terrifying. According to the Bank for International Settlements, US banks alone have an exposure of €478bn to Greece, Ireland, Italy, Portugal and Spain (see chart).
Exit, then, even of a small weak country, is scary. What of an exit by a strong country, such as Germany? Legal issues would arise here, too, though Germany could presumably get the treaty changed in its favour. Again, there would be massive flight, this time into Germany. Moreover, a German exit would destabilise the rump of the eurozone, probably leading to disintegration. Meanwhile, as I argued last week, the strong country would also experience a vast adverse shock, as its banks lost on the value of their foreign assets and its exporters suffered a huge loss of competitiveness. The UBS analysis suggests that a strong country, such as Germany, might suffer a loss of 20 to 25 per cent of GDP, in the first year. Beyond that, an exit of the EU’s core country from the euro (and, under current law at least, the entire EU) would threaten not just the single market, but the whole co-operative fabric of postwar Europe. It would leave Germany and France isolated and strategically bereft.
The eurozone then cannot stay where it is, cannot undo what it has done and finds it traumatic to go forward. But the very notion of exit is destabilising. They made it; and they must now make it work. Right now what is needed is aggressive economic expansion at the core, not least via immediate loosening of ECB monetary policy, along with strong support for the countries that face illiquid public debt markets and big debt reductions, in some cases. In the longer term, the minimum needed is a far greater degree of fiscal solidarity and discipline, and a eurozone-wide banking system, with much higher capital levels.
Is this feasible? I do not know. But I do know what is at stake. The eurozone hates being in the frying pan. It must not jump into the fire.
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