Some time ago (in 2012) I wrote "How to dissolve the eurozone". My conclusion was that it was much easier to have the strongest countries leave the eurozone then to have the weakest leave. So it doesn't look good that a grexit is once more seriously discussed.
Below I reprint it:
The EU likes to see itself as an organization that helps its members to become rich. Thanks to this reputation poor European countries are eager to become members. From this point of view it was very happy to see countries like Greece, Spain and Ireland showing fast economic growth.
But the EU has been a bit too enthusiastic about signs of growth and ignored signals that the Southern European countries lived above their means. Those countries enjoyed a consumption boom thanks to foreign investment in real estate and easy credit. But these are not sustainable sources of growth and when they stopped Southern Europe suddenly found itself living far above its means.
Normally a country would devalue its currency to get out of such a situation but with the euro that road is cut off. So instead those countries have no alternative for government budget cuts and wage cuts. The problem is that this is a very painful way to cut expenses and that it tends to put economies in a negative tailspin that causes serious harm.
So we have seen a quite a lot of discussion of a breakup of the euro recently. One popular scenario is a North-South division of the eurozone – resulting in a “neuro” and “seuro”. Another scenario is the dropout of the weakest links: Greece and maybe one or two other countries. The problem in both cases is what to do with the many financial links – contacts and loans – that would be broken by such a currency split. Mismanagement of the transition can lead to panic and chaos. As the Lehman collapse in 2008 has learned such a chaos can be much more economically damaging than the direct damage itself.
Unfortunately quite a few European politicians seem convinced that an orderly transition is impossible. As a consequence they are determined to defend the euro at all costs. Yet history has known quite a few currency unions that were dissolved. Most recently the dissolution of the Soviet Union and Yugoslavia also meant that the common currencies were dissolved. Their transitions were rather chaotic but we can learn from them how such a process can be managed. Unfortunately Western countries were in both cases instrumental in pushing the dissolution of those countries. Analyzing what went wrong means also taking responsibility for what we did wrong. Many of the Western leaders and academics involved would rather avoid such a disgrace. But such an attitude is harming us now.
It should be noted that the fact that there are many variables involved also means that there is a lot of space for creative solutions.
A departure of Greece won’t work
It would not be a good idea for Greece to leave the euro in the present situation. The weak competitive position of the Greek economy and the semi-insolvency of its government will combine to produce a sharp fall of the new Greek currency – let’s call it drachme. Those who have assets in euro’s or debts in drachmes will be favored while those with assets in drachmes or debts in euro’s will be disadvantaged. This is not a fair solution and it doesn’t provide the kind of continuity that people expect under the rule of law. It will lead to capital flight and chaotic circumstances that might do more harm than the transition itself.
On itself these damages might be taken for granted. In the past numerous countries have suddenly applied major devaluations to their currencies. The unjust effects are seen as just bad luck for those concerned. However, separating a country from the eurozone will take weeks or even months. Banknotes and coins will have to be created and distributed and that takes time. This is a problem. A devaluation happens in a split second and that means there is no opportunity to exploit the gap in valuation. In contrast the long time needed for splitting a country from the eurozone offers ample opportunity to exploit this gap. So one should expect effects like a major capital flight. And given the level of connectedness of the European economies it will be impossible to stop such transactions.
One might think up measures to counter this movement. Greece might manage to secretly create new money and distribute it very fast or the EU might have some general emergency money that could be used if a country left the euro. But even if it would be possible that way to stop the damage caused by the capital flight the effect on the next domino’s (most probably Spain and Portugal) would still be there. They would see a major capital flight in anticipation of being the next to leave. And even if the ECB would counter that effect with monetary infusions these countries would still see sinking investment – what would hurt their economies in the longer term.
Another consequence will be that the European banks will be hurt. This might happen directly – when their loans to Greek companies and people are converted in drachmes - or indirectly – when the loans stay in euros but those Greek companies and people are no longer able to repay euro loans with their devalued drachmes – but the effect is the same. It is very likely that as a consequence some banks will need government support. Greece itself might need support from the EU too to bridge the transition period. The eurozone governments will likely react to those extra expenses with budget cuts elsewhere. This restrictive economic policy will make it harder for Greece to export to the eurozone and cause the drachme to sink even lower.
It is important to realize that the expected sharp drop is nearly the only reason why a breakup of the euro by the departure of Greece is problematic. If there was the expectation that the drachme would keep approximately the same value as the euro after the breakup there wouldn’t be much of a problem. A breakup would still be a lot of work for many people but it would be manageable.
So to put it bluntly: the very reason why we are under pressure to break up the eurozone is also the reason why it is so hard to do so. And the longer we wait the bigger that reason is likely to become.
What if the north left?
These problems wouldn’t occur if instead the strongest economies left the euro. They would have the freedom to temporarily follow an expansive economic policy after the transition so that their currency wouldn’t rise too fast. And the block that they leave behind will be strong enough not to see the kind of melt-down that Greece alone would face. Also all the countries that might devalue would do so at the same time so that there wouldn't be a domino effect.
The leavers would be at least Germany and the Netherlands: the two countries with the biggest trade surpluses. As these trade surpluses are – specially in the case of Germany – the product of an economic policy aiming to increase their competitiveness that was out-of-synch with the rest of the eurozone this would also be a logical consequence.
Some of the smaller countries like Finland, Austria and Slovakia might choose to follow Germany because their economy is strongly connected with it, but the majority would stay with the euro. I won’t address the issue of whether these countries should adopt a common currency – what would result in a neuro-seuro configuration or that they would each re-introduce their own currency. Convenience will probably dictate the former option.
As the seceding countries are the stronger ones there would be a much better possibility to manage the transition. Yet it still would need to be managed. Preferably there should be an initial period in which there is a fixed rate while everyone is free to exchange his euro’s for the new currency. This would require a considerable commitment from Germany that might include a promise to keep interest low for the first year and to - initially - follow an expansionist monetary policy.
France – with a huge trade deficit – and Italy – with its budgets problems – would stay inside the euro. With those countries the remaining eurozone would be strong enough not to see the kind of disaster that would face Greece if it gave up the euro alone. Yet it would be weak enough to see its currency gradually weaken and its competitive position improve.
If Greece would leave the euro alone most bonds and financial obligations would stay in euros and that would hurt Greece. But if Germany leaves the euro most contractual obligations will stay in the weaker currency. Only when both parties are German should contracts be converted. That would mean that the stronger instead of the weaker party bears most of the pain.
An eurozone with a weaker currency will also benefit Eastern and South-Eastern Europe where many companies and private people have debts nominated in euro’s.
Having an expansionist economic policy will not be popular in Germany. But in this scenario it would have to happen only for a short time while if Germany stays in the euro it might have to be implemented for a very long time. It will also be stimulated to do so by the fact that not doing so will lead to the rise of its new currency what has as a consequence that the value of its bonds to the eurozone sinks and its competitive position towards that zone deteriorates.
In the end Greece might even be too weak for the reduced eurozone. But the EU would be in a much better position to handle it. The chance of a domino effect would be much smaller and competitiveness gap between it and the remaining eurozone members would be much smaller as the present gap.
What if the north doesn’t want to leave?
Germany was reluctant to join the euro and to give up its own strong currency. So a return to the mark or a neuro will not be unpopular in Germany. What might make it reluctant is the cost of the transition, both financial and in decreased competitiveness for its exporters when its new currency rises compared to the euro.
Germany’s politicians are now at the crossroads. Leaving the euro will have costs and risks and its risk-averse politicians would rather avoid that. But the longer they wait the higher the cost will become. They made that mistake before with Greece when they preferred band aid above real solutions for so long that a departure of Greece from the eurozone is no longer a realistic option. If they make the same mistake regarding a partition of the eurozone an anarchic breakdown may become unavoidable.
France has the key position in the future of the eurozone. Without it a southern euro zone would be too weak, both economically and in the negotiations about the conditions under which the euro should be split up. It will certainly take some swallowing for the French to choose to be grouped with the weaker economies. On the other hand: France would be able to play a leading role in the new eurozone while at the moment it is just acting as a servant of Germany. If France would make this choice it would leave Germany virtually alone and with little choice but to comply. The present trade deficit of France justifies a grouping with the South too.
We might see an intermediary step. In that phase Germany would be condemned for having a large trade surplus with the rest of the EU and for following policies that aim to even further enlarge this surplus. Germany might be ordered to lessen this surplus and be fined if it didn’t succeed with this. It would be the logical mirror image of the fines for countries with a too large budget deficit. The consequence of such a rule would be that Germany is forced to choose between two unattractive scenarios.
No country can permanently have a large trade surplus that isn’t supported by sustainable flows of money in the other direction. Germany has abused the EU to keep such an extra large trade surplus where a normally a rising currency would have countered it. It has no choice but to end this policy as it is untenable.
The present setup of the eurozone offers Germany the wrong kind of incentives. It makes it feel that it would be better off with a restrictive fiscal policy than with an expansive fiscal policy. It allows it to blame others and have others partially pay for the resulting deficits in the South of the eurozone. And being a payer itself gives it a power position that allows it to continue this policy. When it has a separate currency it will no longer be able to do that as such actions will result in a rising currency. So psychologically a separate currency will make it more attractive for German politicians to follow a policy that also benefits the South of Europe.
The present configuration offers also the wrong incentives to the South. The monetary union makes it unattractive to follow a restrictive fiscal policy as it leads to a downward spiral – a spiral that would be less worse with separate currencies. On the other side it decreases the unattractiveness of nearly going broke as that is also the problem of the richer member states. The close connectedness of the economies in the currency zone makes that the Northern countries will be heavily harmed too if one of the Southern countries goes broke. And that makes them more prepared to pay for some kind of support.
Yet although the North has incentives not to let the South go broke it does not have incentives to let flourish. On the contrary: it would like to keep it as a willing market for its products.
As the EU primarily aims to keep its member states happy it doesn't have an incentive to change the situation either.
What should be converted?
Only those contracts where both parties are German (or member of the new neuro zone) should be converted to the currency. This could be explained as harming the creditors in favor of the debtors. However, as the new configuration will be more stable as a whole it already contains an element that favors the creditors.
Existing German government debt would stay in euro’s too. The market already has taken into account the difference of solvency of the different countries by awarding different interest rates. Converting debts into the new currency would be an unexpected and undeserved bonus for those having German bonds. This is money that can be better invested to keep the currencies on par for some time.
It is desirable that the German government takes effort to keep the new German currency at the same level as the euro for at least half a year so that most short term contracts can expire and there will be time to convert longer term contracts. This will mean low interest rates, increased government spending and maybe some fine that has to be paid to a stability fund if the mark rises too much.
If the currencies start to differentiate too soon those most vulnerable would be funds with obligations in the new mark – like pension funds. This might cause the need for legislation that binds their payout partially to the euro.
Of course the long term goal of the whole currency operation is to devalue the Southern currency with some 10 to 20% compared to the Northern so that its competitiveness improves. However, the EU countries should keep control of the pace of that devaluation, keep it gradual to diminish the damage and be prepared to crush speculators who want to force a faster devaluation. The transition period might take some two years. In that period the EU would have exchange rate targets comparable to the “Snake” that connected the European currencies before the euro.
The new configuration will contain two strong currencies instead of one. The new currencies will not have the standing of the present euro and may be less used as international reserve currencies. But that is the price we will have to pay for renewed stability.
A fiscal union?
One option that has been mentioned is a fiscal union. That will not really work.
The idea behind a fiscal union is that if everyone pays taxes to Brussels and Brussels distributes it over the countries no one will complain when it spends more on the poor member states than they bring in in taxes. Germany might still end up as a net payer and Greece a net receiver but it will be hidden by layers of obscure bureaucracy. So basically it is a trick to deceive the public.
This might be defensible if it would work but that is questionable. It looks more likely that the receivers will permanently become dependent on the richer countries, just like Southern Italy has been dependent on its North for over a century now.
The discussion is very similar to that about development aid to Third World countries. With them there is nowadays a near consensus that money transfers only create dependency and corruption and that only the opportunity to export agricultural and industrial products really helps their economy.
The EU is very proud about how much its poorer members have grown and likes to think that its money transfers have been an important contribution to that. But while certain investments – like in highways – may have helped much of the money did nothing to make its recipients more competitive. It may actually have made these countries less competitive by driving up their wages. The main reason the older countries paid for this was that it also created new markets for their companies.
This policy is quite comparable in both its motives and effects to the way Western countries for a long time looked at development aid. We not only gave aid but also pushed the developing countries to buy as much from us as possible – often things they didn’t need – and when they overspent we sent in the IMF to force them to have more “responsible” economic policies. If one considers Germany’s refusal to cancel Greek defense orders while it pushes at the same time for budget cuts in Greece it is hard to ignore the similarity.
Advocates of a fiscal union often mention the example of the US. But the US is one nation while Europe consists of many different nations and migration between their areas faces considerable resistance at both sides. Treating them as one nation would be a violation of the principle of self-determination of nations and will very probably backfire. In addition one should remember that the American civil war settled the principle that the states of the US are not allowed to secede and that they will be confronted with violence if they try. Do we really want German soldiers in Greece to prevent it from leaving the EU?
Another idea is now being introduced: stronger control by the EU over the budgets of the member states. It is an illustration of the dysfunctionality of the European decision making process where every proposal that promises a tighter integration is adopted while proposals that results in decentralization become a priori rejected. The ever closer union is looking more and more like a tightrope.
In fact budget problems have played only a minor problem in the creation of the present situation and if the proposed rules had been in force they would have made no difference. Spain and Ireland had very healthy budgets until their real estate market collapsed and Greece seemed to be healthy with its forged figures. If the true figures of Greece had been widely known it would have been corrected by the bond markets. When the problems of those countries became apparent they were too deep for simple solutions and a fine from Brussels would only have made the financial position of those countries worse.
Forcing all countries to have a restrictive budget makes it harder for the Southern countries to bridge the competitiveness gap with the North. If anything, the Northern countries with a trade balance surplus should be forced to have an expansive economic policy.
The future of Europe
The growth in power and size of the EU in the past decades has not been driven by rational arguments or popular support. Instead we have the irrational call in the Treaty of Rome for an “ever closer union” and continuous reminders of the threat of war between European states. As our last war is fading from the memory of most Europeans advocates of the European Union have added new fears to advocate their cause. We are now told about the risk of a “loss of momentum” in building the EU and the risk of Europe “becoming irrelevant” in the face of the US and a rising China.
But fear is not a good adviser and it has prevented the EU from taking rational steps towards solving the present financial conundrum. Its eagerness to promote the euro has proven to be a bridge too far. But instead of making a tactical retreat the EU seems only prepared to accept solutions that increase the power of Brussels. Although it is clear that a common coin for counties that are at a different level of development creates a risky situation the EU hasn’t even withdrawn its requirement that new member states join the euro as soon as possible.
In the face of mega-units like the US and China a common EU market is a very rational choice. Most individual countries are simply too small to play any significant role on the world stage. Our common interest is what binds the European countries more than anything. In that light it is frightening to see that the EU has done nothing to retort claims that Greece might be thrown out of the EU if it leaves the euro. This is a denial of the common interest. No matter the merits of a punishment of Greece in this case we will have to consider that once pushing countries out of the free trade zone becomes a possibility every country will have to consider that it might be targeted for a similar measure in the future. And so they will take measures in order not to become too dependent on the EU. This strikes at the heart of the EU.