A controlled break-up of the euro would be hugely risky and expensive.
So is waiting for a solution to turn up

Tempted, Angela?

The Economist, August 11th 2012

For all you know, Angela Merkel is even now contemplating how to break up the euro. Surely Germany’s long-suffering chancellor must be tempted, given the endless euro-bickering over rescues that later turn out to be inadequate. How she must tire of fighting her country’s corner, only to be branded weak by critics at home. How she must resent sacrificing German wealth, only to be portrayed as a Nazi in some of the very countries she is trying to rescue.

But for this very practical woman there is also a practical reason to start contingency planning for a break-up: it is looking ever more likely. Greece is buckling. Much of southern Europe is also in pain, while the northern creditor countries are becoming ever less forgiving: in a recent poll a narrow majority of Germans favoured bringing back the Deutschmark. A chaotic disintegration would be a calamity. Even as Mrs Merkel struggles to find a solution, her aides are surely also sensibly drawing up a plan to prepare for the worst.

This week our briefing imagines what such a “Merkel memorandum” might say (see article). It takes a German point of view, but its logic would apply to the other creditor countries. Its conclusions are stark—not least in terms of which euro member it makes sense to keep or drop. But the main message is one of urgency. For the moment, breaking up the euro would be more expensive than trying to hold it together. But if Europe just keeps on arguing, that calculation will change.

Grexit, pursued by a bear

Begin with Greece. There is a common fallacy, not least in Germany, that dropping the Greeks would be a fairly costless way to teach a useful lesson. In fact the European Central Bank (ECB) owns Greek bonds with a face value of €40 billion ($50 billion), which would be converted into devalued drachma and which Greece might not service. A further €130 billion or so of loans that Greece has received in the bail-out would have to be written down, or written off. The €100 billion of the temporary debts Greece has stacked up in the ECB’s payments system would crystallise into a loss. Add in a one-off grant of say €50 billion to tide Greece over—call it conscience-salving “solidarity”—and the bill might come to €320 billion. Estimating the price of a “Grexit” is guesswork, but Germany’s share might reach €110 billion of this, about 4% of the country’s GDP.

At first sight that is a bargain, because it would save German taxpayers from an open-ended commitment to Greece. And yet proof of the euro’s reversibility will throw markets into a panic. Ireland, Portugal, Cyprus and Spain also all owe investors abroad a net sum of 80-100% of GDP (the gross debt is much larger). One reason why these foreigners have hung on is the belief that the euro cannot break up. Greece’s defenestration would turn that calculation on its head, triggering soaring bond yields in southern Europe. Stampeding domestic savers would cause runs on banks. With the single market in peril and depression looming, Mrs Merkel would come under huge pressure to pay whatever it takes to save the rest of the euro zone. She would have no time to negotiate the pan-European federal discipline that she has always demanded as the price for German aid. A rescue would be a blank cheque.

A bolder Plan B would amputate well above the site of infection, cutting off Spain, Ireland, Portugal and Cyprus too. Italy, which has net foreign debt of just 21% of GDP, would probably escape the chop: even with its heavy debts and chronic lack of competitiveness, Mrs Merkel would reckon that the euro zone could not function politically without it. The cost of a bolder Plan B would be high. When you add up the ECB’s holdings of their bonds, the temporary debts in its payments system, written-off rescue loans, and a care package to soften the blow of being chucked out, the total for Spain, Ireland, Portugal, Cyprus and Greece comes to perhaps €1.15 trillion. Germany would also have to put money into its own banks, hit by losses in the five departing countries. Altogether, this might cost Germany getting on for €500 billion, or 20% of GDP. But the blank cheque to defend the other four weaklings after a chaotic Grexit might exceed that; and the broader break-up would establish a more co-ordinated, defensible euro zone.

I’m a chancellor, get me out of here

If neither break-up looks attractive, is there a better way? This newspaper has argued that the euro zone’s members should use their combined strength to create a banking union and to mutualise a chunk of the outstanding debt (as well as introduce policies to temper austerity and promote growth).

This more federal Europe would also involve costs. Recapitalising banks and financing a euro-wide deposit-guarantee scheme might cost €300 billion-400 billion, perhaps a third of it paid for by Germany. But this would be a one-off and might be reclaimed from the banks. Mutualising a slug of debt would lift Germany’s interest costs by €15 billion or so a year. The numbers are rough, but, even allowing for some extra loans to the south, rescue would be cheaper than break-up. And that is before you factor in the enormous political costs of disintegration, with, say, Greece departing into a new Balkan hell.

Our solution, then, is broadly the same as Mrs Merkel’s appears to be. But a prescription is useless if it is never applied—and our doubts that this one ever will be are increasing.

The euro could have been saved a long time ago, had the politicians agreed on who should pay what or on how much sovereignty to surrender. Rather than push forward, Mrs Merkel has waited, hoping that fiscal adjustment and structural reform will lead to economic growth in southern Europe and that the politicians could sort out their differences. The ECB has once again bought her a bit more time (see article).

The evidence, though, is that time is not on her side. Southern Europe’s economic rot is deepening and spreading north. Politics is turning rancid as the south succumbs to austerity fatigue and the north to rescue fatigue (see article). Populism only makes a grand bargain more elusive. For the moment, breaking up the euro would be riskier than fixing it. But unless Mrs Merkel presses ahead, the choice will be between an expensive break-up sooner and a really ruinous one later.

Breaking up the euro area

The Merkel memorandum

The Economist, August, 11th 2012

Angela Merkel, the German chancellor—and also, in effect, the euro area’s boss—has always insisted that she wants to preserve the euro area in its current form. But as the euro crisis intensifies and the potential bills for Germany mount, she would be imprudent not to be considering a Plan B. Drafted in utmost secrecy by a few trusted officials for the chancellor’s eyes only, this is what the memorandum outlining a contingency plan might say.

TO: Angela Merkel
FROM: ???
SUBJECT: Plan B

The current impasse

I. Since the euro crisis started over two years ago you have said that Germany will defend the single currency, based on your conviction, shared by business and the political class, that its survival is in our national interest. To that end Germany has pledged large amounts of public money, both in our contributions to various rescue funds and through the Bundesbank’s share of risks taken by the European Central Bank (ECB). At the same time you have tried to minimise the bill for German taxpayers by insisting that bailed-out states implement strict austerity programmes and, more generally, by resisting calls for debt mutualisation—code for Germany underwriting the euro area—while demanding greater central control over all national budgets.

II. Bluntly, the plan isn’t working. Greece is a disaster zone. Ireland and Portugal are making some progress (it was encouraging that Ireland was able to raise some money from the markets in July) but they still have a long way to go and could easily be knocked off course. Worse, Spain looks as if it may need a full bail-out rather than the partial one for its banks you had hoped would suffice. And Spanish sickness is infecting Italy, undermining all the good work that Mario Monti has been doing since the Italians saw sense and got rid of Silvio Berlusconi, as you had been urging behind the scenes. Meanwhile François Hollande isn’t doing enough to get France into shape and is playing the usual French game of calling for Germany to do more while resisting your attempts to centralise control at the European level. Mario Draghi, the ECB’s president, has calmed things down for the moment, but his plan could easily come unstuck.

III. The position is dangerously unstable. If capital flight from the peripheral economies gathers pace, it could trigger runs on entire banking systems. That would put the ECB—and thus, indirectly, the Bundesbank and Germany—on the hook for deposits worth trillions of euros. The domestic politics are already ugly in several countries, notably Greece. This is poisoning our position in southern Europe, where our help is increasingly seen as a new form of German tutelage. The situation is deteriorating in Germany, too, where your ability to act is being limited by a backlash against bail-outs and against the euro itself. If anything, the backlash in Finland and the Netherlands is even more vicious.

The case for plan B

IV. Hence the need to consider an alternative strategy. The aim of this contingency plan is not the complete break-up of the 17-country euro area. That would be against the German national interest, destroying the hard-won respect we have achieved since the second world war by embracing European integration. And it would needlessly damage our economy by bringing back currency risk for trade with countries such as Austria and the Netherlands, which have adapted perfectly well to the euro. Plan B seeks to save the euro by surgery, excising states that cannot cope rather than clinging to the vain hope that they can regain their health within the euro zone.

V. We propose two options. First, the one that may be forced on you anyway: an exit by Greece arising from gross dereliction of its duties under the various bail-out agreements. We have taken as a given that MPs in the Bundestag will not sanction a single euro more in bail-out money to Athens. If that forces the Greeks out, so be it. Second, we also consider a wider exit of other countries that have failed the euro test. We think this should include all the states that have already been rescued, or are requesting bail-outs, because those countries share with Greece a fundamental loss of competitiveness and vulnerability to foreign capital flight. This means that they cannot be cured within a reasonable period of time while staying within the euro.

VI. In assessing the two options we have relied mainly on a cost-benefit analysis. That has been informed, where relevant, by historical precedents and the legal position (we are well aware of your concern that Germany must at all times be seen as law-abiding). We also look briefly at some of the practical issues involved in an exit. Naturally, we have taken into account the political constraints you face both at home and among your fellow European leaders. Caution is your watchword, so we’ve highlighted the risks of things going wrong if you adopt Plan B.

Can an exit happen in the first place?

VII. We start with the most basic question of all: can one or more countries leave (or be forced out of) the euro, both legally and practically? As a matter of legal principle, the answer is no, because when countries joined the euro the conversion of their former currencies was supposed to be “irrevocable”: a Hotel California that you can never leave. Indeed, a legal opinion published by the ECB in 2009 argued that because European treaties did not conceive of the possibility of a country leaving the euro, an exit would require them to leave the European Union (EU) as well. That would exacerbate the economic pain because the departing state would lose access to both the single market and valuable regional-support funds.

VIII. But we think this argument of legal impossibility is overstated. European laws are in constant flux because of the ease with which new agreements can supersede old ones. The Maastricht treaty of 1992 banned bail-outs, but you have yourself authorised two agreements allowing them: the temporary rescue fund and the permanent European Stability Mechanism, whose legality our constitutional court is considering at the moment. Similarly, we think that it will be possible to find a way round the supposedly binding rule that a country exiting the euro would also have to leave the EU.

IX. What about the practical obstacles to an exit? There are two main ones. First, it would take several months to design, print and distribute an entirely new currency, leaving a departing country bereft of new cash. Second, news of a country leaving or being ejected would almost certainly leak, prompting bank runs so massive that they would overwhelm even the ECB’s ability to counter them. That would lead to a total (and chaotic) break-up rather than a controlled one.

X. We think it will be possible to deal with both these practical difficulties. Yes, it took six months to launch a new currency when, for example, the Czech-Slovak monetary union broke up in 1993. And yes, they were able to overstamp existing notes as either Czech or Slovak—something that would not work for a country like Greece, which relies so heavily on euros spent by tourists. But modern economies have become much less reliant on cash than they used to be. We think a country could get by for a few months through enhanced use of electronic payments (which might also flush out more of the black economy) and by using existing euro notes and coins for small transactions, as proposed by Roger Bootle, the head of Capital Economics, a consultancy, who recently won a competition set by Lord Wolfson, a British businessman, on how one or more countries might leave the euro.

XI. The worry about bank runs is more justified, but we think it too can be overcome. The most obvious way would be to keep the exit decision completely secret until the weekend it was implemented. That is tricky, because you would need to convince other European leaders ahead of a council meeting, and news would be bound to leak. But if the news did get out, then a state leaving the euro could immediately impose an extended bank holiday and implement capital controls (normally illegal under European law, but there is a get-out clause for up to six months in exceptional circumstances). That should deal with the problem.

An exit of Greece alone

XII. Assuming the legal and practical hurdles to an exit by any state can be surmounted, then the first option is for Greece to leave, which on the face of it looks less risky than a bigger break-up. One immediate difficulty is that the Greeks don’t want to go, so they would have to be expelled. There are two ways they could be forced out: first, by cutting off the flow of bail-out funds, which would mean that the Greek government would have to meet its deficits by issuing IOUs that would start to circulate as a de facto parallel currency, trading at a discount to euros; second, by cutting Greek banks off from refinancing from the ECB and its payments system. The first approach might take some time but would create such monetary chaos that a clean break would eventually seem preferable. The second would force the issue since the banks would collapse without access to ECB liquidity.

XIII. What would happen then? Even if Greece did slide towards the exit rather than jumping, at some stage the government would have to complete the process by introducing the new drachma one weekend when the markets were closed. All assets, debts and contracts written under domestic law, including bank deposits and loans, would be redenominated one-for-one from euros to drachmas. Crucially, the moment the markets reopened, the drachma would depreciate, probably by more than 50%.

XIV. That devaluation, if not squandered in a lurch towards hyperinflation, could deliver Greece from its current misery of perpetual recession by letting it regain lost competitiveness at a stroke, rather than by grinding down domestic costs over several years. That should swiftly deliver a hefty boost to the sagging economy from net trade. But what would it mean for Germany?

XV. First, you can count on the move being popular—and not just in Germany—making it feasible to win support from other European leaders whose electorates are just as fed up with the feckless Greeks. Second and vitally, expelling Greece would draw a line under the costs of bailing it out and prevent it from becoming a permanent drain on German taxpayers. Third and scarcely less important, the decision would give bite to conditionality, sending a stern lesson to the rest of Europe that bail-out terms cannot be flouted with impunity.

XVI. Set against these benefits there will be costs. From a strategic perspective, there is the danger of Greek politics souring still further and the country becoming a permanent trouble-spot in the eastern Mediterranean, even if it is out of the euro. To fend off that possibility it will be essential to show goodwill by keeping Greece in the EU. So it will in fact need a third bail-out (only we will call it an aid package) to pay for things like essential drugs for patients. We think this could be capped at, say, €50 billion ($60 billion) of which Germany would chip in a third, or around €17 billion.

XVII.That will be just the beginning. Drawing a line also means ending the fiction that our loans to Greece will be repaid in full. Germany, along with other European creditor nations, will face hefty losses (see chart 1) arising from our exposure to Greece. First, there is the money already disbursed: almost €130 billion. Second, the ECB still owns Greek government bonds worth some €40 billion. Third, the Bank of Greece owes the ECB about €100 billion in so-called Target2 debts, which have arisen through the Target2 payments system as local banks made up for the drain of deposits out of Greece by borrowing from the central bank. That adds up to an exposure of over €270 billion, or 3% of euro-wide GDP. (We don’t include the indirect exposure we all have through our stakes in the IMF, which has lent Greece about €20 billion, since the IMF usually gets its money back).

XVIII. Some of that €270 billion might be recovered, but it would be irresponsible to bank on any of it. The devaluation would increase—in drachma terms—Greece’s euro indebtedness. That will force the Greek government wherever possible to redenominate its liabilities into drachma, inflicting heavy losses on creditors; and it may follow that up with a further write-down. Prudence suggests that we should assume no recovery and that Germany will be on the hook for a third of European losses—more than its formal share of just over a quarter, on the assumption that the other bailed-out states won’t be able to pay anything at all. That would cost Germany €90 billion, raising the bill (including the aid package) to almost €110 billion. On top of this taxpayers might have to stump up €10 billion to support German banks as they wrote off their claims on Greece. Assuming that the state picked up half the resulting losses, this would take the total German bill to nearly €120 billion, or 4.5% of GDP.

Going for broke

XIX. If that was that, it would be a bargain compared with the likely present value of transfers from Germany to Greece over the next few years and maybe decades. But there is a sizeable risk that a Grexit could turn into a calamity, as markets reacted badly to the admission that euro membership was no longer irreversible. At worst there could be a market collapse to rival the one that took place after the Lehman bankruptcy in late 2008, which could in turn trigger a recession on the scale of the desperate downturn of 2008-09. In the panic, you would come under intense pressure (Barack Obama would be on the line immediately) to concede debt mutualisation without getting the quid pro quo of fiscal control at a European level that you have been demanding. After holding out for so long against demands that you write a blank cheque, that is what you might well end up having to do.

XX. Given the risk that Germany might have to pay such a heavy price for a Greek exit, does that mean Plan B is a non-starter? Not necessarily. Another conclusion might be that the seemingly safer scenario of an exit by Greece alone is in fact the riskier option. If Germany is going to have to make big concessions to deal with the exit of one state, it might make more sense to make such concessions in conjunction with more radical surgery that really gets to grip with the euro crisis. Altogether, five out of the 17 member states have been rescued or asked for a bail-out—testimony to the fact that they have not been able to cope with the rigours of the single currency. The other four—first Ireland, then Portugal, and now Spain and Cyprus—are also teetering in the relegation zone. Expelling them too might be better for them, for the euro and for Germany, because it would make the remaining euro area more viable.

XXI. The plight of the other four economies reflects private debt (especially in Cyprus, Ireland and Spain) as much as public debt (which was clearly at fault in Greece and to a lesser extent in Portugal). But the fundamental weakness that they all now share with Greece is that they owe foreigners far more than they own abroad. In each of the five countries, external liabilities exceeded domestically owned foreign assets by between 80% and 100% of GDP in 2011, putting them in a league of their own within the euro area (see chart 2). Italy, by contrast, has low net external liabilities worth only 21% of GDP (lower than America’s 27%).

XXII. External-debt levels are far higher in the five countries than in emerging economies that have fallen victim to “sudden stops”, in which foreign investors and banks stop lending and try to pull out their money. Small wonder that the markets have lost confidence in them. But even though bail-out loans can shield governments, that loss of confidence continues to undermine the peripheral economies, as foreign deposits are withdrawn and foreign investors refuse to buy their debt. Central-bank funding is plugging the gap, but that makes banks worryingly beholden to the ECB, causing them to clamp down on their lending to firms and households. This squeezes the economy even more tightly and makes it harder to get the public finances in order.

XXIII. As well as being burdened by unsustainable levels of external debt, all five economies share the misery of trying to regain lost competitive ground through internal devaluation, in which domestic costs are ground down year after year. With the exception of Ireland, which has achieved a worthwhile reduction in its unit labour costs (though after the biggest rise of all), you could hardly select a group of countries less able to make a success of internal devaluation. Labour markets in southern Europe are notorious for protecting insiders (permanent workers) at the expense of outsiders (employees on temporary contracts or the unemployed). This rigidity means that firms cut their labour costs through hiring freezes and by sacking temporary employees, rather than by reducing pay rates.

XXIV. Some progress is being made, but as in a marathon, it is the second half of the race that is the most agonising. Unemployment has already risen to perilously high levels: around 15% of the workforce in Ireland and Portugal and 25% of the workforce in Spain. Ireland has been running a small current-account surplus and deficits have generally fallen (though they remain very high in Cyprus and Greece) but they would be far worse if the peripheral economies were not so depressed, which has slashed demand for imports.

XXV. What this suggests is that if Greece has to depart, it should not go alone. Like Greece, the other four bail-out countries would gain from the swift improvement in competitiveness that currency devaluations would achieve, provided credible policies were pursued to ensure it was not frittered away in runaway inflation. And if politics can trump the law for Greece, then the same should be true for all five countries, allowing them to stay in the EU and retain access to the single market.

XXVI. Such a move would of course come as a tremendous shock, and it would be essential to protect Italy and France at once by making far-reaching concessions that shift the remaining euro area towards mutualisation of debt and the creation of a banking union. But that would be less of a setback for Germany than before, because in principle there should be less need for burden-sharing in a more viable monetary union. Indeed, the most important potential benefit of this bigger break-up is that it could bring the euro crisis to a decisive end by restoring confidence in a smaller but sturdier single-currency area.

XXVII. In addition, a line would have been drawn under potentially much higher costs by preventing the bail-outs from becoming a permanent flow of transfers. This is what happened in Germany after reunification and is still happening. Recent research by the IMF shows that the flow of money to the poorer German states has created a form of benefit dependency. The German public’s big fear is the same outcome, writ large, across the euro area. For example, a transfer union across the existing single-currency zone based on the Canadian model would seek to make governments’ revenues more equal. Transferring cash so that the poorest governments (including Greece and Spain) had a level of revenue close to that of a mid-tier but still below-average country like Ireland could involve annual transfers of €250 billion—of which €80 billion would need to come from Germany, around 3% of its GDP.

XXVIII. In the short term, however, the cost of a five-country exit would clearly be much heavier than that of a Grexit. Although the other four departing states would be in a less desperate condition than Greece, they might also need some aid to smooth the way—a further €100 billion, say, of which Germany’s share would be €33 billion. The additional exposure through official loans would be bearable because the other four bail-outs were individually much smaller than Greece’s. Altogether euro-area governments have made commitments approaching €200 billion—the same as to Greece—but actual disbursements have been less than half that. The big exposure lies in the euro system. The ECB is estimated to hold an additional €80 billion of Irish, Portuguese and Spanish bonds bought over the past two years to calm markets. In addition, it has claims on the other four countries through the Target2 system of around €600 billion.

XXIX. That would bring the cost arising from an exit of all five countries to €1.15 trillion, of which Germany’s share would be €385 billion, or 15% of its GDP. The additional expense of bank bail-outs would increase this to €496 billion, or 19% of GDP, lifting German government debt from 81% of GDP in 2011 to 100% and imperilling Germany’s triple-A credit rating. German non-financial firms and individuals would also take a big hit on their claims of over €200 billion in the five economies.

XXX. The biggest risk associated with this scenario is that the moves towards debt mutualisation and a banking union might not, after all, be enough to stabilise the remaining euro area, resulting in a total break-up of the euro zone and triggering a savage recession with hugely damaging economic consequences. Markets invariably ask “who’s next?” and there is an obvious answer. Italy might not need to leave the euro on grounds of its net external liabilities, and its primary budget (ie, before interest payments) is under control. But its public-debt burden of 120% of GDP is the second-highest (after Greece’s) in the euro area. And it is mired in recession again. Like Greece, Italy has found it hard to live with the single currency. Growth has been dismal over the past decade (Mr Berlusconi was an economic calamity) and unit labour costs have risen sharply. The task of restoring Italian competitiveness would be far harder once the five departing economies had adopted new, much cheaper currencies.

XXXI. The more that markets fretted about Italy, the more they would also fret about France, given its strong trading and financial links with Italy. Given all this, it would be very difficult for Germany to get support in the European Council for this more drastic plan. The political obstacles to co-ordinating a solution that keeps the euro area intact may seem insuperable, but getting agreement for a planned ejection of five countries would be even more daunting.

Conclusion

XXXII. Of the two options, our judgment is that the larger break-up makes more overall economic sense than an exit of Greece alone. But we must emphasise that the economic and financial risks of it going wrong are much greater, and pushing it through would be an order of magnitude more difficult than co-ordinating an exit by Greece alone. Finally, a drawback associated with both options, even if they were to work, is that many of the benefits would lie in the future (by not having to make transfers to peripheral Europe) whereas the costs would be felt here and now—and blamed on you and your government.

A note attached to this memorandum by a member of her staff indicates that after reading it, Mrs Merkel thought long and hard about how to respond. She is a scientist by training, a politician by vocation and, most important of all, a cautious person by temperament. After much deliberation she concluded that despite the advantages of Plan B compared with her current strategy, she was unwilling to countenance the associated risks—at least for the moment. She ordered the memo to be shredded, resolving that if the euro area is to fragment, it will not be at her behest. But the staff member who was told to destroy the memo thought it might be useful to keep Plan B in reserve just in case. Plucking it from the shredder, he filed it away instead. No one need ever know that the German government had been willing to think the unthinkable. Unless, of course, the memo leaked…