Currency disunion

Why Europe’s leaders should think the unthinkable

The Economist, April 7^th, 2012

The Irish left the sterling zone. The Balts escaped from the rouble. The Czechs and Slovaks left each other. History is littered with currency unions that broke up. Why not the euro? Had its fathers foreseen turmoil, they might never have embarked on currency union, at least not with today’s flawed design.

The founders of the euro thought they were forging a rival to the American dollar. Instead they recreated a version of the gold standard abandoned by their predecessors long ago. Unable to devalue their currencies, struggling euro countries are trying to regain competitiveness by “internal devaluation”, ie, pushing down wages and prices. That hurts: unemployment in Greece and Spain is above 20%. And resentment is deepening among creditors. So why not release the yoke? The treaties may declare the euro “irrevocable”, but treaties can be changed. A taboo was broken last year when Germany and France threatened to eject Greece after it proposed a referendum on new bail–out terms.

One reason the euro holds together is fear of financial and economic chaos on an unprecedented scale. Another is the impulse to defend the decades–long political investment in the European project. So, despite many bitter words, Greece has a second rescue. Its departure from the euro, Angela Merkel, Germany’s chancellor, now says, would be “catastrophic”. Yet Mrs Merkel is not ready to take the action needed to stabilise the euro once and for all. Last week’s decision to boost the euro’s firewall to “€800 billion” ($1.07 trillion) is less than meets the eye; the real lending power will be €500 billion. And there is no prospect, for now, of mutualising any part of the sovereign debt.

So the euro zone remains vulnerable to new shocks. Markets still worry about the risk of sovereign defaults, and of a partial or total collapse of the euro. Common sense suggests that leaders should think about how to manage a break–up. Some may be doing so. But having described a split as bringing economic Armageddon, leaders dare not be seen planning for it.

Instead, the most open thinking is being promoted by a British think–tank close to the Eurosceptic Conservative Party. This week Policy Exchange announced a shortlist of five contestants for a £250,000 ($400,000) prize for the best plan to manage a break–up of the euro. It may be a sign of the magnitude of the task that the organisers did not declare a winner; instead they asked those on the shortlist to do more work and resubmit their ideas. (A cartoon produced by an 11–year–old Dutch boy won a €100 voucher.)

One of the five entries, by Jonathan Tepper, lists 69 currency break–ups in the past century. Most have not led to long–term damage, he says. In fact, leaving the euro would help troubled countries recover quickly. Drawing on the demise of the Austro–Hungarian empire, among others, Mr Tepper sketches out a scenario for the departure of the likes of Greece. A surprise announcement is made over a weekend, and all deposits are redenominated in new drachmas while banks are kept shut. Capital controls are imposed to prevent the flight of money abroad. For cash, Greeks at first use existing euro banknotes defaced with ink or a stamp. These are withdrawn as drachma notes are printed. Border checks restrict the export of unstamped euro notes. Financial institutions are given time to update software.

The real problem with the euro, says Mr Tepper, is the fact that many countries face large imbalances and high debts. Devaluation for Greece would increase the burden of euro–denominated debt. This would be alleviated by converting bonds issued under Greek law to drachmas. Foreign–law bonds would be restructured. Indeed, says Mr Tepper, default is essential to recovery.

His formula might be summed up by three Ds: depart, default and devalue. Roger Bootle, another shortlisted entrant, says it might be better to start with the departure of Germany and other strong countries. But however it happens, any fragmentation will create winners and losers, with many bankruptcies and legal nightmares. Anybody involved in cross–border activity will find that their assets and liabilities change value. Neil Record says the sums involved would be so large, and the litigation so ruinous, that the best option would be to abolish the euro as soon as one country leaves, so as to invalidate all euro contracts.

Unlike Mr Record, who favours secrecy, in their paper Jens Nordvig and Nick Firoozye argue that open contingency planning would reduce uncertainty. They reckon there may be a total of €30 trillion–worth of cross–border exposure under foreign law, including bonds, loans, derivatives and swaps. Disruption, they say, could be minimised by converting all euro contracts to a modified form of the European Currency Unit, the basket of national currencies that preceded the euro. Catherine Dobbs, the final entrant, proposes to unscramble the omelette by splitting the euro into two (or more) zones: “yolk” and “white”. All euros in all countries would be converted into a fixed combination of the two. Savers would be protected, initially at least, and capital flight to other euro–zone countries would be deterred. Over time, the weaker yolk would devalue against the stronger white.

Plan ahead

The fate of the euro will probably be determined by politics as much as economics. A debtor state may tire of internal devaluation. A creditor may want to stop supporting others. And any one of the euro’s 17 members may balk at the loss of sovereignty involved in saving the currency. But the worst outcome of a euro split would be a chaotic breakdown. An orderly process increases the chance that it might be possible to salvage from the wreckage other gains of European integration, notably the single market.

So euro–zone governments need to think the unthinkable. No self–respecting general would refuse to plan for a predictable war, no matter how much he dislikes the idea of fighting it.

Still sickly: The euro zone’s illness is returning

The German problem (again)

The Economist, March 31^st, 2012

When the editors of the German tabloid Bild met Mario Draghi recently they gave him a Pic kelhaube —a spiked helmet— to remind the Italian that they had last year depicted him in Prussian garb as the most Germanic of candidates to run the European Central Bank. It may come in useful: hardliners are taking shots at Mr Draghi for spraying banks with €1 trillion ($1.3 trillion) of cheap money. This “powerful drug” may have side–effects, he says, but it works: “The worst is over” for the euro zone.

Don’t be so sure. The fever has been rising again in Spain after the government wildly overshot its deficit target last year. The Italian prime minister, Mario Monti, expressed alarm (which he later withdrew) that the Spanish illness might harm his own country’s convalescence. Portugal and Ireland are in recession, and may need second bail–outs; Greece will probably require a third rescue (and the restructuring of official debt).

As fear returns, so have calls to boost the euro zone’s rescue funds. “The mother of all firewalls should be in place, strong enough, broad enough, deep enough, tall enough—just big,” says Ángel Gurría, secretary–general of the OECD, the rich–world think–tank. But Germany prefers a slow, incremental response. The latest signal is that it will agree, at a meeting of finance ministers in Copenhagen on March 30th and 31st, to raise the firewall somewhat. The temporary rescue fund, the European Financial Stability Facility (EFSF), would be allowed to overlap with the permanent new European Stability Mechanism (ESM), which is to be activated this summer. By combining the two funds, perhaps only for a year, the lending capacity could be raised from €500 billion to about €740 billion.

This may be enough to persuade the Chinese, the Americans and others to allow the IMF to increase its resources, so helping the defences, but it is hardly the overwhelming force Mr Gurría seeks. Germany worries that reducing the pressure on weak states will lead to complacency. “The Germans think that the only way to make countries reform is to dangle them out of the window,” says one diplomat. “This only reinforces the belief in the markets that the euro zone is on the edge of disaster.”

One worrying sign for Germany was Spain’s partly successful attempt to loosen its deficit target this year. Another is growing trouble over the “fiscal compact”, a treaty signed by 25 European Union countries to toughen budget discipline. Ireland, with a history of awkward votes on EU treaties, holds a referendum on May 31st. The Socialist front–runner in the French presidential election, François Hollande, wants to renegotiate the deal to include more focus on growth. Germany’s opposition Social Democrats are making similar noises. In the Netherlands the opposition Labour Party—which is supposed to support the minority government on European issues—threatens to block ratification if the government imposes austerity to meet next year’s deficit target of 3% of GDP. (Ill–disciplined countries that have received a tongue–lashing from the Dutch are savouring the irony.)

Even assuming all these difficulties are resolved, the fate of the euro will remain uncertain. Raising the firewall and ratifying the compact will address only some of the symptoms. A cure requires “treating the whole patient”, as set out recently in a clear–eyed paper by Jay Shambaugh for Brookings, an American think–tank. It says the euro zone is afflicted by three ills: a banking crisis, a sovereign–debt crisis and a growth crisis. Dealing with one often makes the others worse.

A big problem is that the euro zone is only partly integrated. Its members have given up economic tools, such as currency devaluation and monetary policy, yet lack “federal” instruments to cope with shocks. The problem is not so much the budget deficit (though Greece was certainly profligate) as the net foreign borrowing by all actors, public and private (say to finance a trade deficit). The euro zone has only small internal transfers, and its workers tend not to move far for work. Fiscal stimulus is impossible for most governments, given their indebtedness. Structural reforms to promote growth can take years to work.

So redressing the imbalances must come through “internal devaluation”: bringing down real wages and prices relative to competitors. This was easier before 1991, when inflation around the world was higher, but has rarely been achieved since then (Hong Kong is one exception). With the ECB determined to keep inflation at around 2%, internal devaluation brings severe recession, even depression. And falling GDP wrecks the debt ratio.

Mr Shambaugh offers some advice. Deficit countries could cut payroll taxes to reduce labour costs and raise VAT to discourage imports; the effect would be magnified if surplus states did the opposite. Germany could help by stimulating its economy, or at least slowing down its budget consolidation. The ECB could let inflation run higher, especially in Germany, and could declare that it stands fully behind solvent sovereigns. The EFSF/ESM could recapitalise weak banks. A Europe–wide bank–deposit insurance scheme would help. Mutualising part of the national debts would create a risk–free European asset.

The German problem (again)

All these options ultimately run into the same obstacle: Germany. It does not want to bear bigger liabilities, it wants to set an example of budget discipline, it refuses to compromise its competitiveness, it is allergic to inflation, it does not want the ECB to print money and it thinks Eurobonds create moral hazard.

There is little sign that the chancellor, Angela Merkel, is ready to do much beyond tweaking the firewall and pushing through the fiscal compact. She talks of a future “political union”. If she really wants to save the euro, she will have to put on a Pick elhaube and lead the way to greater fiscal federalism.