|The Breakup of the Euro Area1
University of California, Berkeley
This version, October 2008
The possibility of the breakup of the euro area was already being mooted even before the single currency existed.2 These scenarios were then lent new life five or six years on, when appreciation of the euro against the dollar and problems of slow growth in various member states led politicians to blame the European Central Bank for disappointing economic performance.3 Highly-placed officials, including possibly members of the governing council of the German central bank, reportedly discussed the possibility that one or more participants might withdraw from the monetary union.4 How seriously should we take these scenarios? And how much should we care – how significant, in other words, would be the economic and political consequences?
The conclusion of the author is that it is unlikely that one or more members of the euro area will leave in the next ten years and that the total disintegration of the euro area is more unlikely still.5 The technical difficulties of reintroducing a national currency should not be minimized. Nor is it obvious that the economic problems of the participating member states can be significantly ameliorated by abandoning the euro, although neither can this possibility be dismissed. And even if there are immediate economic benefits, there may be longer-term economic costs, and political costs of an even more serious nature. Still, as Cohen (2000) puts it, “In a world of sovereign states….nothing can be regarded as truly irreversible.” Policy analysts should engage in contingency planning, even if the contingency in question has a low probability.
The remainder of this paper considers such scenarios in more detail. While it is widely argued that the technical and legal obstacles to a country unilaterally reintroducing its national currency are surmountable, it will be argued here that the associated difficulties could in fact be quite serious. To be sure, there are multiple historical examples of members of monetary unions introducing a national currency. It has also been suggested that the legal problems associated with the redenomination of contracts can be overcome, as they were when the ruble zone broke up or when Germany replaced the mark with the reichsmark in 1923-4. But changing from an old money to a new one is more complicated today than in Germany in the 1920s or the former Soviet Union in the 1990s. Computer code must be rewritten. Automatic teller machines must be reprogrammed. Advance planning will be required for the process to go smoothly, as was the case with the introduction of the physical euro in 2002. Moreover, abandoning the euro will presumably entail lengthy political debate and passage of a bill by a national parliament or legislature, also over an extended period of time. Meanwhile there will be an incentive for agents anticipating the redenomination of their claims into the national currency, followed by depreciation of the latter, to rush out of domestic banks and financial assets, precipitating a banking and financial collapse. Limiting the negative repercussions would be a major technical and policy challenge for a government contemplating abandonment of the euro.
The economic obstacles revolve around the question of how debt servicing costs, interest rates spreads, and interest-rate-sensitive forms of economic activity would respond to a country’s departure from the euro area.6 A widespread presumption is that departure from the euro area would be associated with a significant rise in spreads and debt-servicing costs. But further reflection suggests that the consequences will depend on why a country leaves (the defector could conceivably be a Germany concerned with politicization of ECB policy and inflationary bias rather than an Italy facing slow growth and an exploding public debt). They will depend on whether credible alternatives to the ECB and Stability Pact are put in place at the national level (whether national central bank independence is strengthened and credible fiscal reforms are adopted at the same time the exchange rate is reintroduced and depreciated). It seems likely that there would be economic costs but that these could be minimized by appropriate institutional reforms.
The political costs are likely to be particularly serious. The Treaty of European Union makes no provision for exit. Exit by one member would raise doubts about the future of the monetary union and likely precipitate a further shift out of euro-denominated assets, which would not please the remaining members. It might damage the balance sheets of banks in other countries with investments in the one abandoning the euro. Diplomatic tension and political acrimony would follow, and cooperation on non-monetary issues would suffer. The defector would be relegated to second-tier status in intra-European discussions of nonmonetary issues. And, insofar as they attach value to their participation in this larger process of European integration, incumbents will be reluctant to leave.
The paper starts by describing scenarios, revolving around high unemployment and high inflation, under which euro-area participants may wish to leave. The immediately subsequent sections then evaluate the economic, political, procedural and legal obstacles to doing so. An empirical section provides evidence on the realism of the exit scenarios using survey data from Eurobarometer, and on the economic barriers using data on the impact of euro adoption on commercial credit ratings. Following that is discussion of reforms that might attenuate dissatisfaction with the operation of the single currency. A coda immediately preceding the conclusion discusses the implications of the 2008 financial crisis in Europe for the arguments of this paper.
Different countries could abandon the euro for different reasons. One can imagine a country like Portugal, suffering from high labor costs and chronic slow growth, reintroducing the escudo in the effort to engineer a sharp real depreciation and export its way back to full employment. Alternatively, one can imagine a country like Germany, upset that the ECB has come under pressure from governments to relax its commitment to price stability, reintroducing the deutschemark in order to avoid excessive inflation.
These different scenarios would have different implications for whether defection implies breakup – that is, for whether one country’s leaving reduces the incentive for others to remain. In the case of Portuguese defection the residual members might suffer a further loss of export competitiveness, while in the event of German exit they might find their competitiveness enhanced. Specifically, if other countries are similarly experiencing high unemployment associated with inadequate international competitiveness, then Portugal’s leaving will aggravate the pain felt by the others and may lead them to follow suit – but Germany’s leaving may have no or even the opposite effect. Similarly, if discomfort with the inflationary stance of ECB policy is shared by other countries, then Germany’s leaving, by removing one voice and vote for price stability, may heighten the incentive for others to do likewise.
More generally, if the country that leaves is an outlier in terms of its preferences over central bank policy, then its defection might better enable the remaining participants to secure an ECB policy more to their liking, in which case the likelihood of further defection and general breakup would be reduced. Disagreements over the stance of policy being an obvious reason why a participating member state would be disaffected, one might think that the defector would automatically be an outlier in terms of its preferences over central bank policy. But this is by no means certain: countries whose preferences differ insignificantly from those of other members could choose to defect for other reasons, for example in response to an exceptionally severe asymmetric shock, or because of disagreements over non-economic issues.7
And if the country that leaves is small, this would be unlikely to much affect the incentives of other members to continue operating a monetary union that is valued primarily for its corollary benefits. The contribution of the euro to enhancing price stability would not be significantly diminished by the defection of one small member.8 The impetus for financial deepening ascribed to the single currency would not be significantly diminished.9 If Portugal left the euro area, in other words, would the other members notice? Even if it used its monetary autonomy to engineer a substantial real depreciation, would its euro-area neighbors experience a significant loss of competitiveness and feel serious pain?
If, on the other hand, Germany defected, the size of the euro area would decline by more than a quarter. This would imply significant diminution of the scale of the market over which the benefits of the euro were felt in terms of increased price transparency and financial deepening. Countries balancing these benefits against the costs of being denied their optimal national monetary policy might find themselves tipped against membership. Defection by a few could then result in general disintegration.
In practice, a variety of asymmetric shocks could slow growth and raise unemployment in a euro area member state and create pressure for a real depreciation. The shocks that have attracted the most attention are those highlighted in Blanchard’s model of rotating slumps (Blanchard 2006). The advent of the euro has brought credibility benefits to members whose commitment to price stability was previously least firm and where interest rates were previously high.10 Enhanced expectations of price stability have brought down domestic interest rates, bidding up bond, stock and housing prices. Foreign capital has flooded in to take advantage of this convergence play. The cost of capital having declined, investment rises in the short run. Households feeling positive wealth effects, consumption rises as well. The capital inflow has as its counterpart a current account deficit. In the short run the result is an economic boom, driven first and foremost by residential construction, with falling unemployment and rising wages.
But once the capital stock adjusts to the higher levels implied by the lower cost of capital, the boom comes to an end. Unless the increase in capital stock significantly raises labor productivity (which is unlikely insofar as much of the preceding period’s investment took the form of residential construction), the result is a loss of cost competitiveness. The country then faces slow growth, chronic high unemployment and grinding deflation, as weak labor market conditions force wages to fall relative to those prevailing elsewhere in the euro area. The temptation, then, is to leave the euro zone so that monetary policy can be used to reverse the erosion of competitiveness with a “healthy” dose of inflation.
This particular scenario has attracted attention because it suggests that the tensions that could eventually result in defections from the euro area are intrinsic to the operation of the monetary union. It suggests that the intra-euro-area divergences that are their source are direct consequences of the monetary union’s operation. This story tracks the experience of Portugal since the mid-1990s – first boom, then overvaluation, and finally slump. There are signs of similar problems in Italy, where the difficulties caused by slow growth are compounded by the existence of a heavy public debt, and in Spain, which experienced many of the same dynamics as Portugal. The implication is that Greece and Slovenia (and future EMU members like Estonia and Latvia) will then follow.11
3. Economic Barriers to Exit
But would reintroducing the national currency and following with a sharp depreciation against the euro in fact help to solve these countries’ competitiveness and debt problems? The presumption in much of the literature is negative.12 A country like Italy where slow growth combined with high inherited debt/GDP ratios to raise the specter of debt unsustainability (that it would become necessary to restructure the debt or for taxpayers and transfer recipients to make inconceivable sacrifices) might be tempted to reintroduce the lira as a way of securing a more inflationary monetary policy and depreciating away the value of the debt; but doing so would result in credit-rating downgrades, higher sovereign spreads and an increase in interest costs, as investors anticipate and react to the government’s actions. A country like Portugal where high real wages combine with the absence of exchange rate independence to produce chronic high unemployment might be tempted to reintroduce the escudo as a way of securing a more expansionary monetary policy and pushing down labor costs; but doing so will only result in higher wage inflation, as workers anticipate and react to the government’s actions. Estimates in Blanchard (2006) suggest that Portugal would require a 25 per cent real depreciation in order to restore its competitiveness.13 It is not clear if the government sought to engineer this through a substantial nominal depreciation that workers would look the other way. Observers pointing to these effects conclude that exiting might not be especially beneficial for a country with high debts or high unemployment. To the contrary, the principal obstacle to exiting the euro area in this view is that doing so may have significant economic costs.
Yet one can also imagine circumstances in which reintroducing the national currency might constitute a useful treatment. Assume that Portuguese workers are prepared to accept a reduction in their real wages but confront a coordination problem: they are willing to accept a reduction only if other workers or unions accept a reduction, perhaps because they care about relative wages.14 Under these circumstances there will be a reluctance to move first, and wage adjustment will be suboptimally slow. Then a monetary-cum-exchange-rate policy that jumps up the price level, reducing real wages across the board, may be welfare enhancing; this is the so-called “daylight savings time” argument for a flexible exchange rate. Importantly, in the circumstances described here there will be no incentive for individual workers or unions to push for higher wages to offset the increase in prices. The lower real wages obtained as a result of depreciating the newly-reintroduced currency deliver the economy to the same full employment equilibrium that would have resulted from years of grinding deflation, only faster.
Note the assumption here: that whatever caused real wages to get out of line in the first place is not intrinsic to the economy, so that the problem will not recur. Thus, the Portuguese example contemplated here is described under the assumption that real wages have fallen out of line for reasons extrinsic to the operation of the economy – for example, irrational exuberance on the part of workers in the run-up to Stage III of the Maastricht process, something that will not recur. If, on the other hand, real wages are too high because of the existence of domestic distortions, for example the presence of powerful trade unions that exclusively value the welfare of their employed members, then it is implausible that a different monetary-cum-exchange-rate policy will have an enduring impact.
There are similar counterarguments to the view that a country like Italy that reintroduced the lira in order to pursue a monetary-cum-exchange-rate policy that stepped down the value of the debt would necessarily be penalized with lower credit ratings and higher debt-servicing costs. Sovereign debt is a contingent claim; when debt is rendered unsustainable by shocks not of the government’s own making and the source of those shocks can be verified independently, there are theoretical arguments for why investors will see a write-down as excusable.15 Even when the country’s debt problem is of its own making, credible institutional and policy reforms – strict legal or constitutional limits on future budget deficits, stronger independence to insulate the central bank from pressure to help finance future debts – may reassure the markets that past losses will not recur. The fact that the debt burden has been lightened similarly makes it look less likely that prior problems will be repeated. There is ample evidence from history that governments that default, either explicitly by restructuring or implicitly by inflating, are able to regain market access following appropriate institutional and policy reforms. The mixed findings of studies seeking to identify a reputational penalty in the form of higher interest rates are consistent with the view that this penalty can be avoided by countries that follow up with institutional and policy reforms reassuring investors that the experience will not be repeated. The implication is that the cost in terms of reputation may not be a prohibitive barrier to exit.
How applicable is this scenario to countries like Italy? It is hard to argue that Italy’s heavy debt burden is due to factors not of its own making. Italy does not have a reassuring history of guarding the central bank’s independence or of adopting budgetary procedures and institutions that limit free-rider and common-pool problems. Whether exiting the euro area and reintroducing the lira would therefore result in credit-rating downgrades and increases in spreads sufficient to deter any such decision is an empirical question.16
The other economic barrier to exit cited in this connection is that a country that abandoned the euro and reintroduced its national currency might be denied the privileges of the single market. A country that reintroduced its national currency at levels that stepped down its labor costs by 20 per cent might be required to pay a 20 per cent compensatory duty when exporting to other members of the EU, reflecting concerns that it was unfairly manipulating its currency and solving its economic problems at the expense of its neighbors. Whatever the compensatory tariff, collecting it would require the reestablishment of customs posts and border controls, adding to transactions costs. Other states might seek to tax foreign investment outflows on the grounds that the defector was using an unfair monetary-cum-exchange-rate policy to attract FDI. In this climate of ill will and recrimination, they might seek to limit the freedom of movement of its citizens.
But it is not clear that other member states could or would respond in this way. Sweden, Denmark, the United Kingdom and all but one of the new member states have their own national currencies, yet they are not denied the privileges of the single market. If Germany, Italy or Portugal decided to join their ranks, it is not clear that it could be treated any differently under European law. To be sure, the UK, Sweden, the Czech Republic, Hungary and Poland do not presently participate in the ERM-II, and therefore there are no formal restrictions on the currencies’ fluctuation. It can be objected that these countries anchor their monetary policies by inflation targeting, which frees them of accusations that they are manipulating their currencies relative to the euro. But a country like Germany that left the euro area out of dissatisfaction with the ECB’s inflationary bias would presumably do likewise.17 Even a country abandoning the euro because it saw a need to step up the price level as a way of addressing debt and unemployment problems might then adopt inflation targeting as a way of avoiding reputational damage. In turn this could insulate it from accusations that it was continuing to manipulate its currency. Countries can remain EU member states in good standing and enjoy all the privileges associated with that status without adopting the euro. To be sure, most of the new members have not adopted the euro because they do not yet meet the preconditions laid down by the Maastricht Treaty, where there is a presumption that this status is purely transitional. The UK, for its part, negotiated a derogation permitting it to remain outside the ERM and to retain sterling indefinitely as a condition for agreeing to the Maastricht Treaty. An Italy or Portugal that abandoned the euro would enjoy no such derogation. Would it then have to joint the ERM-II? But Sweden, alluding to the British precedent, announced unilaterally that it would not enter the ERM or follow a fixed schedule for adopting the euro. Is it clear that a Sweden that never entered the euro area should be treated differently, in terms of its access to the single market, than an Italy that left it?
4. Political Barriers to Exit
More generally, a country that abandoned the euro and reintroduced its national currency because of problems of inadequate international competitiveness, high unemployment and slow growth might suffer political costs by being relegated to second-class status in negotiations over other issues. One interpretation of the process of monetary integration that culminated in the advent of the euro is that monetary integration is a stepping stone to political integration, which is the ultimate goal of the architects of the European Union. As the point was once put by Jacques Delors, “Obsession about budgetary constraints means that the people forget too often about the political objectives of European construction. The argument in favor of the single currency should be based on the desire to live together in peace.”18 Like the EU’s blue flag with 12 yellow stars, the single currency is a visible symbol which fosters a sense of Europeanness among the continent’s residents. As suggested by the theory of neofunctionalist spillovers (Haas 1958), the existence of the euro and the European Central Bank generates pressure for a more powerful European Parliament to hold the ECB democratically accountable for its actions.19 A country that unilaterally abandons the euro, something for which there is no provision in the Treaty of European Union, would deal a setback to these larger political ambitions. It would signal that it did not attach high value to the larger process of political integration.
On both grounds such a country would be unlikely to be regarded as a respected interlocutor in discussions of how to push the process forward. An Italy that abandoned the euro would have a diminished role in discussions of how to strengthen the powers of the European Parliament. It would have less sway in discussions of how to revise and ratify the European constitution. Other member states would be less likely to grant it a seat at the table in discussions of whether to formulate a common foreign policy or to create a European army. For better or worse, the common European position on such issues has grown out of discussions among a core of countries centered on France and Germany that first develop a common position and then sell it to the other members. For a country like Italy that has participated in this larger process of European integration from the foundation of the European Economic Community half a century ago, precisely as a way of elevating itself to the status of a “first-tier” European country, these political costs would be substantial. In turn this constitutes a major barrier to exit.
What about Germany? If Germany abandoned the euro out of dissatisfaction with excessively inflationary ECB policies, this would significantly diminish the prospects for political integration. Germany would be indicating that it regarded the experiment with a supra-national institution with real powers, in this case the power to make monetary policy, as a failure. The idea that Germany would then cede to other supra-national institutions at the EU level the power to make its security policy, its foreign policy or its fiscal policy, these being three of the key prerogatives of a sovereign state, would become less plausible. Germany has always been a strong proponent of the larger European project. Reflecting memories of World War II, it continues to feel limits on its ability to formulate an assertive foreign policy, maintain a standing army, and deploy troops abroad; at a basic level its interest in political integration is to regain a foreign policy voice in the context of an EU foreign policy. And without German support, European political integration is unlikely to display the same momentum.
Given this, Germany will presumably attempt to fix the problems it perceives with the ECB in order to salvage its vision of political integration rather than concluding that further integration is infeasible and abandoning the euro – or at least that it will invest more in seeking to fix perceived problems than another member state with a weaker commitment to the larger European process. It will choose voice and loyalty over exit, complaining publicly about the inflationary stance of ECB policy and lobbying to change it, precisely in order to demonstrate that supra-national European institutions can work and that its integrationist vision is still viable. This is not to deny that there could come a point where the German government and its constituents conclude that voice and loyalty have failed. But this argument does suggest that Germany may be prepared to suffer with a monetary policy not to its liking, and that it will work to change that policy rather than abandoning the euro, for longer than other member states less committed to the larger process.
Not everyone will agree that a monetary union process that adds to momentum for political integration is desirable on these grounds. Some would argue that the EU should concentrate on economic integration while shunning aspirations of political integration. For them, if a failure of monetary union means a failure of political union, then the latter is not a cost.20 But for influential political elites, political integration remains a valued goal. For them, exits from the euro area that set back its progress would be a significant cost.